These are the factors that could contribute to accelerating the end of inflation

By Silvia Dall’Angelo, Senior Economist, Audra Delport, Head of Corporate Credit Research, Jonathan Pines, Lead Portfolio Manager and Orla Garvey, Senior Portfolio Manager for Fixed Income at Federated Hermes.

The year has been an unforgettable one, and not always for the right reasons. The past 12 months will live on in economic history as the year global economies staggered under the weight of tremendous inflationary pressures.

Many of the causes of this unwelcome resurgence in inflation can be traced back to structural issues related to the Covid-19 pandemic, subsequent supply-chain disruptions, and shocks caused by the Russia/Ukraine war and European energy crisis.

As the year draws to a close, there has seldom been a more appropriate time to think about the future of inflation. We have asked our investment teams to discuss what might happen if these economic headwinds were to subside or, indeed, be removed from the equation entirely. What might this mean for markets and investors – and how might they respond to a bursting of the inflationary bubble?

Factor 1: Supply chain improvements signify light at end of tunnel

Silvia Dall’Angelo, Senior Economist, notes how although both supply-side and demand-side elements have driven inflation higher globally in 2022, corrections on both sides of the equation could bring inflation down over the next few years.

Supply-side factors have been prominent drivers of the surge in inflation globally, although their weight varies across geographies. In the US, the San Francisco Fed estimates that roughly half of inflation is accounted for by supply-side disruptions.

The correction of dislocations in global supply chains is a key driver of lower inflation in our base line scenario for 2023. Recent developments have been encouraging. Many gauges of supply-chain pressure have recently started to dwindle. Cargo shipping prices have plummeted, with spot rates for shipping containers plunging by about 60% this year4. Port congestion has also improved across the board, with delays shortening significantly when compared to headlines from earlier this year. Delivery times cited in the manufacturing PMI survey indicate global improvements, and producer prices have cooled too.

Summarising these developments, the Global Supply Chain Pressure Index compiled by the Federal Reserve Bank of New York showed significant and consistent improvement between May and September 2022, as illustrated by Figure 2 on the next page. The index suggests there are still some dislocations, but these are comparatively limited when measured against the peak experienced at the end of 2021, and normal levels are predicted to be within reach for 2023.

While the weakening of global demand has contributed, and will contribute further, to the easing of supply chain pressures, the process is unlikely to be plain sailing. For one thing, the gradual relaxing of China’s harsh zero-Covid policy may not gain the momentum investors had until recently hoped for. Furthermore, looking at the longer-term, the increasingly confrontational relationship between China and the US has been the catalyst behind a constant reshuffling of global supply chains – and this, too, could continue.

More generally, it is possible that some of the supply disruptions that the pandemic and the war in Ukraine unleashed will become more permanent. Indeed, these recent shocks happened against a backdrop of growing international geopolitical tensions and intensified pre-existing trends pointing towards a partial reversal of globalisation.

Longer term, the impact of climate change might also contribute to a picture of supply constraints (e.g., food shortages), while an uncoordinated and mismanaged transition to net zero is certain to be inefficient and costly.

Overall, it is possible we are heading towards a world dominated by supply constraints and slow-moving but relentless supply chain re-arrangements, which might imply higher inflation – at least when compared with the pre-Covid era.

Figure 2: Supply chains disruptions have eased significantly but are still well-above the norm

Factor 2: Energy price moderation (but it’s still too early to be complacent)

Despite the recent positive developments in the gas market, investors must heed with caution, says Audra Delport, Head of Corporate Credit Research.

As we entered 2022, higher inflation was mostly attributed to factors relating to the Covid-19 pandemic: supply chain disruptions due to asynchronised re-openings, a shift in demand from services to goods putting a strain on production, as well as labour shortages.

Russia’s invasion of Ukraine in February 2022, meanwhile, resulted in a significant increase in both oil and natural gas prices, adding to fears of a supply disruption given Russia’s role as a major exporter of both commodities.

The energy shock further exacerbated inflationary pressures throughout the year and remains a major contributor to the current cost of living crisis. Natural gas prices in Europe witnessed a spike in August as Russia restricted flows and as the continent rushed to fill storage to prepare for winter.

As demonstrated by Figure 3 overleaf, the cost of reduced EU reliance on Russian gas is clear. In the Announced Pledges Scenario (APS), the European Union has committed to doubling down on clean energy, spending $65bn per year to bring natural gas demand down by 60% by 20305.

Figure 3: The price tag for reduced EU dependence on natural gas

More recently, natural gas prices have fallen from the August highs, as Europeans have benefitted from unseasonably warm weather in October, meaning fears of an energy shortage and potential winter rationing have abated.

Global oil prices also retraced from the March highs but remain at elevated levels and are higher when compared to the same period last year (owing tight supply and OPEC production cuts).

While such recent commodity pricing moderation is encouraging, and we believe will likely help ease inflationary pressures in the near term, it is too early to declare victory against commodity-driven inflationary pressures. The key reasons for this are as follows:

• The risk remains that natural gas prices will spike in the event of a colder winter. The UK’s Met Office recently raised the probability of a colder season to 25% – a larger probability than usual.
• If European inventories get depleted this winter, it will be hard to refill them next year. If China fully re-opens, Europeans will face higher competition to acquire liquefied natural gas. This will add to upwards pressure on prices.
• December’s ban by Western countries on the provision of maritime services to shipments of Russian oil (unless the oil is sold below a set price) will also drive prices higher.

While recent lower energy prices can clearly help contain inflationary pressures, our outlook on inflation remains cautious going into 2023.

Factor 3: A fiscal impasse – over to you, Fed

The results of the US midterms have resulted in a divided government, and probable policy gridlock. Here, Senior Economist Silvia Dall’Angelo asks whether the election outcome puts the US Federal Reserve on a firmer footing in its fight against inflation.

The extraordinary fiscal response to the Covid-19 crisis imparted a boost to aggregate demand, which has likely contributed to the recent surge in inflation globally. Advanced economies were more profligate than emerging countries, with the size of US fiscal stimulus standing out.

According to the International Monetary Fund’s (IMF) estimates, the cyclically-adjusted primary balance (as a percent of potential GDP) increased by five percentage points on average across advanced economies between 2019 and 2020. However, since 2021, the fiscal stance has become restrictive across the board, with most countries embarking on a process of fiscal consolidation.

In 2021 and 2022, fiscal deficits fell sharply, reflecting the unwinding of pandemic-related measures, and a positive contribution from inflation surprises. Looking at 2023, reducing deficits will be necessary to support the fight against inflation, and ensure debt sustainability, as seen in figure 4 below.

Figure 4: Fiscal impulse, inflation, and debt for G20 countries

While governments might be tempted to let inflation run higher to accommodate fiscal correction, this approach is not sustainable.

First, low and stable inflation is a key precondition for macroeconomic stability and good economic performance in the longer term. Second, higher inflation has put pressure on governments – especially in Europe – to resort to fiscal stimulus to cushion households and firms as they face the worst cost-of-living crisis since the 1970s.

So far, European governments have generally opted for targeted and limited fiscal support, although there have been differences across countries, depending on their respective fiscal position.

Overall, the process of fiscal correction has slowed or stalled but has not been reversed yet, although this is a risk for the future, if the European energy crisis proves longer-lasting.

Wherever you look, policymakers are facing trade-offs that are difficult to square. On the one hand, any creation of additional fiscal support could help stoke the very inflationary pressures central banks are aiming to combat. On the other, raising rates – the pre-requisite for fighting inflation – limits the headroom for fiscal stimulus.

Against this backdrop, the US is in a slightly stronger position. For one thing, policymakers are not facing the same energy price shock as Europe. But most of all, the current political configuration – a divided government, with policy gridlock – implies no additional fiscal policy in the foreseeable future. A severe recession could change this thinking – but as yet this is not our base case scenario.

Factor 4: The prospect of a global recession

The macroeconomic outlook steadily deteriorated over the course of 2022, and for Silvia Dall’Angelo, Senior Economist, the shadow of a global recession is looming. What does this mean for inflation, and how should investors brace themselves for impact?

While the recovery from the Covid-related recession was still ongoing in most countries, the Russian invasion of Ukraine in early-2022 imparted a new energy shock to the global economy, which has been particularly painful for net commodity importers.

More recently, the outlook has deteriorated further, largely reflecting three main drivers:

• First, the European energy crisis has intensified in recent months, with Russia cutting its gas provisions to Europe. The terms-of-trade shock from high energy prices is likely to tip the region into a recession this winter, and risks are skewed to the downside with the potential for the price shock to morph into a quantity shock.
• Second, inflation has continued to surprise to the upside across the board, proving even higher and stickier than expected a few months ago. This has resulted in a faster pace of monetary policy tightening. Historically, inflation at current levels has almost always been the precursor for a recession.
• Third, the Chinese economy has performed poorly as a result of the government’s harsh zero-Covid policy, and the ongoing correction in the property sector.

According to the latest IMF forecasts, global growth is now set to come in at only slightly above 3% this year, and 2.7% next year, well below the trend prevailing in the few decades before the Covid recession (~3.5%).

Risks to those forecasts are on the downside as a broad information set, including national surveys and hard data on industrial production, consumption and the labour market, points to a broad-based economic slowdown (although it is worth noting the differences across regions and countries).

The US economy has so far outperformed, reflecting energy independence and, to some extent, the long-lasting impact from the large Covid-related fiscal stimulus. Nonetheless, the Fed’s aggressive tightening since March 2022, coupled with waning fiscal support and the tendency of rising inflation to erode real incomes, has changed this scenario. In our view, the US is likely to enter a mild recession, with our base case for this to occur in mid-2023.

Figure 5: The International Monetary Fund (IMF) expects a significant slowdown in global growth in 2023

Factor 5: Not if, but when: China’s zero-Covid policy is not made to last

It’s difficult to predict when China might loosen its strict zero-Covid policy, but Jonathan Pines, Lead Portfolio Manager, Asia ex-Japan Equity, argues the country is approaching a crossroads where attempting to contain the virus is no longer possible.

China’s authoritarian approach to virus containment, which it calls ‘dynamic zero’, has been in place for almost three years. Investors are holding onto the hope that China may ease measures over the coming months, in order to release the pressure exacted on the world’s second-largest economy.

As the global economy continues to be buffeted by various macro headwinds, for China, the huge economic and social cost of trying to contain the virus may finally cease to be a price worth paying, as the recent eruption of anti-government protest in the country bears testament.

In our view, current market prices present an unmistakable buying opportunity. That said, nothing is simple, and prices are not low as a result of zero-Covid alone. The delisting of alternative dispute resolutions (ADRs), the collapse of the property market, geopolitical tensions, and common prosperity are all factors contributing to low valuations in China.

While we think investing in China is worth it on a priceadjusted basis, our risk assessment of China is that we need to consider all these risks, and not just zero-Covid.

Figure 6: Spike in China Covid-19 cases look set to surpass level during Shanghai outbreak

Factor 6: Higher interest rates as a solution to inflation?

In the current environment of above-target inflation, central banks have turned hawkish in their efforts to dampen inflation and keep expectations in check. For Orla Garvey, Senior Portfolio Manager for Fixed Income, the question remains: will it work?

The inflation we are currently experiencing has been driven for the most part by a combination of supply constraints post-Covid, the Russia/Ukraine war, the China zero-Covid policy, labour shortages, and the impact of extremely loose central bank and fiscal policy post-pandemic.

Central banks do not have the tools to impact the supply channel, and this is complicated further by a lack of clarity over how fiscal policy will interact with growth and inflation as we head into 2023.

On the demand side, we are seeing some weakening in sectors sensitive to interest rates such as housing, where high mortgage rates and a sharp rise in prices post-Covid has weighed on demand and consequently on pricing. Demand destruction is also visible in used car prices, which is similarly helping prices to deflate.

The services sector is trickier: tight labour markets are leading to shortages across some sectors which, in turn, has pushed up costs– and it is likely this will only be resolved by higher unemployment.

The result has been a broadening of inflation across the services basket which, in turn, will likely add to pressure on central bankers to maintain tight policy even as headline inflation continues to fall.

The question for investors is which way central banks turn from here. Do they maintain their hawkish path with all that implies for growth – or do they soften and so risk inflation expectations becoming dis-anchored?

Figure 7: US Owners’ equivalent rent vs. home prices yearon- year and US Zillow Rent Index (ZRI)

Figure 8: Global Supply Chain Pressure Index (GSCPI) and Shanghai-to-LA container freight rate