The US economy is heating up

The US economy accelerated rapidly on the back of an enormous monetary and policy expansion; other economies have done the same. The entire global financial system has come under severe strain due to a shift to goods away from services, under-investment in select sectors such as natural goods and difficulties attracting workers low wage jobs. The consequence has been an increase in supply chain and wage costs, among others, while interest rate costs have remained somewhat subdued. The question now is: how transitory are these pressures? The answer is complex, but it points to eventually lower inflation than is currently expected.

The unexpected path away from inflation
We are dealing with a series of shocks; some are intense but short-lived, others will continue for the longer term, such as building new factories to produce microchips. The scenario is complicated.
The sharp shock of factory closures due to Covid-19 has caused ripples in the supply chain. These shocks can last for months and are snowballing – with goods accumulating at ports across the globe where inventories pile up sometimes for weeks before being released down the supply chain. Business owners and investors are keeping their fingers crossed that demand holds as price pressures increase.
Another source of concern is the uncertain economic outlook. The ongoing pandemic creates doubts when assessing the demand of goods that are outpacing services. Should a factory expand toy production if children might be less affected by Covid-19 six months down the road? The decision to invest in and increase supply though is a function of some degree of certainty regarding the expected path of consumption/demand and the traction producers have in terms of pricing. The latter is the issue.
As inflation rises globally due to supply-chain disruptions, wage pressure and higher energy prices, the longer-term outlook for real wage growth becomes far more uncertain. For example, will wage gains continue for warehouse workers or will companies respond to the challenge by deploying intelligent machines to do the work? This scenario also applies in the context of commodities, e.g. OPEC+ will very likely try to extract as much rent as it can as Green energy steadily picks up over the coming decades. However, as stated earlier, this is very complicated.

Will inflation lead to stagnation?
This becomes a question of “chicken and an egg”. On one side, companies are forced to pass through inflation due to thin profit margins; on the other companies are trying to mark-up prices in the hope of increasing profit margins. The impact of inflation will largely depend on the credibility of central banks and governments, and their ability to manage growth and inflation. This depends in large part on their ability to control the narrative as investors struggle to predict what the future holds. Central banks, in particular, can offer a roadmap and provide a sense of confidence where there is none.
In a world of higher savings in developed markets, both mature and growth sectors can perform – but as the economy slows down and substitution effects increase, reality becomes far more difficult. Companies begin to compete with each other, e.g. Company A breaks its oligopoly pricing with Company B because it sees a structural, rather than tactical advantage in doing so.
Companies can see that they are starting to price themselves out of the market because the long-term growth expectations are overly optimistic. Long-term growth expectations in the Quality and Growth investment styles are too optimistic, but over the coming quarters we should also see large oligopolies start to break down as they reconsider the long-term forces of ageing, shift to services and the rising costs of ESG integration.

What does it mean?

The conclusion to this is that demand in mature sectors is set to slowdown in the coming quarters and even more so in growth sectors. At first, inflation will wane over time – say a few quarters – and competition should rapidly increase compressing profit margins of overly optimistic companies, offering rich opportunities for portfolio managers. In mature sectors, expectations of decent but subdued growth means that larger and better managed companies should significantly increase their investments in automation, outsourcing and client delivery (e.g. AI analysis). This is where company and sector analysis proves itself.
On the fixed income side, we should eventually see downward pressure on the back-end of the US Treasury yield curve and low Eurozone yields, while the US and European economies perform decently. This means that US High Yield could continue to deliver. At the same time, we should see a sharp dispersion across names and a large demand for long dated bonds including in China as a hedge.

Note: Inflation is a function of local but also global factors namely the overall pool of labor and global demand moving temporarily above the output gap. Over time though the output gap should improve with investments reducing inflationary pressures.

Source: Nordea Investment Funds S.A. and Bloomberg
Date range: 12/1/1990-10/22/2021

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