Still looking for clues on inflation risk? Here’s why they are ‘all over the market pricing’
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Historically, stock markets have a habit of bouncing back fairly quickly from geopolitical risks.
News flow around Russia’s invasion of Ukraine is moving fast, but so far ASX microcaps have done just that.
More demand yesterday saw the ASX Emerging Companies index extend its rally to almost 10% in just five trading days, since a sharp fall when the conflict kicked off.
That’s partly due to some historic conflict-related moves across the commodities space.
For now, investors are happy to continue chasing a boom which was already in play with interest rates set to rise.
That was before Vlad (Russian President Vladimir Putin) began “not-so-subtly discussing nuclear weapons” while attacking a sovereign state next door, CBA analyst Philip Brown said.
“You’d hope he’s just bluffing,” Brown added. (Ed note: we second that).
But as commodity prices skyrocket in response to spending supply shortfalls from Russia (a major commodity producer), it’s given rise to some interesting trends in another key risk variable for stock investors; bond yields.
As expected at the outset of a major military conflict, the yield on US 10-year bonds eased back below 1.9% as money moved into safe-haven assets.
Before the war, the main word on every investor’s lips was inflation (more specifically, US inflation).
It’s still running hot. And just as importantly, a surge in oil, gas coal and other energy inputs does two things;
1. Creates higher supply side costs, which flow through to higher prices;
2. Those same supply-side costs restrict economic activity.
In a research note this week, Brown dropped the S-word — Stagflation, the rare combination of higher prices with lower growth.
The Stagflation risk is real, Brown said.
“And if you know what you’re looking for you can see them all over the market pricing.”
For starters, Brown highlighted the fall in US bond yields in response to the Russian invasion.
Among various indicators, a drop in yields indicates the market is reducing its forecast for future economic growth.
But interestingly, at the same time there’s been a sharp rise in inflation expectations, Brown said.
In fact, market pricing currently offers “a sobering outlook for inflation”, he said.
Priced all the way out to 10 years, bond markets are forecasting that US inflation will remain above the 2-3% target band.
But combined with the outlook for interest rates, that also throws up some “curious” results, he said.
Right now, interest rate markets pricing suggests the US Fed will raise rates through to the end of 2023 until they reach 2%, before stopping.
However, that wouldn’t be enough if inflation is still holding above the 2-3% target range, as bond markets currently forecast.
Something has to give, Brown reckons. And the anomalies are partly are function of the unpredictability inherent in a global military conflict.
“What makes this current period so difficult to analyse is that it’s not clear whether the Russian’s will succeed,” Brown says.
“However, over time this uncertainty cannot persist. The Russians will either redouble their efforts and win, or they’ll retreat,” he said.
Either way though, the global supply chains connected to Russian oil & gas are unlikely to ever return to normal.
Therefore, once the dust settles, higher energy costs will form a permanent part of the inflation equation.
“We fear the net result of the war for bond markets will actually be slightly higher yields, in the long run,” Brown said.
“It will be very important to monitor how the inflation outlook if (and hopefully when) the fear premium in yields fades.”