With the European Central Bank (ECB) expected to hike rates for the 10th time in a row today, the macroeconomic forecast panel was unanimous in its conviction that inflation is set to increase – but while an EU rate hike is needed, the window is tight and a pause is likely needed after this meeting. Opinion was divided on policy predictions, but with the grim outlook for Europe and sticky inflation in the US, emerging markets are looking like one of the few bright spots.
Inflation is the core issue for the current macro environment, confirmed Mabrouk Chetouane, global head market strategy, Natixis Investment Managers. This is being driven by both medium and long-term factors including scarcity of resources, increase in commodity prices, shortage of labour and an already noticeable increase in wages in some regions (for example, Germany).
Inflation increase
All these factors together mean that there is no reason to see inflation coming back down to the target that central banks are tracking. “Inflation is still here, and will stay with us for a long time,” noted Chetouane.
In fact, there are signals that persistent, sticky inflation is ramping up again – even in the US, where a proportion has in fact been engineered by policy, which has been geared towards investment and consumption. “It’s puzzling, because we thought that more or less, at least in the US, the job as done and rate hikes were over. But it seems like we may need a bit more,” said Florian Ielpo, head of macro, multi asset, Lombard Odier Investment Managers.
“One of the thoughts we have at the moment is that maybe we are just in a classic late cycle period. We may just be a few quarters ahead of a recession, which is typically the period that inflation builds up again. So maybe this trend is not so surprising.”
Christophe Morel, chief economist and head of global tactical asset allocation at Groupama Asset Management, warned that the ‘transition’ narrative is no longer valid, and markets must get used to a new normal. “We are at the starting point of a new inflation regime and we are facing a huge shock,” he said. “At a time when economic models are changing, you will always see inflation because you face scarcity and you need new resources. We are facing scarcity in commodities, in human capital – this is going to be a huge rebasing.”
European policy
So what are we likely to see from the ECB? The panel unanimously agreed that a rate hike should be expected – at least today.
“We are seeing some signs of an upturn. Central bankers, who are clearly lengthening their horizon, know that stronger growth means an uptick in inflation and will require a further monetary response. Markets should be prepared for an acceleration of quantitative tightening (QT) – we need to curb steepening, and this is the right time to act,” said one panellist.
This is not only the right time, but according to some, possibly the only time. Chetouane warned that there is a narrowing window for the ECB.
“If they pause now, there won’t be an opportunity to do it later. The business cycle is about to downturn and that will put a lot of pressure on companies. When you look at core metrics, alternative inflation measures, they’re all showing the same thing – inflation is declining at a very slow rate. This is a concern for the ECB. Can they continue to hike rates? In my opinion, no. We have two separate goals, price stability and financial stability. If it continues, financial stability and the real economy will suffer. I think they will hike rates by 25bps today and then pause for a long time.”
Emerging markets
Other regions are experiencing different challenges, however. The Bank of Japan has a tricky job for example, and is under a lot of scrutiny.
“We have to carefully monitor what is happening in Japan, and any monetary policy decision,” said Morel. “The Japanese economy is very important, it is the symbol of deflation. Any signal that they plan to digress from their usual monetary policy will be a sign that deflationary policy is over.”
Emerging markets are a tentative bright spot, but opinion was divided on what the approach should be. “We need to be cautious on the emerging credit galaxy,” warned Morel. “This summer there were huge outflows in emerging credit. I don’t think we should put too much risk on these asset classes.”
However, emerging markets were first to hike rates and are likely to be the first to cut them – so they could be a lucrative bet. “One of the best trades we did last year was Chinese bonds,” pointed out Ielpo. “You will find some diversification across EM assets. Last three months, there has been terrible news from EM, especially from China. But a lot of that is already priced in. EM debt and EM equities are probably the only markets that are under-owned and under-valued at the moment. All that we need is standardisation in the bad news flow, especially from China, and we need to see the dollar down. Then I’ll be more comfortable. So basically, we are constructive on EM… just not yet.”
Onwards (and upwards)
With higher rates, increasing premiums and steeper curves, central banks across the world have a tough job. Credibility is key, and the market is waiting to see what they’ll do – but don’t be too quick to judge.
“It’s easy to criticise central banks but we’re not in their shoes and we’re not doing their job,” pointed out Ielpo. “At the moment it’s very hard to know if inflation is higher for structural or for cyclical reasons. We need to bring it back to target first – you don’t change horses mid-race.”
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