Round 1 of inflation has been won, but...
The stock markets have shown signs of joy. The jubilation has even spread to Nasdaq Helsinki where there have been signs of life in recent days.
In this post, we discuss recent inflation and economic data from both the eurozone and the US. Eurozone banks look ridiculously cheap. It suggests that investors do not believe in the current level of interest rates, nor in the sustainability of the European economy. At the same time, inflation is receding in the US, but winning the first round does not mean that inflation cannot return to the stage. Interest rates may therefore remain higher for longer.
Inflation data from Europe and the United States
Inflation in the eurozone is leveling off, but at a painfully slow pace. According to data released last week, the year-on-year increase in the overall price level in August was 5.3%, pushing above the market forecast 5.1% thanks to the rise in energy prices.
Core inflation, which excludes volatile food and energy prices, slipped to 5.3%, as expected. In services, inflation is running at 5.5%. Although the eurozone economy is growing at a brisk pace, there is no sign of a rapid easing in price developments. Germany, the largest economy, is struggling on the brink of recession, yet wages are growing at an average annual rate of 6.6%, according to recent statistics. Persistent inflation feeds wage pressures, which in turn feeds further inflation. This could force the European Central Bank to raise interest rates further, even if the economy looks dangerously weak in the very fragile euro countries.
The Finnish economy, which is particularly sensitive to interest rates, is already feeling the impact of higher interest rates as the housing market and construction melt down. A weak economy and high interest rates are a well-known recipe for misery in the economy.
The question for the market is not whether inflation in the eurozone will cool down. It will cool down slowly. The bigger question is whether it will cool down fast enough to meet market expectations. The current market expectation for the ECB's policy rate one year from now is around 3.5%. Back in the summer, there were still fears of 4% interest rates a year from now. One may well ask whether the current slowdown in the rate of inflation is sufficient in view of investors' lower interest rate expectations. Higher interest rates for a longer period are not out of the question for the time being, provided that wages continue on their strong growth trajectory.
Of course, the central bank's policy rate mainly affects short-term lending rates and, e.g., mortgage rates. The present value of equities is based on cash flows over the next few decades, so they are compared to long-term interest rates. The risk-free rate for European and Finnish equities is the German 10-year bond. It has been hovering around 2.5% since last December, and it is hardly a coincidence that as interest rates have leveled off, equities in Europe have recovered. Except in Finland...
The valuation of European bank shares gives an interesting indication of investors' expectations. If the economy continues to grow and interest rates remain higher for longer, one could think that the European banking sector, which has suffered from negative interest rates and economic apathy, would be popular with investors. However, the European Banking Index is trading at around six times its forecast performance. At the same time, the general index STOXX 600 is paid 12 times as much. Banks have been this cheap in the COVID crisis and the European debt crisis. However, the European Banking Index includes many British banks, and the situation is even more horrid in the UK. Nordea, Finns' favorite stock, is also in that index. Investors could therefore be expected to be skeptical about the renaissance of European banks, with recession, credit losses and falling interest rates eating into future results. European banks have been going horizontal for 15 years after the financial crisis. If interest rates remain at higher levels and the economy limps along reasonably well, one would expect this dog to have its day at some point. Someone has to finance the future green transition.
Similarly, in the US, data on private consumption was published for July. This data comes with a little lag, but it also speaks to the very slow retreat of inflation. So-called “super core inflation”, i.e., inflation in services excluding slowly updating shelter costs, remained at 0.5% per month. Although there were the odd jumps in the price of investment services, and if you exclude them, the monthly inflation rate landed at 0.25%. If that figure were annualized, core inflation would be around 3%. During the pandemic, core inflation excluding shelter averaged 0.35% per month, or 4.3% per year, compared with an average level of 2.3% per year before the pandemic. Inflation is therefore clearly still at elevated levels and the slide downwards is as peaceful as the slide of concertgoers into the concert hall from the intermission cognacs.
It is important to be aware that inflation is only tantalizingly persistent, but it is no longer a surprise to the market. The question is mainly whether interest rates will stay higher for longer because of the inflation that investors now seem to be expecting. Namely, in the US, we are also expecting policy rate cuts in the next few years, as I have mentioned in many videos.
Thanks to hefty pay rises and the consumption of pandemic-era savings, American household consumption grew more than expected, underlining the strong economy. Time will tell how long strong demand will continue as the savings rate rattles around pre-financial crisis levels. While part of the reason is certainly the extra savings accumulated during the pandemic, the savings rate cannot remain this low forever.
The tight labor market that has driven strong wage growth also appears to be loosening. The unemployment rate rose slightly as more people are looking for work. For clarity, unemployed jobseekers are counted as unemployed. If you do not apply for a job, you are not unemployed in economists' statistics. This is a fun graph showing the evolution of the Fed policy rate and the ratio of job vacancies to job seekers. Usually, when the ratio turns downwards, interest rate hikes come to a halt. That is what the market seems to be calling for.
When debating inflation, it’s easy to lose sight of the forest for the trees and focus too much on specific details. For equities, inflation is a negative driver if it surprises with its speed, as it did last year. Now inflation is pretty much in line with expectations. Looking ahead, the market seems to be pricing in a scenario where inflation cools rapidly, and interest rates fall with it. But critically, the economy continues on an upward path. If prices continue to rise for longer than expected and interest rates stay afloat or rise further, expensive US equities will face a headwind.
The higher interest rates go, the less attractive equities look if we suspect that the rest of the economy cannot withstand high interest rates anyway. In the US, you can get a better return on cash than stocks offer on earnings. This is a somewhat populist pattern, as the expected return on equities is not the same as their earnings yield. Earnings yield describes how much money would be paid out of a share if all the earnings were paid out as dividends. Such a situation can last for some years, but in many cases, stocks have eventually taken a hit, as was the case in the tech bubble.
Inflation may also subside for a while, but as soon as you look away it comes back. This happened in the 70s, when the Fed cut interest rates too quickly. Today, inflation is fueled by the energy crisis, Russia's war of aggression in Ukraine and the economic recovery of countries, whereas in the 1970s it was fueled by the Vietnam War, the consolidation of welfare states and energy crises. For the last 40 years, inflation has structurally been helped down by globalization of the world economy and low-cost production in China. The global economy now faces risks of trade wars. Value chains are moving back home away from autocratic China. As climate change worsens, supply shocks will become more common if natural phenomena destroy arable land or paralyze production. With aging populations in the West and China, there will be a shortage of workers, which will increase wage pressures in the long term. Thus, many inflationary drivers have changed position. Central banks are aware of their old mistakes and new challenges, which may lead to higher interest rates than expected. Although we are now taking a slow round victory on inflation, its unpredictability is something investors should keep in mind for the next round.
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