Another week of global inflation data only served to emphasize how important the future direction of this variable will be in setting the course for financial market returns in 2022. U.S. inflation numbers continued to make new highs and now stand at 30-year highs (chart below).
Source: Strategas Research Partners
The U.S. and its economy and bond market are incomparably important for the rest of the world. However, inflation is a global phenomenon. Data from outside the U.S. this past week also confirmed the inflationary trend. In Germany, the major economy with the best record of inflation fighting, the headline rate broke above 4%, the highest since adoption of the euro in 1999 (chart below).
Source: Bloomberg
In China, whose economy was crucial to the low inflation enjoyed by the Western world for the last generation, producer price inflation is now at a quarter-century high (chart below). If the cost of Chinese inputs is increasing, that means the exports that helped keep prices down for decades may now, at the margin, push them upward.
Source: Strategas Research Partners
The original arguments used by Central Banks to claim price rises as transitory have been debunked. This year, the Bureau of Labor Statistics started publishing a rather strange version of core inflation, which excluded food, shelter, energy and used cars and trucks. The reason put forward was that the bounces in commodity and used car prices were skewing the headline number. Making those exclusions, of a number of things that many would consider essential goods, left what was arguably a more reliable “core” number. However, even this adjusted inflation number rose last month to exceed 4% for the first time since 1991. Further evidence that price rises are becoming broader based.
Source: Bloomberg
Persistently high inflation data is starting to feed through to higher bond market volatility. It is inevitable that if unchecked this bond market uncertainty will eventually start to be transmitted to other asset classes. However, it is important to recognize that high inflation has historically become an equity problem only once the monetary authorities decide to fight it – through higher interest rates. Currently, most monetary authorities in the developed countries remain willing to watch, hoping that it does indeed prove transitory. The result, depicted in the chart below, is the lowest real interest rates in history. Despite all the talk of monetary tightening, monetary policy remains as easy as it has ever been in the U.S. This is a major tailwind for many risk assets.
Source: Bloomberg
We have highlighted the chart below on past occasions to determine whether liquidity conditions remain easy or tight. Corporate bond spreads remain close to historical lows, indicating truly little financial stress in the economy. Another positive tailwind for risk assets.
Source: Bloomberg
Furthermore, as recently highlighted, the seasonal tailwinds are now picking up and should also provide a boost to returns to close out the year. As the chart below shows, we are entering what has historically been one of the best 6-week periods for stock returns.
Source: Strategas Research Partners
In the last weekly update, we started to reveal some of the areas in the market that we judge there to be real attractive investment opportunity – even in the context of rising inflation and an overall expensive market. Following on in this vein, the chart below highlights a remarkably interesting investment observation. The U.S. investment advisory firm, Strategas, has shared their research showing that small companies are the only asset class to outperform inflation in every decade. An even more interesting observation is gleaned from a more granular analysis of their data. This remarkably record is due to the performance of small cap Value stocks which are truly the only segment of the market that has consistently outperformed inflation over the decades (chart below). Small-cap growth underperformed inflation in both the 1970’s and 2000’s.
Source: Strategas Research Partners
In the current context of excess liquidity and strong stock momentum, we must remain highly vigilant to building risks that significantly threaten our positive outlook. The table below show the readings of a number of investor sentiment indicators which we monitor to gauge potentially harmful investor optimism. Investor sentiment is running hotter than it was just a few weeks ago. However, our indicators do not as yet signal that this optimism is so broad based as to suggest a more defensive investment stance be adopted.
Source: Strategas Research Partners
