Inflation from a small cap perspective
I’ve spent the last few days talking to most of the folks I know in the market, collecting opinions, information and discussing what other investors are thinking on the big topic of the moment – inflation. Not all inflationary forces are equal, and their impact is different in different economies.
The idea that US interest rates are lifting is neither new nor not priced into markets. Currently in the US bond market, relevant expectation is “priced” two-fold:
- Quantitative easing is now moving in the other direction or Quantitative tightening with the likely unwind of some US$2 trillion (Source: UBS) over two years expected. UBS and others suggest that this will have approximately the same effect as there 25bp interest rate rises.
- Four rates rises this year (with more on the Calendar 23 runway), March is locked in for 25bps says the bond market.
The unknown, and the recent volatility we have seen in global equity market prices is down to the uncertainty over how big the steps the US Federal Reserve (the Fed) takes and if they walk, run or leap – as we discuss below.
Inflation drivers and opinions
Not all inflationary forces are equal, and their impact is different in different economies.
The prevailing view, for much of the last year, was that inflation would be transitory, a description promoted by the Fed, when it was happy to do whatever it could to support the US economy and avoid a pandemic driven deflation problem. However with the perception that the pandemic impact on the economy is waning and the impact from stimulatory support now showing up in data the Fed relies on to gauge the suitability of US interest rate settings, the time has come for change, and the risk that the Fed may move quickly to get “ahead” of the curve. There are consequences globally to this shift, as the Fed’s policy settings has a huge influence on the global price of money.
Elsewhere, Europe is problematic too and China is cutting rates (reflating its economy, not fighting inflation). Australia has a question rather than a problem our inflation issues are smaller, and we have more non rate increase solutions to deal with it. But the world is going to feel what the US does, so let’s look at a high level at how the balance of inflationary drivers are set there.
Transitory is a dirty word, but many of these transitory forces that have caused a rise and spike in the inflation data are easing, and its likely taking inflation lower from here, albeit a bit later than expected. So what’s the problem?
The issue is that inflation appears to be settling in at a higher level than “transitory” suggested, aided by some items in transitory (like shipping costs) having intensified and lasting longer than expected. But the main area of focus is not on these items that economists are confident will dissipate, but now in components of inflation that have historically been more persistent, and need more focus or direct management. These items are now rising in their intensity, particularly Services inflation with its strong connection to local wages in the US economy. And that’s something the Fed, and the market, want to see brought under control.
With strong growth, and the prospect of a better outlook as the pandemic effect fades, and an expectation that current high levels of goods spend will shift to services as the economy opens further the US economy looks like it can tolerate materially higher interest rates, and the evidence is now visible that the Fed thinks we need to get there. The longer they wait, the more work they will need to do.
The risk of a Fed “Shock and Awe” style leap to get back ahead of the curve
Unemployment in the US has dropped 160bps in six months back to sub four per cent. That’s low. It spiked at 15 per cent in 2020. This is firmly back where the Fed would like it to be. US CPI was almost six per cent % at its last print. That’s way above. The Fed has a dual mandate – full employment and a two per cent inflation target.
There is a rising fear pricked by Jamie Dimon’s comments on JPMorgan’s latest earnings call, that the Fed doesn’t walk. A walk would be raising once a quarter or four times in its eight meetings in calendar year 2022. There is a risk that they run – more than four raises.
There is risk that they leap – it’s not 25bps, but 50bps in March, then another raise in quickstep fashion.
Are equities over?
Inflation is generally regarded as a negative for sharemarkets. Inflation leads to higher borrowing costs, higher labour costs, and a rise in materials costs; all of which have the potential to reduce company earnings and profitability. Taming it is a good thing in the medium to longer run. But are we can see from the recent market volatility, and the explanation above, it brings some uncertainty about how fast and at what level the Fed will position US interest rates at.
Provided growth stays strong, the Fed fighting inflation is another issue for the market to consider rather than an equity end game. If growth dramatically slows and inflation doesn’t that’s a different story.
We now wait to see how the Fed engineers its growth V unemployment V inflation outlook. But we know its objectives – full employment and two per cent inflation, you need stable solid growth for that objective to be sustained.
It may turn out to be not as bad as feared. Or worse. And it may change. That’s the small print.
Meantime its heads down from the small cap team. We have plenty of work ahead from the inflation rotation.
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Gary is the Portfolio Manager of the Montgomery Small Companies Fund – a small-cap Australian equity fund investing in 30 to 50 high quality, undervalued small and emerging companies with strong growth potential. The fund invests outside the ASX100.