Mazars’ chief economist George Lagarias (pictured) recommends that investors keep one eye on the central banks and money markets and the other on the development of the pandemic.
“Markets rebounded last week, even as the Fed’s favourite inflation gauge, the core Personal Consumption Expenditure, hit its highest level since 2008 prompting fears that the twelve-year rally on cheap money may come to an end.
“Central banks persist that supply-side inflation is temporary. However, to gauge inflation and growth, investors would do well to keep one eye on the central banks and money markets and the other on the development of the pandemic.
“As the Delta variant hits the European continent, worries peak again. The UK is the world’s second most-vaccinated country, with 64% of the population having received at least one shot and 50% having received both. Yet, last week it saw Covid-19 cases skyrocket to nearly 15,000, the most cases since February, when vaccination levels were at 24%.
“Talking about a post-Covid environment may be too early. We have often said that we will have to learn to live with Covid-19, not dissimilarly to how people in Europe learned to live with the consequences of Chernobyl for decades. We can possibly talk about the end of universal lockdowns, but not yet about a return to life as we knew it in January 2020. Localised measures, travel restrictions, disruptions in production, working from home, could very well be with us for some time.
“Will this matter for investors conditioned to look to the Fed for answers? By and large, probably yes. Risk asset prices have for a long time depended on the assumption that the Fed can ‘throw a wall of money’ at any problem. This thesis has relied on another assumption, that low inflation would enable central banks to keep printing money without serious consequence.
“Globalisation has been the purveyor of low inflation and a migration towards white-collar jobs for western economies. Yet, the pandemic continues to disrupt business travel, tourism and ultimately the constant exchange of ideas and flow of money across borders. The core assumption behind ‘the Fed will solve everything’ thesis, becomes shaky. The pandemic is the greatest de-globalisation force the world has seen, far more serious than trade wars. The effects of de-globalisation are already apparent: a massive shortage of goods and raw materials around the globe pushing inflation persistently higher. Central banks may believe that supply chain issues are transitory, but the more we become de-globalised, the more economies succumb to the temptation of on-shoring operations.
“Global value chains are just that: chains. They work best when the economies at every link of the chain are in harmony. Goods and services then flow unencumbered, and patterns form which allow producers to re-stock in time for demand to pick up, and de-stock at a point where demand would go down. For perishable, or short-lived goods this process is central and a key to bringing costs down and efficiencies up. The pandemic disrupts that harmony. Ultimately, this means higher production costs and more variability in the availability of materials and unfinished goods. While it is a fair assumption that ‘eventually supply chains will sort themselves out’, it is plausible that disruptions will last longer than the Fed’s patience and that on-shoring will have some lingering effects on long-term inflation.
“Yet things may not be as dramatic as they sound, from an investment perspective. Higher rates are not a remedy for all types of inflation. There’s still a distinct probability that central bankers acknowledge that supply chain problems will probably not be solved with higher interest rates, i.e. that this inflation cycle may not affect the Fed’s ability to supress volatility. While this would broaden the chasm between the real and the financial economy, clear central bank thinking could ensure the avoidance of major disruptions for risk assets.
“At the same time as the global economy becomes less global. In Washington Mr. Biden has had to negotiate his infrastructure package down significantly, to less than 50% of the original, and still faces opposition. Hopes that rising inflation could be matched with higher growth are fading, as political realities and partisanship are hindering the most ambitious fiscal plan in decades and remind investors why they have had to rely on central banks for so long.”