Inflation/Deflation

Europe is hampered by a lower trend growth rate, but has room to grow faster than the US over the next two years. How can investors profit from this outlook?

Provided that US inflation is due to excess demand rather than supply constraints, demand destruction will likely be needed to bring core inflation below 3.5%. Such growth contraction is positive for counter-cyclical currencies like the US dollar. In China, the Party's focus is to alleviate structural inequality and a long-term confrontation with the US; and authorities are not yet panicking about the cyclical state of the economy. Hence, an economic recovery is unlikely in the coming months.

We recommend that investors use the following framework to think about whether potential disinflation would be bullish or bearish for share prices: disinflation will prove to be bullish for global share prices if it is due to an improvement in supply-side dynamics, but bearish if it is demand driven. We believe it is the latter.

It takes time for wage inflation to die. So, if 2022 was the year that central banks’ monster tightening killed bond and stock market valuations, then 2023 will be the year that it finally reaches the economy and kills profits, jobs, and the wage inflation that has so far refused to die. This means that commodity prices have substantial further downside, while healthcare relative performance has substantial further upside.

Is the US in a wage-price inflation spiral that could lead to more aggressive Fed rate hikes? Is it time to buy UK Gilts after a wild month of volatility? We answer "no" to both questions, as we discuss in this week’s report.

The Fed’s tone has taken a decidedly dovish turn during the past week and, despite September’s hot CPI print, there is mounting evidence that a period of disinflation is coming. This makes the case for a pause in the Fed’s tightening cycle in Q1 or Q2 of next year.

The September CPI report was disappointing, but we still see several signs pointing to a rapid decline in inflation. Our constructive near-term view on stocks and the economy remains intact.

The ECB will continue to lift rates due to sticky inflation and a tight labor market. Will it be enough to push long-term German yields higher?

The kinked Phillips curve not only explains why inflation surged last year but makes a number of surprising predictions, chief of which is that inflation could fall significantly over the coming months without a major increase in the unemployment rate. In the near term, that is bullish for stocks.

The G7’s attempt to insert itself in the oil-price-formation process performed by global trading markets will distort markets and the signals driving production, consumption and investment. The G7 will need a face-saving off-ramp to ditch this planner-based proposal. We expect Brent prices to move toward our expectations of $105/bbl in 4Q22 and $118/bbl in 2023, and remain long the XOP ETF.