Inflation expectations are still overly optimistic. A painful correction is coming.

Even as the Fed has reaffirmed its tough stance on inflation in the latest FOMC meeting, some investors still remain hopeful that inflation will fall to 2% quickly in the months ahead, allowing the Fed to cut rates as the economy slows. The one-year breakeven inflation rate – a market-based measure of expected inflation – currently suggests that investors are betting that the consumer price index (CPI) will rise by about 3.1% over the next 12 months. However, as the Fed’s preferred inflation gauge is the PCE price index, which grows more slowly than CPI, investors’ expectations imply the central bank will be able to bring inflation down to near its 2% target by early 2024.

This is still overly optimistic. As inflation slows, it will get harder to fight.

As we have been highlighting in our research articles since 2022, we expect inflation to take much longer than what markets are currently expecting to come down to 2%. We continue to hold this view. While inflation has indeed moderated in recent times, it remains a long way from the Fed’s 2% target.

There are reasons to believe that the Fed will struggle to achieve its inflation goal.

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Labour market remains incredibly tight

For a start, there is still a continued scarcity of workers in the labour market.

This has been underscored by January’s jobs report, which painted a picture of an incredibly robust labour market, with nonfarm payrolls increasing to 517,000, up from 260,000 jobs in December. The latest reading was also more than double the 189,000 increase expected by economists. Meanwhile, the unemployment rate fell to 3.4% – its lowest level since 1969 – indicating that the economy is still running hot despite the Fed's most aggressive monetary policy tightening since the 1980s. There are now close to two vacancies for every person currently registered as unemployed (Chart 1).

Chart 1: Demand for labour in the US remains high

That appears puzzling, given the recent stream of high-profile layoffs, particularly in the technology sector, with big names from Amazon, Meta, and Microsoft announcing tens of thousands of job cuts over the past few months. Companies in the financial sector, including Goldman Sachs and Morgan Stanley, have also been letting go of their workers.

Yet, the recent increase in layoffs has been more than offset by a jobs boom in the services sector, particularly in private education, health services, and leisure and hospitality. Together, these service industries have added 1.1 million jobs over the past six months, accounting for nearly 60% of all private-sector job gains during that time. In comparison, the tech-heavy information sector, which recorded a second straight month of job losses, only makes up 2% of all private-sector jobs.

Meanwhile, the strength in labour demand has occurred alongside the weakness in labour supply. The labour force participation rate remains below pre-Covid levels (Chart 2), with the more than 2 million workers that left the labour force during the pandemic having yet to re-join. They may never return due to Covid-related deaths, early retirements, and a broader decline in immigration. In the longer term, slowing population growth and an ageing population will further constrain labour supply.

Chart 2: Labour force participation rate remains below pre-Covid levels

This lack of labour supply is likely to force many business owners to increase wages in order to maintain competitive compensation and retain workers. Last month, Walmart – the largest private employer in the US – announced its second wage hike in six months, raising its minimum wage from a range of USD 12-18 an hour to USD 14-19 an hour, as it seeks to attract and retain employees in a tight domestic labour market. Furthermore, with more than half of US states announcing minimum wage hikes of around 7-8% for 2023, wage growth could start to pick up again.

Even amongst businesses that have not raised their wages in recent times, some have resorted to reducing their operating hours instead, such as CVS Health and Walgreens, both of which have shortened their working hours in order to cope with a pharmacist shortage. The resulting cost pressures from lower productivity could force businesses to raise prices, further pushing up inflation.

For as long as labour market tightness persists, wage growth is likely to remain strong going forward. With labour costs accounting for about two-thirds of the CPI, a tight labour market could continue to exert upward pressure on inflation.

Disinflation does not happen in straight line

Furthermore, the drivers of the recent disinflationary episode could be themselves transitory.

Take used car prices, for example. The prices of used cars, which surged to record levels earlier last year as a result of pandemic-related disruptions to new car supply chains, have been falling steadily and steeply, a major factor in the slowing of inflation. That could be about to change. According to industry data (Chart 3), wholesale prices for used cars being sold at auctions jumped 4.1% for the first 15 days of February compared with the level for all of January, the largest gain since October 2021.

This is likely due to the strong labour market, which has been driving demand for used cars. With higher wholesale prices for used cars, higher retail prices are likely to be close behind, making it more difficult for the Fed to bring inflation down.

Chart 3: Wholesale used car prices are on the rise again

Another worrying possibility is further shocks to commodity markets.

While energy prices have been falling in recent times, contributing to the current bout of disinflation, there are no assurances that energy prices will remain where they are throughout 2023, particularly as China reopens its economy. China is the world’s largest crude oil importer. Based on estimates by Goldman Sachs, China’s reopening from its Covid-19 restrictions could boost oil demand by at least 1 million barrels per day, boosting oil prices by roughly USD 15 per barrel. If international travel recovers more rapidly, prices could rise even further.

It is also worth noting that China consumes almost one-fifth of the world’s oil, over half of refined copper, nickel and zinc, and more than three-fifths of iron ore. It is also the world’s largest consumer of agricultural goods. With China’s economy under lockdowns for most parts of 2022, a reopening could accelerate upward momentum for demand and prices of commodities.

Furthermore, the impact of goods disinflation could start to recede as the base effect washes through. As inflation is measured year-on-year, the easing of pandemic-induced supply chain disruptions will no longer act as a disinflationary force at some point if the prices of physical goods stop falling.

Our bottom line is this: inflation never goes down in a straight line. It is now so broad-based that any unexpected supply shocks or unforeseen developments could trigger another inflationary surge.

Markets are wrong about Fed pivot. A painful correction could be coming.

In case anyone thought that inflation would be easy to control, here is some bad news: based on historical data, inflation across advanced economies has taken an average of 10 years to return to 2% once it breaks above 5%, according to Bank of America. In a similar study conducted by VanEck, inflation took a whopping 18 years to moderate to 2% once it breaches 5%. Either way, inflation has taken an awfully long time to come down. Rarely has inflation fallen that much, so quickly. Even if it did, the process was not without pain.

As such, markets are likely wrong about a Fed pivot.

Given our belief that investors are likely underestimating the persistence of inflation, we expect rates to remain at their peak level for an extended period of time. A rate cut this year is out of the question. Our views are also largely aligned with the Fed’s messaging: it, too, does not expect any rate cuts in 2023. In the words of Jerome Powell, “given our outlook, I don’t see us cutting rates this year”.

There is, however, still a disconnect between what the Fed says it will do, and what markets expect the Fed to do this year. While the Fed has been clear that a Fed pivot is not on the horizon, investors are still pricing in rate cuts. According to the Fed funds futures market, which reflects market expectations for future interest rate changes by the central bank, markets are expecting the Fed to bring its policy rate to a peak of 5.00%-5.25%, before cutting in September (Chart 4).

Chart 4: Markets are still expecting the Fed to cut rates in September

For investors who are still harbouring hopes of a Fed pivot this year, it is time to ditch them. At this point, we believe it is foolhardy to think the Fed will cut interest rates this year given the tightness of the labour market. It is unlikely that the central bank will be able to bring inflation back to 2% without tipping the economy into a major downturn.

When markets finally come to the realisation that inflation will be more persistent than expected, and that a Fed pivot is far from certain, there could be a sharp market correction, especially in riskier assets that have done a lot better this year. We also expect long-term yields to move up further.

Adopt a more defensive portfolio positioning

Buckle up, the world could be headed for a stagflationary environment characterised by slow growth and persistently high inflation. As such, we believe it is prudent for investors to adopt a more defensive positioning in their portfolios.

At the asset class level, we have a preference for fixed income over equities, as we are starting to see attractive value emerging within this asset class. Fixed income assets have never been more attractive in more than a decade. Following the sharp sell-off last year, global bond yields have climbed to their highest levels since the global financial crisis. 

Furthermore, the valuations of bonds have turned much more attractive as compared to equities, as seen from the tightening spread between earnings and bond yields (Chart 5). The spread has reached 2.5%, which is one of its lowest points on the record and is also about two standard deviations below the long-term average since 2009. This implies that investors are currently not adequately compensated for the risks that they are taking in equity markets. Besides, if the global economy does slide into a recession, there could be further downside risks to earnings estimates and profit margins.

Chart 5: Fixed income has become increasingly more attractive compared to equities

With fixed income, our preference is for short-duration bonds as short-term bond yields have moved significantly higher as compared to long-term yields, implying that investors can receive alluring yields without having to take on greater duration risk. Given our view that markets are underestimating the persistence of inflation, we see the potential for long-term yields to move up further. An unconstrained bond strategy is also viable as it allows for better management of interest rate risk in this tough environment.

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Within equities, we prefer the US and Japan. Furthermore, given our expectations that inflation is likely going to be higher for longer, value stocks and commodity-linked equities will be amongst the winners. Investors could also consider ASEAN equities for their supplementary portfolios, as the region is poised to benefit from the shift of production away from China.

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Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.