• Supply shocks have created scarcity inflation, making higher inflation more persistent and increasing the risk of a growth slowdown.
• Ten-year U.S. Treasury yields hit three-year highs after it became clear the Fed will start to reduce its balance sheet quickly. We see further yield rises ahead.
• We could see European Central Bank officials trying to guide down market expectations for multiple rate hikes this year and next.
Scarcity inflation is here. Supply shocks have created shortages of goods, energy and food that are driving up prices. We see this making inflation more persistent. It’s also spurring central banks to normalize policies faster. This is needed, in our view, as the economy no longer requires stimulus. The problem: Scarcity inflation has raised the risk of a global growth slowdown, either via the direct impact of the supply shocks or through central banks slamming the brakes on the economy.
Scarcity shock and inflation
Change in U.S. PCE and euro area inflation, 2022 vs. 2015-19 average
Higher inflation is still driven by the sudden restart of economic activity from the pandemic’s lockdowns. Supply has struggled to keep up with shifting bursts in demand across sectors. Russia’s horrific invasion of Ukraine added a classic
supply shock that is driving inflation higher and hurting economic activity. First, the West’s drive to wean itself off Russian energy added to an existing energy crunch. The result: Rising energy prices today are contributing 4 percentage
points more to euro area inflation than in the five years before COVID, as the chart shows. Second, reduced food and fertilizer exports from Russia and Ukraine have created food insecurity around the word. These new supply disruptions add to existing pressures: Farmers already faced sharply higher fertilizer and diesel costs. Food inflation (green bars in the chart) could become a larger driver of inflation in developed markets as a result. World food prices jumped 13% in
March to a new high, Food and Agriculture Organization data show.
What is the impact of the two supply shocks and resulting scarcity inflation? It differs greatly by region. For Europe, the
second shock could result in outright stagflation as the region’s energy costs have surged to near-record levels, as we detail in A new supply shock. In the U.S., a net exporter of energy these days, the momentum of the economic restart is strong. The risks to growth there stem from the Federal Reserve’s response to headline inflation running at 40-year highs, in our view.
Indeed, scarcity inflation is compounding the dilemma for central banks around the world: Inflation is high, but economies are not overheating. The usual playbook of jacking up rates to cool the economy doesn’t really apply in a world shaped by supply. Central banks are normalizing policy rates back to neutral levels that neither stimulate nor restrain the economy. Minutes of the Fed’s March meeting released last week reinforced our view that the central bank is determined to normalize very quickly, with a large projected rate increase this year and a quick reduction of its balance sheet.
The key issue: Will central banks go beyond neutral and slam the brakes on the economy with higher rates that crush activity – and risk assets? We believe central banks will ultimately choose to live with higher inflation, rather than destroy growth and employment. As a result, we expect the sum total of rate hikes to be historically low given the level of inflation. Once the Fed gets closer to neutral levels of rates later this year, inflation will likely have peaked. Growth and spending on goods should be normalizing. We see two risks. First, central banks could slam the brakes anyway because they think they can lift rates higher without causing damage. Second, the sticker shock from higher day-to-day prices causes inflation expectations to become de-anchored from central bank targets.
What are the investment implications? We prefer equities over credit because the inflationary environment favors stocks, in our view. Many developed market companies so far have been able to pass on rising costs and kept margins high. Firstquarter results starting this week will provide a reality check. We are underweight government bonds. We see long-term bond yield rising further and yield curves steepening as investors demand extra compensation for the risk of holding longterm government bonds amid high inflation and debt loads. Short-term bonds could outperform as we believe market expectations for rate increases have become overly hawkish. Such a backdrop could still be positive for equities because it represents a relative investor preference for stocks over bonds. We favor U.S. and Japanese equities over European peers within developed markets because we see the impact of the energy and food shocks as greatest there.
U.S. 10-year Treasury yields jumped to three-year highs of around 2.7% even as short-term yields steadied, causing the
yield curve to steepen sharply. The Fed’s plans to shrink its balance sheet – so-called quantitative tightening – was close to expectations but helped spark the back up in yields. We expect a further steepening of the yield curve as investors demand more term premium, or extra compensation for the risk of holding long-term bonds.
Assets in review
Traditional energy stocks have delivered strong returns amid a difficult start to the year for the broader stock market. See the yellow and orange lines on the chart. As the West seeks to wean off Russian energy, greater demand for non-Russian fossil fuels has pushed up prices, leading investors to expect higher profits from energy producers. Clean energy stocks have also outperformed the broad market since Russia invaded Ukraine (green line) as markets see the drive for energy security, particularly in Europe, as a positive for renewables. Sustained high fossil fuel prices act like a carbon tax on consumers. Europe now spends over 9% of its GDP on energy, the highest share since 1981. Even before fuel prices surged, wind and solar power were competitive with fossil fuels. Renewables have become even more competitive now that fuel prices are even higher. This should spur Europe toward renewables and electrification. Bottom line: The effective stranding of Russian fossil fuel supply has created investment needs in both traditional energy and renewables.
1)Living with inflation
• We expect central banks to quickly normalize policy. We see a higher risk of the Federal Reserve slamming the
brakes on the economy to deal with supply-driven inflation after raising rates for the first time since the pandemic.
• The Fed has projected a large and rapid increase in rates over the next two years. We see the Fed delivering on its
projected rate path this year but then pausing to evaluate the effects on growth.
• Normalization means that central banks are unlikely to come to the rescue to halt a growth slowdown by cutting
rates. The risk of inflation expectations becoming unanchored has increased as inflation becomes more persistent.
• We believe the eventual sum total of rate hikes will be historically low, given the level of inflation. DM central banks
have already demonstrated they are more tolerant of inflation.
• The Bank of England hiked rates for a third time but signaled that it may pause policy normalization on concerns
about the growth outlook from spiraling energy costs. This is the bind other central banks will likely face this year.
• The European Central Bank has also struck a hawkish tone, planning to wind down asset purchases and leaving the
door open for a rate increase later this year. We expect it to adopt a flexible stance in practice given the material hit
to growth we see from higher energy prices.
• Investment implication: We prefer equities over fixed income and overweight inflation-linked bonds.
2)Cutting through confusion
• We had thought the unique mix of events – the restart of economic activity, virus strains, supply-driven inflation and
new central bank frameworks – could cause markets and policymakers to misread the current surge in inflation.
• We saw the confusion play out with the aggressively hawkish repricing in markets this year – and central banks have
sometimes been inconsistent in their messages and economic projections, in our view.
• The Russia-Ukraine conflict has aggravated inflation pressures and has put central banks in a bind. Trying to
contain inflation will be more costly to growth and employment, and they can’t cushion the growth shock.
• The sum total of expected rate hikes hasn’t changed much even with the Fed’s hawkish shift.
• Investment implication: We have tweaked our risk exposure to favor equities at the expense of credit.
3)Navigating net zero
• Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that
investors need to start adapting their portfolios today. The net-zero journey is not just a 2050 story; it’s a now story.
• The West’s decision to reduce reliance on Russian fossil fuels will encourage fossil fuel producers elsewhere to
increase output, but we don’t expect an overall increase in global supply and demand. We see the drive for greater
energy security accelerating the transition in the medium term, especially in Europe.
• The green transition comes with costs and higher inflation, yet the economic outlook is unambiguously brighter
than a scenario of no climate action or a disorderly transition. Both would generate lower growth and higher
inflation, in our view. Risks around a disorderly transition are high – particularly if execution fails to match
governments’ ambitions to cut emissions.
• We favor sectors with clear transition plans. Over a strategic horizon, we like sectors that stand to benefit more from
the transition, such as tech and healthcare, because of their relatively low carbon emissions.
• Investment implication: We favor DM equities over EM as we see them as better positioned in the green transition.