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“We were so far back in the woods, they almost had to pipe in sunlight"

- Roy Rogers

The world is a very complicated place at the moment. Indeed, what began as an immediate and acute threat to the health and lives of global populations has evolved into a diverse spectrum of aftershocks and implications affecting different economies and different sectors in different ways. Adding to the complexity, the spread of Covid (and subsequent variants, and thus aftershocks) occurred in a nonsynchronous manner. The effect on the global economy is therefore a function of many different factors.

One of the most talked about factors to emanate from the pandemic is inflation. Inflation, from our perspective, remains transitory, and a function of a faster return of demand from the global pandemic, compared to supply. This has likely been exacerbated by the method of dealing with the initial outbreak (badly in the west - and successful lockdowns in Asia), that meant recent variant outbreaks met with low natural antibodies and a maintained strategy of lockdown in Asia (notably recently in Australia). As global aggregate supply is predominantly of Asian origin and global aggregate demand predominantly comes from the West, the supply/demand mismatch that has driven inflation continues.

On this basis, it likely follows that ultimately global supply catches up with demand, and thus price pressure normalises - inflation is transitory. There are similar arguments for the global microchip shortage, but there are also some other factors that could potentially become more permanent. It is not clear yet how the pandemic has affected the labour market. I remain sceptical that there have been permanent changes to the demand for paid work (even if there has been a global shift to the left - higher state handouts - as a function of the pandemic), and I expect that the scaling back of emergency unemployment insurance (or benefits) likely sees a return to work across the wage/skill spectrum, thus lowering wage pressures. At the margin though there may be more friction in the labour market post Covid.

The question about inflation is not one of one-off price changes due to supply/demand dynamics, but a more persistent tendency for price levels to (continue to) rise. It is also possible that global suppliers (notably European automakers, but potentially Oil, Gas and natural resource ‘owners’) feel they have increased pricing power (lower competition/substitutability). But still, this is unlikely to be unlimited. However, even with all of the identifiable factors driving price pressures - whether transient or more persistent - the impact globally has been very diverse: headline inflation in Brazil is above 9.5% and 5.3% in India. Even among economies that might appear similar, there are clear differentials: Germany is at 3.9%, Denmark just 1.8%.

When we look at growth, there is also a great deal of differentiation. However, the focus on growth likely still has too much emphasis on the near term sequential or second derivative growth picture, and not on the medium term sustainable or equilibrium growth. While factors driving inflation appear to be more global (with some obvious caveats), the growth backdrop is likely a more idiosyncratic function of fiscal (and monetary) support, and the chronological position on the reopening/stimulus wave. We continue to see the steady state, or equilibrium levels of growth in China and the US as being dominant.

Interest rate differentials have been less of a dominant factor in FX markets through the pandemic, as Risk-On, Risk-Off has dominated. However, we expect that the increased emphasis on the rate tightening cycle in DM likely returns to the fore over coming months. Indeed, next week we get the September Federal Open Market Committee meeting, which brings the updated dot plot and likely more ‘dots’ that show a rate increase in 2022. Likewise, though less globally relevant, the Bank of England meeting likely delivers a majority of the Monetary Policy Committee that views the conditions for the removal of monetary stimulus having been met. Both have implications for the yield curves and front-end interest rate differentials.
Lastly, we have to consider debt. The common response to the global pandemic was massive fiscal loosening, and where possible, monetary loosening; the common rationale being that subsequent recovery stimulus should be debt funded, as underlying global rates remain low (and thus debt affordability stronger). Indeed, it seems that the eurozone is currently in the process of reviewing the Stability and Growth Pact (SGP) in order to consider the efficacy of strict debt reduction rules that mandate a swift return to pre-crisis debt targets (60% GDP). This seems like a sensible strategy to foster a faster growth rate over subsequent years. But what if inflation is not transient; what if labour market friction implies higher NAIRU rates and thus nearer implied rate rises; what if the global investor community becomes less comfortable with the (very tight) pricing on global credit?

And then there is geopolitics…

Essentially, all of these factors are consistent with a rise in volatility as we move ahead. Greater volatility, driven by widening growth (and perhaps inflation) differentials, widening interest rate differentials and even widening credit differentials - and even geopolitical risk premia. Greater volatility is usually synonymous with Risk-Off; however, from my perspective - at least to begin with - I would envisage the potential volatility to be a function of positive growth, and the move towards normalisation at differentiated speeds.

Other risks may follow. As the European Central Bank President said this week “We are back from the brink, but not out of the woods”.

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