- While overall inflation has moderated meaningfully in recent months, core inflation continues to remain sticky, driven by a tight labour market and elevated shelter costs.
- Investors are likely underestimating the persistence of inflation. We do not expect to see any rate cuts in 2024 as inflation remains sticky.
- Inflation is hard to tame, and previous high inflationary regimes suggest that inflation across advanced economies has taken an average of more than 10 years to return to 2% once it breaks above 5%.
- Structural factors and changes to the global economy also imply that inflation will be higher for the longer-term. Decarbonisation, increased government spending, and deglobalisation are factors which will add to long-term inflationary pressures.
- With inflation expected to remain higher for longer, we continue to prefer short-duration bonds within fixed income. For equities, we have a preference for quality companies and commodity-related stocks.
2023 will likely be remembered as a year marked by economic resilience. Despite facing numerous growth headwinds created by high inflation and interest rates, the global economy continues to expand. In particular, the US economy has continued to defy recessionary fears, and even expanding at an annualised rate of 5.2% in the third quarter, revised up from the previously reported 4.9%.
As the US economy continues to remain resilient, we believe that inflation may prove stubborn. With this in mind, investors should brace themselves for an extended period of higher inflation and higher interest rates. We do not expect to see any rate cuts in 2024, and think that that long-term inflation may settle at 4% given structural changes to the global economy.
The Fed is unlikely to cut interest rates so soon as core inflation remains sticky
US headline inflation marginally slowed in November, falling from 3.2% in October to 3.1% in November on the back of a decline in gasoline prices. Core inflation on the other hand, which strips out the highly volatile food and energy components, and is seen by economists as a better predictor of future inflation has increased by 0.3% in November from the previous month, and witnessed a 4.0% year-on-year (YoY) increase (Figure 1).
Figure 1: US inflation data
continues to show sticky inflation
A main culprit behind high core inflation is that of services. The persistent stickiness in this wage-sensitive area reaffirms our view that despite the significant progress on inflation, the labour market still needs to cool further.
As it stands, the labour market remains tight, marked by strong wage growth and continued scarcity of workers in the market. For instance, the Atlanta Fed’s wage growth tracker, which measures the nominal YoY wage growth of all individuals, was 5.2% higher than a year ago (Figure 2). Moreover, there are also more than 1.5 unfilled positions for every job seeker, indicating the imbalance between labor demand and supply (Figure 3).
Figure 2: Wage growth remains uncomfortably high
Figure 3: Demand for labour in the US remains high 
Figure 4: Markets are expecting the Fed to cut rates in early 2024
Figure 5: One-year Treasury breakeven inflation
rate
We think that this scenario is too optimistic, as inflation remains sticky. Despite the Fed officials penciling in at least three rate cuts in 2024, we think it could endanger their progress in fighting inflation if done too soon. It is unlikely that inflation and economic growth will decelerate as smoothly as the Fed’s forecasts imply. Not to mention, Federal Reserve Chairman Jerome Powell has even said officials are prepared to hike again if price pressures return.
Previous high inflationary regimes suggest inflation will stay higher for much longer
We know from previous experiences that after a period of high inflation, it can take several years for inflation to fall back to low levels due to second-round effects, such as wage-price spirals (where higher wages lead to higher prices and so on) or mark-up pricing by companies.
As seen from 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.
Figure 6: Inflation has taken an awfully long time to come down 
Beyond second-round effects, there are also lags between tighter monetary policy and inflation. For example, policy rates may not be enough to achieve target inflation levels. This is especially so when nearly 90% of US mortgages have interest rates fixed over long periods. Many US households took advantage of the low interest rates on offer in the pandemic, with the typical mortgage being locked for 30 years. Unless those households choose, or are forced to move, they are unaffected when the Fed tightens.
It is therefore not a straightforward task to bring inflation down in a short period. Even the Fed has mentioned that the process of getting inflation sustainably down to 2% has a long way to go. With this, it is too soon to assume that the Fed has won its battle with inflation, meaning that inflation will stay higher for much longer.
Long-term structural factors that continue to drive inflation
The world has gradually moved into a new regime where structural forces have led to more persistent inflation in the years ahead. We find several factors behind this.
First is that of decarbonisation, where reconfiguring economies around renewable energy and away from oil, natural gas, and coal would likely come at a cost. This energy transition is a necessary condition of meeting ambitious targets to reduce greenhouse gas emissions such as carbon dioxide to net zero by 2050 in order to avoid the effects of global warming, with policy frameworks and incentives being put into place to achieve this (Figure 7).
Figure 7: Policy frameworks and
incentives aid towards clean energy transition
These efforts to accelerate the transition to carbon neutrality would have inflationary impacts over the next decade. Spending to replace the existing fossil-fuel based energy system represents a demand driver where we would witness government spending rising to fund green investments. Current estimates put required spending at USD 3-5 trillion per year, or roughly 3-5% of global GDP, with advanced economies likely to see related spending representing a larger share of GDP.
Furthermore, the long-term transition away from carbon and towards green energy is likely to be marked by a period of generally higher and more volatile energy prices. Take for instance, corporates are reluctant to invest in the oil and gas sector due to the on-going green transition and investor pressure to maintain capital discipline. Structurally, the oil and gas sector is also a market that is defined by underinvestment, and this is a persistent problem that is difficult to change, with investment being on a downward trend since 2014. With this in mind, any unexpected supply shocks arising from geopolitical conflicts could trigger another inflationary surge brought about by energy prices.
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It’s not just the increased spending in the area of clean energy that would drive inflation. Investors would also need to watch out for other long-term factors fuelling inflation, such as rising government expenditures on healthcare as populations age, and in the area of defence with geopolitical tensions being on the rise. For instance, world military spending grew for the eighth consecutive year in 2022 to an all-time high of USD 2.24 trillion, with the sharpest rise in spending (13%) being seen in Europe.
Last but not least, we think that is the slow-burning threat of deglobalisation is another structural driver of inflation. Globalisation has long acted as a deflationary force by reducing labor and production costs, but this powerful disinflationary force is now in retreat with geopolitical tensions, protectionism, and trade conflicts being a regular occurrence.
In particular, China’s deteriorating geopolitical relations (particularly with the US), have led many companies in the West to rethink their China strategy. With this, diversification strategies, such as the China Plus One strategy have increasingly been considered by companies. This trend of “reshoring” or “friendshoring” however, does not happen overnight as companies take a relatively long-term approach to reshoring which includes significant capital investment. Beyond increased capital investments, a reduction in international trade and access to cheap labour make it harder to transfer productivity gains from one country to another, and these are factors that aid in driving up inflation in the long run.
Inflation will remain persistent, here’s how to position ahead
Inflation is expected to remain persistent. In fact, inflation is never a linear downward trend, and comes in waves with several peaks and troughs. Tight monetary policy will do little to address some of the structural drivers of longer-term inflation as mentioned earlier. With markets likely still underestimating the persistence of inflation in the coming years, investors should consider the following ways to manage the impact of inflation on their portfolios.
Within fixed income, our preference is for short-duration bonds as sticky inflation and resilient growth in the US means that the higher for long interest rate environment would persist. Besides, the yields offered by short duration bonds are attractive relative to history and thus investors can receive these yields without having to take on greater duration risk.
Within equities, we like high-quality companies as regardless of economic conditions, these companies will remain resilient due to their competitive advantages and dominance. Moreover, given our expectations that inflation will remain higher for longer, an allocation to commodity-linked equities could be beneficial.
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Table 1: Recommended products to consider
|
Market / Sector |
Recommended Product |
|
Short Duration Bonds |
Nikko AM Shenton Short Term Bond SGD |
|
United SGD Fund Cl A Acc SGD |
|
|
US Quality |
JPMorgan US Quality Factor ETF (NYSE:JQUA) |
|
Commodity-linked Equities |
Blackrock Natural Resources Growth & Income A2 USD |
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