Inflation has been peaking globally and is likely to decline into 2023, as many countries are coming to terms with the idea of living with Covid-19. However, the Russia-Ukraine conflict has added further complexity, essentially creating a “shock on top of a shock”. We believe that inflationary shocks have always led to deflation through the subsequent supply response and the slowing of demand. In the changing market environment, we remain committed to focusing on the future, where we see improving economic returns and idiosyncratic investment opportunities that are on the right side of change.
Huge distortions from the pandemic are unwinding
Before Covid-19, it was clear that supply exceeded demand in many parts of the world, with little impulse for strong inflation. The global spread of Covid-19 had a huge impact on demand and supply. On the demand side, the US Federal Reserve took extraordinary measures to stabilise the global economy, lowering the Fed funds rate to 0% and rolling out massive monetary stimulus to support a global economy that would otherwise have faced serious problems. The Fed effectively backstopped risk. Extreme valuations emerged for the most speculative areas, and these are now unwinding. Elsewhere, governments transferred cash to private-sector savings and investment.
On the supply side, the pandemic and related lockdowns dramatically changed people’s behaviour, from halting travel abroad to forcing many people to work from home. The pandemic also paralysed global supply chains. Looking back, this has turned out to be one of the most important economic consequences of Covid-19 due to its inflationary effects as we emerge from the worst of the pandemic.
China’s Covid‑19 strategy will be critical
It is still too early to say that we have entered a post-coronavirus world. However, in recent months, many countries have been coming to terms with the idea of living with the virus. So, what does this mean from a supply and demand perspective?
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First, demand is slowing. The Fed is in the process of removing excess stimulus by ending quantitative easing and raising the Fed funds rate. This will introduce risk, but it will also stem the wild flow of funds to private equity, venture capital, financial fads and certain nascent digital businesses. Furthermore, multiples have contracted, and demand is contracting in areas most distorted by the pandemic-Fed combination. This is where the pain is being felt most at present.
At the same time, healing supply chains have had a positive effect across several areas, such as oil, semiconductors, cars and housebuilding materials. There are few large-scale shortages in the world if supply chains are functioning.
In many parts of the world, Covid19 infection levels remain high, but vaccination programmes have helped reduce hospitalisation and death rates. China’s handling of infection will be critical. If China can successfully manage Covid-19 cases and the world does not see a more severe Covid-19 mutation, supply chains are likely to steadily recover over the next year or two. Moreover, in the US, we are seeing strong signs of workers returning to work, which should ease labour market tightness in time.
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Russia‑Ukraine ‘shock’ creates further complexity
Prior to Russia’s invasion of Ukraine, inflation was peaking globally and was expected to decline into 2023. In the scenario we have been working with, demand for specific sectors benefitting from pandemic-related behaviour is set to slow as high inflation and rising inflation rates pinch. Simultaneously, supply chains begin to function more normally. As a result, both trends likely lead to lower inflation.
However, the Russia-Ukraine conflict has added further complexity. Unfortunately, logical economic incentives are poor tools when it comes to predicting this kind of global entanglement.
What we do know is that inflationary shocks such as this have almost always led to deflation through the subsequent supply response and the slowing of demand. High prices should force substitution, new relationships, accelerated investment and changes in consumption.
Idiosyncratic stocks offer solid upside potential
Many investors are still trying to make money from the same stocks that were distorted so positively in the Covid-19 world. However, we believe that focusing on where pandemic behaviour is fading on top of Fed distortion could open new return drivers.
We continue to like the expansion of travel and tourism as well as capital market stocks that are beneficiaries of market volatility. We are also looking to be carefully contrarian in select emerging markets, including China and Brazil.
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While the probability of stagflation and/or a recession is higher than it was six months ago, one scenario is still more likely than the many others that could play out. This includes our expectation that interest rates will move higher, but not by an extreme amount, especially as supply chains heal and inflation subsides. Under this scenario, new supply emerges from existing and new sources, and we learn to live with Covid-19, which also unlocks supply chain tightness.
Uncertainty remains over China, but the Chinese authorities’ message has changed in recent weeks, erring towards intervention, stimulus and support for its own economy.
Amid this challenging market environment, we remain committed to focusing on the future, where we see improving economic returns. We believe that being disciplined about what we pay for companies, embracing change and using our imagination will be essential to delivering strong long-term results.
David Eiswert is portfolio manager of global focused growth equity strategy at T Rowe Price
