Inflation creeps higher: What it means for markets

Inflation is rising again but markets are still moving higher. Are markets underestimating inflation risk or pricing in something bigger?

This month’s Investment Insights breaks down the real drivers behind investor optimism. Get the latest market perspective from Chief Market Strategist & Economist Guy Miller in his new Key Investment Insights video.

- Higher but manageable inflation
- Central banks switch to hawkish mode
- Equities have further to run

Transcript

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[Music starts, Title: Coming soon] Inflation is rising. Central banks have turned more hawkish, but the operating environment today for pricing is very different to that following the[Music ends] COVID crisis.

Guy Miller, Chief Market Strategist & Economist, Zurich Insurance Group: 0:09

Welcome to Key Points for June. This month, we look at the rise in inflation and ask how much of a risk could this be? We turn our attention to the response function by the central banks and ask, is this appropriate? And as always, we looked at the equity markets where we see further upside ahead. So turning to our first point, inflation has begun to creep higher. If you look at the chart I'm showing you here, We know, of course, inflation came down precipitously following the post-pandemic period. It moved largely sideways around central bank targets. But you can see in recent months it has begun to take higher, really across the globe. And of course that's a function of the higher energy price as a result of the conflict in the Middle East. Now, we suspect that is likely to drift a bit higher. But the operating environment today is very different to the operating environment post-COVID. Yes, we've got a bit of a supply shock coming through, but we don't have the same demand shock that we had back then. Consumers are not pent up wanting to go out and spend, and frankly, they don't have a lot of the fiscal stimulus that helped them spend back then, so the supply-demand dynamic is more balanced than it was then. Importantly, the labor market is also less tight than it was back then – yes, unemployment is low, but there's a lot of job uncertainty out there. Companies are not hiring the way they were doing then. So we're not seeing the same pass-through in terms of wage growth that we had back in the COVID period. So net-net, although we think prices are likely to move higher, we don't think they're anything like as severe as we saw post-COVID. Now turning to our second point, the global central banks are rather hawkish. They had learned some lessons back from the post-Covid period where they were a little bit slow to move interest rates higher. That is now shifting. And if you look at the chart I'm showing you here this is our classic three-month rolling average of the number of the percentage of central banks that are tightening and also the percentage or central banks that are easing policy rates. And you can see up until fairly recently, the number of central banks cutting the percentage was actually pretty high. Very few banks were hiking rates. Japan started at the back end of last year, but that dynamic has now changed. We're now at the point where a number of central bank are actually moving rates higher. We've seen this very recently in the case of Indonesia, we're seeing it of course in Australia, we are seeing it actually in Iceland and other places as well. And the longer that inflation proves persistent, of course, the more likelihood is that that red line is going to pick up. Now we still think that the inflation environment, although challenging, is not greatly concerning and therefore we don't expect this to change dramatically. Yes, we now expect the ECB to move rates higher by 25 basis points in June. We suspect actually that's probably one and done because the growth dynamic in many of these countries is also weakening. Higher input prices are a headwind and moving interest rates higher is a further headwind to the growth dynamics. And moving rates higher doesn't really affect the energy crisis that we're in currently. So net-net, yes, is going to be further central by hiking, but we don't think this is a prolonged or severe hiking cycle. Now turning to our third point, although equity markets have been resilient, we think there's still further upside ahead. So if you look at the chart I'm showing you here, these are really the global MSCI equity indices. And there's no doubt for the last couple of years, as we all know, they've been in a big uptrack. We had, of course, the issues around Liberation Day. And of course we had some wobbles back following the war in Iran. But broadly speaking, investors are in good mood. Now we're often asked, how can that be the case? We see inflation picking up, energy prices are so high, gasoline prices are surging in the U.S. And the answer is because other factors are simply outweighing some of these headwinds. Yes, cost of energy is going to impact margins a little bit. Yes, it's also going to impact growth a little. But there are a number of key drivers of equity markets that investors are latching onto. We're, of course, seeing the biggest capital spending cycle we've seen for pretty much 20 years. Of course, that includes AI. But we're also seeing, of course, defense spending pick up. We're also see renewable energy spending picking up. And these mean that the demand for electrical components, computer parts, semiconductors is all in huge demand. We're seeing demand pick up and we're seeing prices of these components pick up as well. And this is leading to very strong profitability. So when we look at the market currently, yes, there is still the risk of a war that is raging still in the Middle East, but net-net we think that these other factors are likely to stay high in investors' minds. Yes, the risks there coming from the Middle Eastern are high, but investors have pushed that to one side for the time being because they know that the earnings and the margins are being more impacted by these positive trends that we're seeing, rather than the headwinds we're seen coming from energy costs. Net-net, we still think there's further upside for equities.[Music starts] Remember, as always, you can read the full report on zurich.com, and I look forward to seeing you again very soon.[Music ends, Title: Visit us here: zurich.com/msme]