FOMC’s inflation model fails, interest rate sensitivity, capex drought

Equities 9 minutes to read
Peter Garnry

Head of Equity Strategy

Summary:  FOMC is still betting on transitory inflation in its economic forecasts but the change in the dot plot suggests that several members are moving their views on the economy and inflation. We argue that political the US is forced to keep fiscal stimulus at much higher levels than the GDP output gap model suggests is reasonable, which will make inflation stickier than currently estimated by the market and the Fed. We also discuss the underlying interest rate sensitivity and the potential ketchup effect on interest rates waiting on the horizon. Finally, we show how capex in the global mining and energy sector has collapsed 65% inflation-adjusted since the peak.


Yesterday, the FOMC partially blinked and acknowledge between the lines and in the small details that inflation is increasingly becoming a worry inside the FOMC. The stretching out of dots in 2022 and 2023 in the dot plot indicates that some members are moving their projections acknowledging the trajectory of the US running hot later this year and inflationary pressures are building. Seen from equities, the most interesting fact yesterday was the economic forecasts where the core PCE inflation was revised up to 3.0% from the March projection of 2.2%. In the span of only three months the Fed’s econometric models have been wrong by 0.8%-points which is quite a forecasting error.

This suggest that the calibrated inflation models cannot capture the current inflation dynamics and thus the forecasting error is likely to extent as many of the inflation dynamics will not ease anytime soon. The US 10-year yield is higher, and we got a classic reaction with most high duration and growth pockets in equities selling off (see table). The best performing segment yesterday was the financial trading basket indicating that investors are betting on higher trading income from fixed income going forward and potentially more volatility.

Growth investing and inflation

The FOMC meeting will not be the event that takes us to new levels on US interest rates and cause a bigger sell-off in equities. Inflation data (m/m figures) over the summer months will be key for market dynamics and interest rate direction. As long as consensus is 72% of institutional investors believing in transitory inflation interest rates will be well behaved and growth stocks will not lose a lot terrain to value stocks. With this consensus the likelihood of a ketchup effect on interest rates is high and if we are right about the inflation dynamics (more on that later), then we got get another sell-off in growth stocks later this year on par with what we saw earlier this year. The ‘go-go years’ in the 1960s were also about growth stocks in the US and the 1970s inflation period changed that dramatically. Growth investing is a more difficult discipline under rising inflation and interest rates. More importantly the low free cash flow yield observed in equity growth pockets and the Nasdaq 100 means that the interest rate sensitivity is quite large and could surprise many investors if inflation sticks.

There are several reasons why we believe inflation will turn out to be stickier than what the market and the Fed believe. Fiscal stimulus cannot meaningfully be reduced as it will weaken the economy into a 2022 US midterm election which is not a political option for the Biden administration. It is much more likely that fiscal deficits will remain higher for longer adding long-lasting fiscal impulse keeping GDP above its potential for longer than expected. If the transfer income schemes remain then businesses relying on low-wage workers will have to bid up wages to get them back into the labour force and hike prices to offset the increased wage costs. Lennar’s Q2 earnings yesterday was quite interesting in that the US homebuilder is lifting its fiscal year guidance for gross margin to 26.5-27% from previously 25%, indicating that the homebuilder easily can pass on rising input costs and expand margins. This is a sign of strong demand and excess buying power. In other words, the market is not in equilibrium yet and prices can rise further.

Green transformation and the capex drought

The potentially biggest driver of inflation going forward will come from the green transformation under an accelerated decarbonization policy in the US, Europe, and China. It is the biggest physical transformation of our society since WWII and will require enormous amount of capital and physical resources putting immense pressure on our technologies and resources. A few clients have recently shot back at our view saying mining will just expand capacity because higher prices incentivise them to expand. This sounds in theory and is likely also the long-term reality, but in the short-term the reality is very different. As the chart below shows, capital expenditure in the MSCI World Materials and Energy sectors (covering global mining, metals, and energy industries) has dropped 65% from the peak in real terms (adjusted for inflation) and is now at the lowest level since 1997.

Our fiscal stimulus and green transformation policies are driving enormous demand which is not being met by expanding supply. As Glencore’s CEO said in May, copper prices have to rally 50% for supply to meet demand, which feed through into prices of housing, electrification and EVs ending up with higher consumer prices. This is exactly why the Fed’s econometric models will fail at model the regime shift on inflation. The green transformation and subsequent commodity rally are driven by a political choice to change society and thus the driver cannot be captured in a model until the autocorrelation in inflation figures sticks, but at that point inflation is already out of the box creating new dynamics in consumer behaviour etc.
Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-hk/legal/disclaimer/saxo-disclaimer)

Saxo Capital Markets HK Limited
19th Floor
Shanghai Commercial Bank Tower
12 Queen’s Road Central
Hong Kong

Contact Saxo

Select region

Hong Kong S.A.R
Hong Kong S.A.R

Saxo Capital Markets HK is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo Capital Markets HK Limited holds a Type 1 Regulated Activity (Dealing in securities); Type 2 Regulated Activity (Dealing in Futures Contract) and Type 3 Regulated Activity (Leveraged foreign exchange trading) licenses (CE No. AVD061). Registered address: 19th Floor, Shanghai Commercial Bank Tower, 12 Queen’s Road Central, Hong Kong

By clicking on certain links on this site, you are aware and agree to leave the website of Saxo Capital Markets, proceed on to the linked site managed by Saxo Group and where you will be subject to the terms of that linked site.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

Please note that the information on this site and any product and services we offer are not targeted at investors residing in the United States and Japan, and are not intended for distribution to, or use by any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation. Please click here to view our full disclaimer.