Inflation levels remain too high for central banks

Concerns over inflation were once again the dominant factor influencing risk assets. The inflation outlook is complicated but current levels undoubtedly remain too high for central banks. The problem appears particularly acute in the UK where a tight labour market and fiscal stimulus exacerbated last year’s global supply shock. Equity prices continue to adjust to the expectation that interest rates will be ‘higher for longer’.

The UK’s headline inflation for May came in at 8.7%, materially above the same measure in the US and Eurozone. In response, financial markets once again revised up their expectations for the future path of UK interest rates. Despite the prospect of higher rates, Sterling weakened against both the Euro and the USD on concerns over the medium-term economic outlook. Interest rate-sensitive sectors underperformed.

The question for investors is the extent to which the UK is an outlier relative to other major economies. Despite current elevated readings, UK inflation is set to fall significantly. Energy prices will reduce CPI in July when a cut in the energy price cap is implemented. Food price inflation has peaked and should begin to put further downward pressure on the overall measure. Services inflation remains elevated, but tighter monetary policy is only just beginning to impact demand. Construction activity, traditionally a lead indicator, has slowed and there are some signs of nascent deflation.

The Eurozone’s challenges are similar in some ways but different in others. Domestic demand is more subdued, and Germany is in recession. Despite having tightened policy significantly, the ECB remains hawkish. Central banks face a difficult task, but the ECB once again looks the most likely to make a policy error. Inflation expectations are well-anchored and there are few signs of a classic wage-price spiral. Wage increases thus far have generally offset the impact of the inflationary supply shock.

A more subdued US inflation release led US assets to outperform. The differential is not a consequence of better macroeconomic policy, but the smaller magnitude of the supply shock faced relative to Europe and the UK. The breadth of the rally in US equities remains very narrow with the equal-weighted S&P500 flat in GBP. Elsewhere, China surprised markets by reducing interest rates to stimulate its economy. While the recovery from the pandemic has been disappointing, this is not the denouement of the Chinese economic model. Growth will slow and a degree of currency depreciation will be tolerated.

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