Stagflation Haze

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The COVID wave may have broken, but it is still shaking the world economy: mass exits from the workforce may have tightened U.S. labor markets persistently; savings accumulated during the pandemic and still generous government support push growth, and major economies are already showing an unexpected resilience. China ditching draconian pandemic policies may be inflationary or disinflationary as it spurs commodities demand while easing supply chain snags. The Ukraine war and global decarbonization needs shut down traditional trade routes and production processes, opening up new ones. Tectonic shifts are at play and investors feel that conviction is scarce. Data dependency is at a maximum. 

The most followed economic indicator, inflation, shows how betting on a return to the pre Covid normal is dangerous. After months of talk of peak inflation and wild celebrations at its achievement, it became suddenly and painfully clear that it’s the trough, not the peak, that matters for central banks, and hence for every investor. Are we going back to a 2% inflation world? Or a 4%? And when? Whoever answers these questions right will be the next hero of Wall Street, at least for the year.

Last year’s Stagflation Shock has evolved into something that may better be described as Stagflation Haze. To us, the most likely outcome is that U.S. labor markets will not go back to pre pandemic dynamics anytime soon. The U.S. consumer is in extraordinary health, China’s re opening supports global growth and Europe has its energy needs covered. All this points towards a global economy experiencing a gradual inflation slowdown but no fast return to what once was normal. Central banks thread the needle and err on the cautious side, reaching restrictive interest rate levels and sitting there until incontrovertible evidence of inflation approaching their targets emerge. The “all clear” and much desired rate cuts are unlikely to materialize until well into 2024.

At least the inherent strength of labor markets and consumer balance sheets allow major economies to avoid recessions this year and next. Life within the Stagflation Haze is not so bad, even if slightly disorienting. We attach a 60% probability to this scenario.

As the global economy is transitioning to a new normal, claiming certainty on the point of arrival risks ending up like Columbus: being sure you reached India while touching the shores of Dominica. We continue to attach a 30% probability to our Boiling Over scenario, in which the growth enhancing forces and persisting supply side disruptions brush off the impact of rate hikes. Central bankers awaken to the ghost of Paul Volcker. The only way out is causing a recession, and so they do. An ebullient 2023, with growth above potential and full employment, is followed by a sharp recession. However, it may not deliver the traditional spike in unemployment as corporates take the hit on their margins rather than shedding too many workers they have struggled so much to hire. Extreme yield curve inversion helps firms to secure long term financing at lower rates.

Release after release, data have made an imminent recession less and less likely. In a normal situation one could be reasonably sure that demand could not weaken suddenly and a standard recession ensue. But what if savings have been invested in illiquid assets, used to pay back debt, or fruitless M&A, leaving firms and households in need of funding? Couldn’t the brutal increase in the cost of credit then start to bite? And will all those who left the workforce have to come back now that the savings have been depleted? We do not attach more than a 10% probability to such a scenario, but a Steeper Slide cannot be ruled out completely.

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