Economic growth is slowing and for many countries, particularly in Europe

Economic growth is slowing and for many countries, particularly in Europe, the slowdown will be so significant that recessions are likely to develop. Policymakers and financial markets may anticipate that such slowdowns or recessions will kill off inflationary pressure. After all, that’s been the model that’s worked for many decades. But this time it’s different.

You can see from market pricing of implied central bank policy rates that the release of softer-than-expected real-side data lifts hopes that central banks won’t have to push so hard with rate hikes. Last week, for instance, we saw a number of soft US data releases covering the PMI surveys, housing data, and unemployment claims. All these have helped support bonds and led to a modest decline in the amount of Fed tightening that’s priced into the front end of the curve. This is not unusual; the markets' knee-jerk response to real-side data is the same now as it has always been, which is to assume that weak data leads to lower rates, and that may well prove correct.

However, the point Mr. Steve Barrow, Head of Standard Bank G10 Strategy would make is that inflationary pressure has been coming predominantly from the supply side, not the demand side. This makes it questionable whether softer demand—even in a recession—will bear down significantly on inflation and so allow central banks to go a bit easier with their policy tightening.

In fact, we could make the argument that, with labour markets so tight and job vacancies so high, the economic distress brought about by weaker growth is likely to make wage pressures even greater as s become more militant or workers simply get up and walk out for another higher-paid job.

When we think about the current situation in this way, it helps put to bed the arguments that the central bank should not be hiking rates as much, if at all, because a recession is coming down the track given things such as the Russia-inspired surge in energy prices.

Unfortunately, perhaps, rates need to be lifted not just to bring demand down to levels that may have existed in the pre-Covid world, but to even lower levels consistent with the new level of supply that exists. And even if you think that some of the supply chain impediments as they relate to the production of goods are easing, there’s still the issue of very tight labour markets that threaten to make labour supply usurp goods supply as the predominant cause of inflation.

One way to see all this playing out is to look at data surprises. In the US, for instance, we are seeing real-side data consistently undershoot market expectations as the slowdown starts to grip, but, on inflation, data surprises continue to be on the high side, just as we saw again this month with the very high CPI print. It seems that we can’t just make the assumption that if real-side data is generally disappointing, inflation data will predominantly be sub-consensus as well.

What does all this mean for financial market performance? First up, Mr. Steve Barrow finds it hard to believe that risk assets such as equities and corporate credit can mount a recovery in such an environment. This is not just because above-consensus inflation data keeps central banks focused on lifting policy rates. It is also because softening growth that is accompanied by persistent upward pressure on input costs, such as labor, will squeeze profits, as we may see this week when a large number of US firms report Q2 earnings. For currencies, it looks as if the fragility of risk assets will play into the hands of a stronger dollar, while, for longer-term government bonds, we are probably talking about high volatility with little underlying direction as bonds get whipsawed by soft real-side data and higher-than-expected inflation data.