April 2024
Inflation Surprise? No, Not Really
The market is currently correcting mistaken assumptions that were based on a market cycle driven by artificially low interest rates. As market dynamics shift, the source of a company's growth will also shift.
Robert M. Almeida, Jr.
Portfolio Manager and Global Investment Strategist
Over the past couple of weeks, several inflation readings have taken the market by surprise. It wasn’t a surprise, however, for those who buy food, pay utility bills or pay rent. Commodity prices have surged and outpaced stock prices year to date, but the acute pain for households has been the cost of things they need, such as eggs, milk, electricity or shelter, which are not deflating.
Financial assets, including US Treasury bills and sovereign bonds, represent weighted probabilities about future (cash flow) outcomes. When new information changes on those probabilities, asset prices adjust. When financial price volatility is high, it’s the market correcting for mistaken assumptions but also expressing increased uncertainty.
In the final months of 2023, investors took their cues from central bankers. They began to discount that inflation would recede to desired levels, allowing for a loosening of monetary policy and softer sovereign yield curves. Obviously, those assumptions were too strong.
As readers of Strategist Corner and/or clients of MFS know, this wasn’t our base case. Our analysts were hearing from company management teams that labor remained in short supply. We expected this would keep aggregate demand elevated and restrict the type of policy loosening the market wanted. So, what now?
In the Strategist Corner released on April 16, 2024, we described what we think is a paradigm shift. Our world is shifting from one of artificially suppressed interest rates and cheap manufacturing to something else. A world with greater needs for capital, specifically on equipment and labor, will prevent a return to abnormally low inflation and suppressed rates.
A pandemic, multiple wars and rising geopolitical tensions exposed the risks of stretched supply chains and outsourcing. Globalization is not going away, but it’s being rerouted due to the risks of not having goods when needed, and that has financial implications.
2024 may mark the first year since the Black Plague that the global population is expected to decline. While that represents a chronic problem and a topic for another day, we currently have an aging workforce at the same time demand for workers is rising due to reshoring. The give in that equation is price, in the form of higher sustained labor costs.
While this may lead to higher wages, consumer spending, overall economic growth and inflation versus the 2010s, it will come at the expense of profits and valuation that investors are willing to pay for those profits. This is the opposite of the 2010s paradigm.
To be clear, I am not suggesting monetary policy will be tightened or yield curves will steepen. I think the market underappreciated the implications of this paradigm change. And while rates will ultimately fall, it probably won’t be a straight-line decline like the market anticipated. Our world isn’t that simple.
More importantly, as the world adapts, businesses, whose profit streams were primarily sourced via cheap debt and labor, will succumb to balance sheet stress. Unlike during the low-cost regime, companies unfit for purpose will likely deliver disappointing financial results. We believe that avoiding those financial assets may prove beneficial to discretionary managers and advisors.
The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice. No forecasts can be guaranteed.