Strategy Focus - Inflation

Inflation : Different risks either side of the Atlantic

After a decade of modest price growth, most big economies have seen inflation rebound in recent months. United States inflation has been running above the Fed's target rate of 2% since March (chart 1) and hit a post 2008 high of 6.2% in October. Euro area inflation has taken off since May (4.1% in October) and is now also running above the European Central Bank's (ECB) 2% target (chart 2). Leading emerging economies outside Asia have also been under severe inflationary pressure since March, with rates in Brazil, Turkey and Russia reaching double digits.

For the moment, inflationary pressures in the developed world look to be "temporary" here meaning inflation that falls back to central bank policy targets in 2022 without them needing to take pre emptive action. Much of the rise seen in developed economies can be put down to a low comparison base and the havoc wreaked by Covid in 2020.

However, markets, and some central bankers, are increasingly starting to question just how temporary the inflationary blip is. For one thing, the temporary factors feeding it are clearly persisting longer than expected. For another, the Covid crisis has seriously distorted labour markets, raising fears we could be in a new and more inflationary regime. This risk looms larger in the US than in Europe.

We think the Fed will start tightening monetary policy in December by cutting asset purchases and will start raising interest rates at end 2022 /start 2023 The ECB on the other hand will probably maintain its asset purchase programme until 2023 and then go on to raise rates. Given this scenario we remain Underweight sovereign debt and Overweight the dollar vs the euro. This scenario is still bullish for equity markets.

If inflationary pressure does turn out to be long lasting, and particularly if we start seeing heavy upward pressure on wages, the effect would be more severe in the US than Euro area. Under this alternative scenario, the Fed would hike rates faster and harder, negatively impacting growth, and the key risk for the ECB would then be a rise in sovereign rates with spreads once again opening up between member states. This alternative scenario would still be good for the dollar and offer little upside for sovereign debt. But it would be less good for equities which would feel the effects of higher real interest rates.

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