To The Moon

The peak in inflation seems to have been reached, with oil prices pausing and the war in Ukraine combined with higher interest rates beginning to depress economic growth. However, the market still seems to overestimate inflation in the short term but underestimate it in the long term. Therefore, while inflation is likely to fall gradually in the remainder of the year, inflation expectations are set to rise further. In the end, core inflation is what matters to central bankers and the gap between core inflation and rising food and energy prices is very large. In the coming months, the effect of rising food and energy prices (the actual core inflation) will be increasingly felt in core inflation.

Inflation is rising faster than interest rates. This is also because the Fed has only raised interest rates once, by 0.25 per cent. In May and June, it will raise another 0.5 per cent, and in May, the Fed will also tighten its monetary policy by 95 billion dollars. The ECB has indicated that it does not expect to raise interest rates this year. The contrast with the Fed's policy is a further weakening of the euro and therefore more import inflation. The impact of higher energy prices in Europe is also many times greater than in the United States. This is evident from the differences in the development of gas prices alone.

The impact of rising interest rates will be greater than in the past. One of the major advantages of high debt and appreciation levels for many assets is that higher interest rates have a much greater impact than in the past. At the same time, this is also a pitfall because with only a small interest rate increase, the central bank can push the economy into recession without immediately bringing inflation under control. The danger of stagflation looms.

The fact that inflation has been higher than expected for a long time now means that these higher inflation levels are also becoming a reality. This makes it easier for companies to raise prices, but also easier (especially in the current tight labour market) to demand higher wages. This is not immediately visible in the figures, but the fact that more people are changing jobs and that in the Gig economy rates are rising rapidly means that inflation will have less and less of a positive effect on company profits. At least in sales, companies are benefiting from high nominal growth (now probably above 10 percent) in the economy. But the point has come that higher prices and higher wages are starting to squeeze margins. In addition, higher food and energy prices act as a tax on consumption, meaning there is less disposable income left for other spending. Also, the fact that the Fed is about to raise interest rates has made borrowing money for a house a lot more expensive in a short period of time.

These higher mortgage rates mean less demand for new houses and also less demand for products and services that are all involved in buying a house. 

The first signs are that company results for the first quarter are starting to disappoint. Last week, it was mainly the turn of the major US banks. Earnings have been revised downwards further in recent weeks and margin pressure will ensure that these will soon be negative. Even in the event of a soft landing of the economy (instead of the hard landing of a recession), there seems little room for higher margins. There is a strong relationship between earnings revisions and the development of the stock market. Fair value for the S&P 500 is around 4,000 at current interest rates. 

Higher inflation expectations also mean higher interest rates. This leads to a flight from bonds, partly to equities, but rising interest rates and a rising equity market do not go together in the long run, especially if the probability of a stagflation scenario increases. A year ago, almost everyone was convinced that inflation would be temporary, now the market seems to be counting mainly on a soft landing from the US economy (a recession in Europe seems inevitable) and that is why the stock market (in euro) is only a few percent below the top. But the current phase is probably a nasty one, after which a hard landing seems inevitable.