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