The Compendium - The 10 toughest client questions we've fielded

More than 90% of economies have lower inflation the last 3 months than in the preceding 3 months. Although most of that is due to falling oil prices, core goods and services also appear to be turning, albeit tentatively. Bottleneck pressures are easing rapidly (backlogs, delivery times, freight costs and inventories all showing significant improvements) which should come through clearly in goods prices the next few months. Services prices are more likely to run into tight labour market/wage costs constraints but we show that a significant part of the 'broadening out' of inflation we have seen in 'core' may simply be the knock-on effect (with a lag) of the energy price shock.

We estimate (nominal) neutral in the US at 2% and in the Eurozone at 1%. This is little different from pre-pandemic (estimates moved down and then back up during the pandemic) and, on the surface, suggests Fed and ECB policy are turning quite restrictive. However, error bands around r-star models are extremely wide (3pp in the US, 2½pp in the Eurozone) making it impossible to say, with any statistical significance whether policy is indeed tight (the data suggests it is). It is notable how little mention there is in speeches and meeting transcripts of r-star recently -possibly because of central banks' preoccupation to push real policy rates into restrictive territory; possibly because no one has much faith in the estimates. We show how r-star models are little different from a slow-moving average of the policy rate.

Natgas markets are likely to remain tight for years, not quarters or months, if Russian flows, which met 40% of Europe’s demand prior to the invasion, remain depressed at today’s levels. In this case, prices could remain around EUR 200/Mwh compared to 12m futures at EUR 166/Mwh. LNG demand from China (~30% below trend presently) is likely to pick up next year while new capacity is only likely to come through in 2025/2026. The oil market should remain similarly tight amidst lower Russian flows once the EU embargo comes into effect, and limited ability & no willingness from OPEC to increase output. We forecast Brent at $100/bbl at end ’22 (futures at $88 bp) and $90/ bbl at end '23 (futures as $ 77pb). Markets are still adapting to higher energy costs.

Stagflation Pressure has risen in the last 6m, and is the highest in Germany, Scandinavian countries, & the UK, and lowest in APAC, particularly China & Indonesia. We define stagflation as a situation where our Stagflation Pressure index maintains a reading of 2.5 over a 12m period. FTSE 250 prices the highest probability of stagflation at 36% while Eurostoxx are pricing in a 32% chance. By contrast, Eurostoxx is the only market priced for a (shallow) recession. US and Asian equities are not pricing in a recession. The downside in US equities has thus far been driven by derating, not recessionary earnings. We are 4% below consensus on S&P500 earnings for ’23 (8% ex Fins and Energy) and thus see further market downside over the next 3-6m before a recovery to 4200 by end ’23.

Inflation is eroding real disposable income. Temporarily, consumption has been able to deviate from weak income growth through a variety of temporary offsets (pent up demand for services, fiscal support for households, excess savings) but these are unevenly distributed across countries or across different parts of the income distribution. Australia and the UK are likely to experience disproportionate consumption weakness relative to other major economies.

A new wave of fiscal stimulus is delaying a return to sustainable finances and, in the eyes of some central banks, adding to inflation pressure. We show that 29 out of 35 economies have approved some kind of 'cost of living support' (alongside other stimulus) and in 11 cases this was enough to flip the fiscal stance from contractionary to expansionary. However, the global fiscal impulse remains negative for '22 (and also '23), and 16/35 economies still have a contractionary fiscal stance, even after the approval of new stimulus (in many cases expiring Covid measures neutralize the stimulus). Moreover, for those countries that are, on net, expansionary, the stimulus exceeds 1% GDP in only 7 cases. The argument that energy price caps and other measures being approved adds significantly to inflation is tenuous at best. And in those cases where central banks react forcefully, the tightening can fully offset the growth impact of the stimulus packages (in the UK the mortgage shock almost fully offsets the government's proposals).

As a base case, we don’t believe the BoJ will change policy anytime in the next 2 years. If we are wrong, UST and Bunds would likely react with a beta of ~0.7to JGBs if the BoJ makes small changes to the interest rate corridor under YCC, and with beta of 1 in the unlikely event that BoJ abandons YCC completely. MBS yields, OATs and ACGBs could react with a beta >1 given the large Japanese footprint in these markets, and USDJPY could drop towards 130. We expect up to 6%-12% hit to TOPIX and 3-5% hit to Eurostoxx / S&P500 if we see adjustment to YCC parameters, and up to 23% hit to TOPIX and 8-10% hit to Eurostoxx / S&P500 if YCC is abandoned.

Net duration issuance to the market is set to rise over the next 12m as a) global central bank balance sheet shrinkage accelerates, b) governments increase spending on ‘cost of living’ support, with one notable exception – the US, where deficits continue to shrink (this dominates the aggregate number). Our analysis shows that aggregate supply of net duration to the market is set to increase by $208bn. This estimate includes a ~$480bn decline in duration from lesser deficits (all US) and $689bn increase from active and passive QT globally. By countries, US duration to be absorbed by the market falls by $252bn (-0.9% of GDP) whereas that in the UK goes up by $234bn (7.7% of GDP) and Europe goes up by $188 bln (1.2% of GDP).

Goods consumption continues to run 8% above its pre-pandemic trend and services consumption 4% below. Despite the removal of nearly all mobility restrictions, the pandemic spending pattern shifts have been surprisingly persistent and remains a source of inflation pressure. Services consumption has returned to its pre-pandemic growth rate but seems unable to exceed it. In the US, shortfalls are not in things like travel or restaurants but rather in health care, some recreational services (e.g. cinemas, live performances) and transport services (bus, taxi, subway), possibly reflecting more long-lasting shifts in work from home arrangements. The relative price increase in goods vs services is another factor preventing nominal wallet shares from reverting to their pre-pandemic state--on our forecast that starts to dissipate in coming months.

We see this as very unlikely for at least three reasons: 1) US dollar valuations are not significantly dislocated from interest rate differentials and terms of trade. 2) A strong dollar may be a concern for other economies, but not yet for the US administration. They will likely not want to send conflicting signals on inflation management. 3) There is little international consensus on using FX as a policy tool. China will likely not want a stronger CNH into a weaker economy. The most aggressive phase of dollar appreciation may be ending with the back up in US yields maturing, but the dollar is unlikely to turn lower until the global cycle turns stronger. In the meantime we recommend playing $ strength against APAC.