The conundrum

The conundrum

The market is left uncertain as to whether we are through the eye of the needle or through a period of calm that portends more difficult time ahead. Inflation still seems on the rise in advanced economies with pipeline pressure from corporates and some evidence of second round effect as higher inflation leads to pressure for higher wages. Neither the sticky nor transitory thesis is disproved, all we have is a period of calm as equity markets find some stability. The question is whether we will break out of the range and in which direction.

A pipeline of inflation

The picture on the pipeline of inflation is a difficult one. US producer price inflation (PPI) is as high as 10.7% and that may be under-estimating the problem as social measures are taken. Similarly, PPI pressures remain elevated in many countries as they have opened up again, but many workers tend to still work from home and are spending their money on new homes or furnishing their apartments/houses. In the meantime, virtual education opens the window for competition for tablets among children. Supply disruptions continue to ripple through the systems as some factories that had to close are having difficulty playing catch-up. The entire supply chain system creaks and groans. Add to this the misery of rising energy prices from oil to natural gas and it creates a potent inflationary mixture. Indeed, it will take years for the supply of natural gas and LNG tankers to grow while the demand is high now. Similarly, microchip factories need enormous investments that take a long time to build. Finally, experienced truckers are missing probably given the difficult working conditions and poor benefits.

Tightness of the labor market

The job market in the United States and Europe is steadily improving and there are signs of second round effects. The question is whether surging inflation and declining savings will eventually hurt consumption. Although sentiment is suffering, consumption continues at a decent pace with evidence of substitution. Over time though, as savings decline, the odds are that consumption will also start to decline. This is particularly the case for workers in mature sectors. They may benefit from a cyclical rebound but corporates will likely find it increasingly difficult to pass on rising costs. In contrast, in growth sectors, rising wages driven by rising demand are likely to benefit workers. The question is whether productivity rises sufficiently to offset rising costs. Investors in particular are likely to become increasingly demanding as they favor stable large earnings – namely the so-called Quality Style.

 

What does it mean?

In such an environment, short-dated European credit solutions which protect against the risk of rising yields and deploy leverage are of interest. There is also the point to consider as to how to position for the unthinkable. In a crisis, most assets flow to currencies, leading to large movements. In such an environment, counter-cyclical currency strategies embedded in multi-asset strategies offer opportunities.

 

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