Vaccination campaigns are being implemented at speed in most Western nations and lockdown measures are being scaled back. There is a risk that the jump in US inflation will not be just temporary. But the US labor market is still too weak for an inflation explosion. The latest US economic figures were disappointing. Central banks, like most other investors, are investing pro-cyclically and have increased their quotas for “investments” in risky instruments. Many central banks intend to hold less US dollars and more “other currencies” in their reserves.
Vaccination progress in the UK and the USA
In the USA and the UK new Covid-19 infections have declined sharply. That is why politicians have been able to implement a further relaxation of restrictions which will help the hospitality and travel industries in particular. In most Western industrialized countries, vaccination campaigns are now being implemented rapidly.
Little progress on Biden’s plans for infrastructure
Negotiations on the infrastructure package planned by the Biden Administration are extremely tough. Not only is there no consensus on the overall size of the package, it has not been possible for Democrats and Republicans to reach agreement on many detailed issues. There is no common ground as to what constitutes infrastructure investment, also no breakthrough thus far on the question of financing. The Republican proposal for at least a partial funding through “user fees” is unacceptable to Democrats. We think it makes economic sense that those who use the infrastructure should pay for that use.
Inflation jumps in the US
In April, US consumer prices rose by 4.2% year-on-year, (March: 2.6%). The less volatile core index, which excludes food and energy, rose by 3.0% (March: 1.6%). In both cases, the reported figure was significantly underestimated by the analyst consensus.
The Fed continues to maintain that this jump in inflation is only temporary and that a noticeable decline can be expected soon. However, we see a risk that inflation rates could remain well above recent levels for some considerable time. With the scaling back of Covid-related restrictions, part of the money created in recent years by the central banks will become “demand-effective”. The velocity of money in circulation will rise, or at least not fall further. This means that a period of elevated inflation in the medium term is almost unavoidable.
Warning lights on a wage-price spiral are flashing amber
As a rule, a permanent inflation problem only arises when a so-called wage-price spiral is set in motion.
In such a spiral an increase in inflation triggers wage increases as workers want more pay because everything has become more expensive. In response to higher wages, businesses raise prices to compensate for their higher wage costs. The situation becomes acute when businesses raise prices in anticipation of higher labor costs and workers demand higher wages in anticipation of higher prices. In an effort to prevent such a development the Fed is trying hard to keep inflation expectations low.
Inflation expectations are likely to be “adjusted upwards” once reported inflation has risen (as has already happened) and when the market consensus has underestimated reported inflation (as has also happened). We think Fed efforts to control expectations can only succeed so long as wage inflation remains moderate.
The improvement thus far in the US labor market is unlikely to trigger a big rise in wage inflation
US non-farm employment is still 5.4%, or about 8.2 million jobs, below the level before the pandemic broke out. April’s labor market data was disappointing, with only 266,000 new hirings as compared with the 1 million expected. High unemployment and a scarcity of available positions tends to “discipline” workers and to moderate their wage demands. Given this, we view US wage inflation as still under control.
A temporary deterioration in the “trade-off” between the unemployment rate and wage inflation
The Biden Administration’s additional unemployment benefit programs have probably caused a significant deterioration in the “unemployment – inflation trade-off”. In other words, for a given unemployment rate, wage inflation is higher because of the additional government support. For many workers in low-paid jobs, it is not worth working given their access to exceptional unemployment support. So employers have to raise wages to fill their vacancies. If, as we assume, these additional benefits are not again extended and are allowed to expire, the trade-off between unemployment and inflation should improve.
US economic data less good
There are signs that the upswing in the USA is already losing momentum again: Retail sales rose by only 0.4% in April compared to the 3.1% gain in March. Industrial production rose by only 0.4% in April while industrial capacity utilization was only 74.9%, well below pre-pandemic levels. Thus, at least in the US industrial sector, the pricing power of entrepreneurs is limited. However, this would likely change if capacity utilization increases.
But a weaker recovery could cause the improvement in the US labor market to lose momentum. This in turn could slow the rise in wage inflation. Compared to a year earlier, compensation per hour rose by “only” 1.2% in April.
Conclusion: There is a risk that the rise in inflation may not be temporary. Although the inflation risk is high, the poor state of the US labor market is currently preventing a further increase.
Pro-cyclical investment behavior of central banks
Not only private investors, but institutional investors as well as regulators are also tending towards high share and low bond ratios, or put another way, high investment ratios in risky assets and low investment ratios in traditionally safe assets. The search for “sufficiently high” interest rates is also evident among central banks. These not only want to buy risky bonds and push down their interest rates for economic policy reasons, they also seek to optimize the income generated by the assets they hold. Currently, central banks hold about 59% of their reserves in US dollars. But a recent IMF survey shows that 44% of central banks polled want to include new currencies in their investment portfolios. This does not bode well for the dollar.
Contact: Thomas Härter, CIO, Investment Office
Telephone: +41 58 680 60 44
Disclaimer: Produced by Investment Center Aquila Ltd. Information and opinions contained in this document are gathered and derived from sources which we believe to be reliable. However, we can offer no under-taking, representation or guarantee, either expressly or implicitly, as to the reliability, completeness or correctness of these sources and the information pro-vided. All information is provided without any guarantees and without any explicit or tacit warranties. Information and opinions contained in this document are for information purposes only and shall not be construed as an offer, recommendation or solicitation to acquire or dispose of any investment instrument or to engage in any other trans action. Interested investors are strongly advised to consult with their Investment Adviser prior to taking any investment decision on the basis of this document in order to discuss and take into account their investment goals, financial situation, individual needs and constraints, risk profile and other information. We accept no liability for the accuracy, correctness and completeness of the information and opinions provided. To the extent permitted by law, we exclude all liability for direct, indirect or consequential damages, including loss of profit, arising from the published information.
In the latest Aquila Focus, Nicolas Peter, Head of Banking & Investments, discusses the continuing rally in US tech stocks and the lack of an interest rate cut in the USA for the time being.
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In 2023, numerous geopolitical risks came to the fore, supplemented by interest rate hikes by central banks in the fight against inflation. The conflict in Ukraine will soon last two years. In addition, the situation in the Middle East has worsened, particularly between Israel and Hamas. An escalation of the conflict to neighboring Arab countries has been prevented so far. Economic weaknesses are also evident in two of Switzerland's key trading partners: China and Germany. These developments are leading to a lack of important impetus from foreign trade. Geopolitical issues will continue to play an important role in the coming year. However, the past has shown that the impact of such events on the global financial markets is often short-lived.
Fewer sustainability investments, but more investments in pharmaceutical companies and the healthcare sector. Artificial intelligence en masse, but shares instead of gold. These are some of the resolutions of independent asset managers in Switzerland for the first quarter of 2024, according to the latest AVI Index.
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