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Economy in Brief

Peak Time
by Andrew Cates  January 28, 2022

Some financial market instability has earmarked the first few weeks of 2022. Risk assets have incurred large losses, and many of those assets that led the way up in recent years have taken some big hits. Some of this instability pertains to heightened geopolitical tensions between Russia and Ukraine. But some of it is rooted in underlying global macro fundamentals too.

In what follows we discuss some of those fundamentals and what they might imply for the outlook ahead. In short many of the macroeconomic drivers of asset prices are peaking and moving into reverse. These include the latest COVID wave, global growth, profitability and even inflation. But partly because of the strength of some of these factors in recent months another key driver of asset prices – namely economic policy support – is also peaking and now moving into reverse as well.


Let's start with the good news. The world as whole is looking at a very different COVID picture at present relative to where we were a few months ago. While the Omicron variant has sent case numbers spiralling higher in a number of countries, hospitalisations and fatalities have not risen nearly as much as they have done in previous waves. Indeed the ratio between fatalities and cases at the global level is sitting at a multi month low (figure 1 below).

Figure 1: Global COVID fatalities have continued to decline relative to cases

If we drill into country-specifics and, for instance, the latest UK experience and despite differing policy responses toward lockdowns and social distancing in the four nations that make up the UK we see a similar picture. Hospitalisations - and more specifically in figure 2 below patient numbers on ventilators - have remained extremely subdued relative to the surge in case numbers that all four nations have seen over recent weeks.

Figure 2: The UK's latest experience with COVID is instructive

This suggests that this strain of the virus, while more contagious, isn't as harmful as previous strains. That in turn can be traced to the immunity that's been built up by the combination of prior infection, vaccination along with better drugs to treat harsher symptoms. In summary, underlying fear about the COVID virus ought to have peaked and should reverse in the period ahead.

Peak growth and profitability

What about growth? Here, the news-flow hasn't been as auspicious. Incoming economic data in the G10, for example, have been disappointing expectations to the downside more frequently in recent days (see figure 3 below). That could be a function of shifting demand patterns – away from goods and toward services – as pandemic polices are being unwound. Surging goods demand (and heightened manufacturing activity) certainly seem to have been responsible for the trend toward positive growth surprises that engulfed the early stages of the pandemic perhaps because of the magnified impact this source of demand typically has on the world economy (relative to services).

Figure 3: G10 growth surprises are rolling over

Another reason though why growth more generally is ebbing concerns its starting position. If we look at output in the major advanced and emerging economies they have mostly already surpassed the levels they attained just prior to when COVID struck (figure 4 below). Putting that another way a lot of the heavy lifting in the early recovery phase of the pandemic era has already unfolded.

Figure 4: Most major economies have now regained their pre-COVID GDP level

Importantly – for financial markets - one of the near-inevitable features of a softer growth environment is weaker profitability. Earnings per share estimates for companies in the US S&P 500 index, for example, are now falling and broader macro-based estimates for corporate profits growth in the US, Canada and Japan are slowing as well (figure 5). This is incidentally not just about weaker nominal GDP growth – or more to the point – weaker revenue growth. It's also being driving by tighter profit margins, heightened unit cost pressures and possibly by a likely lack of pricing power in many sectors too.

Figure 5: Corporate profit growth is slowing

Peaking inflation

Pricing power and cost pressures though are a neat segue in to the next factor namely inflation. Most forecasters, including most Central Banks, have under-estimated the strength of inflationary pressures over the past several months. But there are still a few reasons for thinking that inflation is close to peaking and that it could in fact fall quite quickly over the latter stages of this year.

That relatively relaxed view hinges on a number of global factors. For instance, although US output gap estimates and forecasts suggest limited (if any) spare capacity in that economy, that's not the case from examining those same – albeit imprecise - estimates for China and the Eurozone (see figure 6). Further weakness in China's economy in particular could place more downward pressure on globally traded goods prices in the period ahead than many expect.

Figure 6: Still some excess capacity in China and Europe

Secondly sector-specific drivers of recent price pressures are possibly peaking too. Output price inflation in the consumer goods sector has rolled over, for example, according to the latest December sector PMI estimates (see figure 7).

Figure 7: Globally consumer goods price inflation is finally slowing

On the supply side of the inflation equation some better news has emerged of late. Suppliers' delivery times have shortened (according to purchasing managers' surveys) and global shipping costs have declined sharply (as measured by the Baltic dry index) as evidenced in figure 8 below. That being said a broader albeit slightly more dated index for global supply chain pressures while again off its highs still suggests that global supply side congestion is acute. For the record this is a newly developed index that's been calculated by the Federal Reserve Bank of New York and shows that global supply chain pressures are still some 4 standard deviation points away from normal (figure 9).

Figure 8: Suppliers' delivery times have shortened and shipping costs have declined

Figure 9: Global supply chain pressures overall are still acute

Peak policy support

What do these fundamental matters mean for policymakers? That's not an easy question to answer and clearly the uncertainty about the trajectory of policy is one reason why investors have become jittery in recent weeks. One thing seems certain namely that the era of extraordinary monetary – and fiscal – policy stimulus is coming to an end. In other words we have reached peak policy support. The difficult issue now is how swiftly that support will be withdrawn. Recent commentary, and most notably from the Fed, has left many investors concerned that Central Bankers think aggressive tightening is now increasingly necessary to cool inflation.

There are a few factors that suggest a cautious take may still be appropriate however. The first concerns the stance of fiscal policy in the world's major economies which is now scheduled to tighten quite considerably. According to the IMF, for example, the overall degree of fiscal tightening in the G20 amounts to more than 1% of their combined GDP per annum over the next two years.

The second point is that markets are already tightening policy for Central Banks thanks to their more hawkish communications in recent weeks and the upward revisions to interest rate expectations that this elicited.

The third point is that quantitative easing policies are already been dialled down in a number of countries and that in turn has already generated a big slow-down in narrow money growth (figure 10). That ebbing liquidity is arguably already igniting some financial instability via its impact on market liquidity and asset prices.

The fourth point – as we've already discussed above – is that global growth is destined to slow even in the absence of tighter monetary policy. And a peak in COVID concern – via ebbing supply chain pressures – ought to imply a peak of inflation is at hand as well.

Figure 10: Narrow money growth rates are slowing

To sum up, financial instability can be traced to a number of macroeconomic factors that are now peaking and slowing, including COVID, economic growth, corporate profitability and monetary policy support. How inflation evolves from here in response to these peaks will hold the key to how economic and financial market matters unfold from here. Unsettled conditions certainly seem likely to endure in the near-term not least if geopolitical risks escalate. If inflation shortly peaks too and then falls quite quickly – which still seems like a reasonable base case - volatility too should shortly peak and calmer water should re-emerge.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

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