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“The beautiful remains so in ugly surroundings”

Malcolm de Chazal

Last week, we discussed ‘The Good (Fed), the Bad (BoE) and the Ugly (risk assets)’ of the performances from the previous week, as the market continued to battle with the global Central Bank reaction function to a more pernicious inflation backdrop and by extension the ramifications for future growth. This week, there has been less ‘Good’, an array of ‘Bad’ and sadly a very generous helping of ‘Ugly’!

From a data perspective, there have been very few focal points this week, but the primary event in this regard was the US CPI print for April. We have mentioned on many occasions the significance of the change in the second derivative in inflation on market sentiment and pricing (in the US specifically, but also more broadly) and thus, this data print was a key focus - not just for the US rate curve and the USD but for global risk sentiment. The result, however, was not quite as clear cut as many would have hoped.

While at both the headline and core level the data did fall back from the March level, it did so by less than expected (headline CPI slowed from 8.5% y/y in March to 8.3%, but was expected to slow to 8.1%). In the near term, it is not clear that this is a turn, a dip, or indeed a margin of error on an otherwise upward path. 

Looking at the breakdown, there is perhaps more uncertainty, but there are three key themes that run through the data. The first is the direct impact of the Fed forward guidance on the interest rate sensitive parts of the basket, such as owner equivalent rents - likely largely influenced by the sharp recent rise in mortgage rates as a function of US rate hike expectations. 

The second is the demand factor, those parts of the basket that are driven by surging demand. For example, there is a clear surge in hotel lodgings, and airline fares, both very efficient flexible barometers of demand (today more than ever with search analytics and big data aggregation available). However, it is not clear that this is a sustainable bounce in demand for leisure that should be addressed by monetary policy tightening. Indeed, I would argue that this is more likely a function of successive waves of Covid and Covid restrictions concentrating the demand for a well-deserved summer holiday after 2 years of intermittent lockdown and global (and even domestic) travel restrictions. For example, airfares rose 18.6% m/m - this is not sustainable and through the same market efficiency as described above prices will come back down when the vacation demand has been satisfied and next year is unlikely to see the same concentration. 

The third factor is those prices affected by the current supply chain disruptions, either from China’s Covid restrictions or the logistical blockages from the Ukraine war (auto parts, furniture, new cars,...). While the term transitory has been banished from the Fed lexicon, it is unlikely that global supply inefficiencies will last for a vastly extended period. 

In short, the US CPI data for April gave some hope to the prospect of a topping out of inflation, but also highlighted the complexity of the inflation dynamic, driven by an awkward combination of tighter rate expectations, supply constraints (as a function of the Russia/Ukraine situation and as a function of China’s zero Covid policy restrictions), and excess demand (at least in part driven by a concentrated post Covid rebound). While markets are very keen to price a hawkish Fed reaction function - it is not clear (at least to me at this stage) that the data warrant a policy tightening beyond neutral - wherever that may be!    

The one thing that is potentially clear is the fact that data appears to have cemented (at least for now) the transition in market focus from inflation to growth. Indeed, if the Fed are forced to tighten policy with the intent of reducing inflation driven largely by factors that will in no way be responsive to changes in Fed policy, then the implications for growth are certainly not positive. Ironically, this may mean that longer term yields ease back, as forward-looking growth expectations are revised lower.

This circularity may even be supportive for longer duration equity assets - at least once the near term ‘ugly’ sentiment has played out. From our perspective, US tech with demonstrable future cash flows are beginning to look very cheap - even if that appears to be cheaper by the day against the current fragile risk backdrop.

If we combine the concerns over the drivers of inflation growth, we come back to the concept of different drivers of growth concerns in the different regions that we have outlined in previous commentaries. Globally, the implications of Covid are dominant in China, the Ukraine war dominant in Europe and inflation dominant in the US. We have outlined previously that this differentiation between the dominant factors for policy mean different reaction functions for global central banks, and thus different growth distribution probabilities (a good example being the fact that Europe seem intent to shoot their economy in the foot by removing a Russian energy supply chain faster than it can be replaced by alternatives).

Ultimately, from here financial markets are likely to be increasingly about turning points. The turning point in the global inflation cycle, turning point in China’s zero Covid battle (through success or a change in policy) and even a potential turning point in the Russian aggression in Ukraine. Furthermore, it is not just the individual battles that matter, but likely the order in which they occur will have significant implications for financial markets, for risk assets and perhaps most acutely in currency markets.

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