Structural inflationary forces are rising but stagflationary risks have eased.
There were two dominant and related themes in macro markets this week.
First, a significant repricing of front-end rate expectations across high beta developed markets and emerging market countries. There was a surprise rate hike in Poland, and Polish 1y yields had a 4.8 weekly stdev move higher. However, even where there was no central bank action, yields repriced sharply higher in anticipation of more hawkish central bank actions. This was the case in South Africa, Australia and Chile, all experiencing multi standard deviation moves higher in the 1-3y part of their interest rate curves.
Second, unprecedented volatility in energy markets. European 1mth natural gas forwards rose by 70% in two days at the start of the week, following an 110% rise in September, before comments by Russian President Putin resulted in gas fully retracing the spike to end the week lower by 28%. In oil, the WTI front month contract rose by another 6% to reach the highest level since 2014.
These moves happened in a week full of macro data, most notably Friday's US employment report.
We have held a core viewpoint over the course of the year that we are in a structural inflationary cycle and, as we have been writing, “inflationary environments are more volatile in aggregate, as the market has to price policy reaction or policy mistake”. This risk is exactly what actualized in Poland this week, where the central bank, in the face of consistently rising inflation, capitulated on its view that they could maintain an accommodative stance justified by their heavily challenged belief in the transitory nature of inflation.
This is not a new theme. We have witnessed monetary policy pivots this year in Brazil, Chile, Mexico and Czechia. The bottom line is that when inflation is rising, an additional risk premium needs to be built into the front end of curves to reflect that central bank may have to hike sooner and more sharply. The greater the velocity of inflation, the more risk premium needs to be built in, and with that interest rate volatility moves higher. This risk premium ultimately pushes curves well beyond what is eventually delivered in terms of hiking cycles, but in the early stages of a cycle, while inflation is rising, this risk premium tends to be maintained and should not be faded - even if central banks maintain dovish policy stances.
However, the larger question for the direction of risk assets is whether we are in an inflationary or stagflationary regime.
Data especially in the US has shown clear signs of stabilization, especially in services data. Last week, the ISM services PMI unexpectedly increased from an already high level, and the US economic surprise indices have begun to move higher after several months of decline. In Europe, the data picture is mixed. Supply chain issues and slowing demand from China are a significant drag on the auto sector, which saw German industrial production last week fall sharply by 4% m/m. We will have more information about the Chinese data picture this week, following golden week. However, what is clear is that the Delta variant’s effect on global data is fading, but supply chain issues remain a drag especially on manufacturing activity.
The important point is that these supply chain issues reflect demand, and to date, the inflationary forces in the market have not yet led to significant demand destruction. The employment report this week gives us a clue why.
Wages are rising in the US and globally. Rising wages help offset the real income losses due to inflation. The US employment report this week showed that wages are rising, the labor force participation rate has fallen, and unemployment is dropping. All at a time when job openings are at an all-time high. This is rare but it is consistent with a thesis we have held that the unique combination of post-pandemic fiscal and monetary policy combined with broader societal factors has structurally altered parts of the labor market. The bargaining power of labor has increased, wages are rising, but not enough to bring some people who have amassed savings or found different means of income (hence our tongue in cheek title this week: Why Flip Burgers When You Can Flip NFTs (Non Fungible Tokens)) during the pandemic back into the workforce. This is inflationary and the type of dynamic that can precipitate a structural shift in inflation.
Viewed together, we may be on the cusp of a regime shift in inflation, out of the 2015-2020 secular stagnation era. Market pricing reflects this, 5y5y inflation swaps are at 5y highs, but well below 2010-2014 levels. We have held this view since Q2, especially around wage inflation, but it took many months for the market to come to this view. This is reflected in our positioning. We remain paid rates in Poland and have added to flatteners. We have positioned for higher inflation via inflation swaps in the US, and have added upside structures on energy sector, Saudi and Russian equities, as well as long positions in European financials. We have also used the September stagflation sell off to add to positions in commodity exposed EM credits. A regime shift in inflation will open up many more opportunities, and if this theme plays out, these are just the early innings.