Weekly Market Update: Inflationary pressures may be moderating. Supply chain pressures aren’t.

Mon 22 Nov 2021

Market Update

Equities in most major markets posted losses last week with global stocks down -0.4% in Sterling terms, as inflation concerns, supply chain issues and rising coronavirus cases dampened investor sentiment. US stocks were up +0.1% with growth stocks exhibiting solid gains, outweighing the losses in more cyclical firms. European stocks were down -1.8%, as countries within the region started imposing restrictions to curb rising Covid-19 cases. UK stocks were down -1.6% amid CPI inflation figures hitting a ten-year high, while EM equities fell by -1.7%. The US 10Y Treasury yield was down 2.2bps finishing the week at 1.548%, while the UK 10Y yield was down 3.5bps reaching 0.880%. In US Dollar terms gold lost some of its previous weeks’ gains, down -1.3%, while oil was heavily down -6.2% to $76 per barrel.

CIO Analysis

In the past few days reports have been surfacing that supply chain pressures are easing. These reports cite lower commodity prices and lower costs to transport dry bulk cargo. Indeed, iron ore and the volatile Dry Bulk Index have shown signs of easing over the past two months. However, crude oil and copper prices remain elevated.

While some easing is welcome, lower dry bulk and iron ore prices constitute only part of the supply-related pressures. A broader look, however, at supply chain related indices suggests that all of the components considerably elevated.

In fact, an equally weighted average of these indices does not even suggest improvement over time.

This is where we must make a significant distinction. Some commodity prices, which trade in futures and always entail a speculative element, might ease in the near future. With them, some inflation pressures may recede.

This is mostly important from a portfolio perspective. A loose monetary policy regime which has lasted more than ten years has conditioned markets to depend on asset purchases. While most central banks are now reducing asset purchases, they are still reticent to raise interest rates. Nevertheless, as recent experience with the Bank of England indicates, inflationary pressures might cause communication confusion for a central bank, which might want to influence inflation expectations and prove they can still influence the real economy without necessarily raising interest rates. Two about-faces from the UK central bank in the last two months have raised eyebrows, and investors are now more vigilant against similar behaviours from much more consequential institutions, like the Fed or the European Central Bank.

Persistent supply inflation could trigger mixed messages from policymakers, some of which believe that inflation is only a monetary phenomenon. Conversely, lower supply inflation may keep portfolio managers happy, as it would allow central banks to convincingly support their dovish stance, for which there has never really been an alternative since September 2008. Iron ore and Dry Bulk prices suggest that we may (that is ‘may’) be at the beginning of some easing.

However, when one looks solely at macroeconomic indicators, the situation is more grim. Supply chains remain pressured beyond their capacity. A year of inertia has damaged them significantly. As demand from the west abruptly stopped in 2020 due to lockdowns, factory workers did not wait like idle robots for it to pick up again. In places like Manilla, Philippines, a daily salary is about £4. Lack of savings and persistent costs forced workers who faced pay cuts or just lost their jobs to move on. New workers needed time to retrain. Meanwhile, orders were piling up and backlogs were increasing exponentially. After decades of dwindling inventories, supply chains that had grown leaner found themselves short of workers, capacity, and storage.  And whereas these might be considered ‘transitory’ problems in economics and finance, they are causing economic distress in real-time.

Recent PMI numbers suggest that delivery times remain very extended, to the point where some customers now just cancel orders altogether. This may ease inflationary pressures, but it will have an impact on growth and the recovery.

Which brings us back to the fabled divide between the real and the financial economy. For financial markets, what matters is that some input prices recede and inflation expectations drop, allowing central banks to maintain their ‘fig leaf’ of structural deflation as a driving force behind accommodative policies. Especially if equity indices are led by a handful of growth stocks which have not seen demand wane. For the real economy, however, things are not straightforward. It could very well be a long time before the world economies become so attuned to allow lean and efficient supply chains to operate in a pre-pandemic fashion. Meanwhile, the non-super-growth and retail-driven stocks, the prospect of lower growth and elevated prices for most of 2022, a phenomenon broadly described as ‘Stagflation’, may have a more significant impact.

-David Baker, CIO