It’s the Supply Side, Stupid!

The Fed is aiming for a “soft landing”, but soft landings are historically rare. With this much debt in the financial system, a soft landing is particularly hard to achieve. Jerome Powell said in an interview last week that “the question whether we can execute a soft landing or not, it may actually depend on factors that we don’t control”. Meanwhile, Treasury Secretary Yellen said that the Fed would need to be “skilful” and “also lucky” to have a soft landing. In other words, we are probably not going to get a soft landing.

The Fed and US Treasury policy is currently indicating a preference for a recession over inflation. At some point, this policy option will change. Until then, the markets will have their feet held to the fire of slower growth and higher prices.

The solution must involve structural improvements to the supply side. To achieve a decent level of disinflationary growth we need more supply per unit of demand. But supply-side reforms take time to implement.

Meanwhile, the supply side remains tight. As a key example, oil producers are not being encouraged to produce more by a downward sloping forward curve. (December 2025 oil is priced at $70 versus a spot price in excess of $100). Energy stocks have risen strongly, but they are now constrained by this signal. China’s extreme COVID policy is making the supply side conditions worse.

Base effects mean that inflation has reached a local top. However, the underlying rate of inflation is likely to remain at historically high levels for several years, until the supply side is fixed.

Early-cycle indicators such as ISM are pointing to a continuing slowing of economic growth. A recession, while not inevitable, is growing in probability. While employment levels and house prices are holding up, these are both lagging indicators.

Bond yields have been going up, and credit spreads have widened and so increasing the cost of capital to weaker indebted companies. Banks remain vulnerable in this scenario.

Political pressure on Central Banks to ease will become intense and the balance of probability is that Central Banks (Fed and BoE) will halt their monetary tightening before the end of 2022. In this scenario, long bonds and other longer duration assets such as tech stocks are looking oversold, in the near term.

Value stocks are more vulnerable in a recessionary environment while growth stocks are in a higher rate environment. Commodities and real assets remain relevant in any period of sustained higher inflation especially one with scope for further supply-side shocks.

Jeremy

Ealing

16/05/2022

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