Market Update: Inflation running out of money

Knowing this (and the US is here merely serving as the representative of all western economies), central banks have set interest rates deliberately high to stem any additional new supply of money while the windfall money flooded back into the real economy in the form of consumer spending.

For us, it is reasonably clear that the remaining windfall cash is not going to be spent – it will remain as savings. It is ‘excess’ savings which have to buy up the available assets. We should be clear that this skews the usual messages about risks. Investors are not buying because the investment risks are lower than usual – no, they have too much liquidity and fear the impact of inflation on their surplus savings. Indeed, the behaviour of companies we described at the start tells us – and all informed investors – that, at current economic activity levels, they don’t think they can pay the going rate on capital. Their expected profit growth is low.

If activity is low and there’s little left in windfall money to spend, why is inflation still high? Should central banks still worry that an inflation spiral has set in?

Last week’s earnings reports, here in the UK, Europe and in the US, provide more evidence of companies trying to offset weak (often negative) volume growth by raising prices. Unilever and Procter & Gamble were notable in this respect. Such behaviour has been termed “greedflation” and given historical precedent there may be some truth to this. However, as investors, we should recognise that we want companies to protect shareholder returns.

As indicated, such episodes are actually very typical as any economy slows down. Companies don’t like to use whatever pricing power they have, but they will if they have to. Inflation almost always goes up at the start of economic slowdowns. The problem for companies is that their micro-economically rational behaviour has in aggregate disadvantageous macroeconomic conse-quences – ‘the fallacy of composition’ – given such individual defensive action slows the economy further since the buyers do not have any more money to spend (Our cartoon this week refers to this, while reminding us these dynamics are nothing new).

We should hope that central banks recognise this as the last throes of a cycle, rather than worrying that the latest service sector-driven inflation data is indicative of a spiral. The windfalls are spent, activity is slowing, supply shortages are no longer an issue, and even the labour market has started to ease, while companies do not think they can return more than the rate of interest.

Short-term interest rates and long-term bond yields are clearly not in line with the private sector’s ability to generate returns at current moderate activity levels. If economic activity levels fall further, that gap will grow and companies will get more stressed. As we head into the next round of rate decisions, it will be important for companies – and the risk assets that represent them – that central banks tell us they recognise they have done enough and the growing need to turn. The Federal Reserve Open Markets Committee meets on Wednesday 3 May, the European Central Bank on 4 May, and the Bank of England meets on Thursday 11 May.

We saw a sharp pick up in bond financing activity at the start of the year when yields dropped down, and it may be that yields are actually not so far away from a more comfortable cost of capital level for companies. Moreover, investors are not fretting greatly, amid reasonable Q1 earnings reports. At least the larger companies are still generating growing, if not stellar, profits.

Market volatility picked up a bit last week but without market levels having changed a whole lot by the end of the week. Perhaps that’s no surprise given the importance of the next two week’s monetary policy decisions. The expectations are that we will get small rate rises but accompanied by the ‘cooing of doves’ – soothing sounds telling us that they expect inflation to cool and rates to be moved to less tight levels as inflation allows.

Therefore, contrary to the old stock market adage of ‘sell in May and go away’ it seems to us that ‘let May’s sway guide your way’ may prove far better guidance for investors this year. We will certainly be monitoring central bank messaging, and the market perception of it, very closely.