Inflation worries become growth worries

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Good morning. The staggering rally in computer memory stocks (which we wrote about here) has hit some rough water. Micron and SanDisk, for example, are both down about 30 per cent in less than two weeks. A specific culprit: a Google research paper suggesting that AI models might need less storage than originally thought. A general culprit: the fact that in cyclical industries, no cycle lasts forever. Email us: [email protected]. 

Inflation was last week. This week, worry about growth.

Up until the past few days, Wall Street’s worries were focused squarely on inflation. The increase in oil prices had undercut the popular narrative that the strong US economy, and strong US corporate profits, would be sustained this year by a benign combination of rate cuts and fiscal largesse. Interest rates have risen, more at the front of the curve, but significantly at the back, as well.

The Iran war is dragging on, though, and the prospect of sustained high energy prices is turning investors’ and analysts’ attention to growth. Strategas’ Don Rissmiller, writing on Sunday, summed it up neatly:

We are worried. There are ways for an economy to manage short-term disruptions (eg, drawing on consumer savings and inventories, using tax refunds). But it now looks like the conflict in the Middle East will stretch into April at a minimum. The hit to real income due to inflation spiking near-term looks substantial . . . Longer-term interest rates are rising. That combination of higher rates & oil should slow economic growth as we move through 2026.

Such a change invites a simple trade: buy some duration. In a lower-growth world, inflation is less of a long-term risk and the safety of sovereign bonds is appealing. We may already be seeing this shift, as the 10-year Treasury rallied sharply yesterday, sending yields down. Ian Lyngen, head of rates strategy at BMO Capital, attributed the rally to investors turning their attention to “the potential risks to global growth related to events in the Middle East rather than simply trading the conflict through the lens of an inflationary impulse”.

Remember, the US economy was chugging along just fine before the war — probably growing above its long-term trend, in fact. There were, however, nagging worries at the edges. While the job market was stable, it was stagnant. Consumption was still growing nicely, but possibly slowing down a touch overall, with consumer credit quality looking squishy at the lower end of the income spectrum. None of this was particularly scary, but it shows the cracks that higher energy prices and weaker consumer sentiment could work their way into.

Scott DiMaggio, head of fixed income at AllianceBernstein, notes that growth is already coming under pressure internationally: 

The longer this conflict drags on the more economic [impact] it is going to have. You’ve started to see that in some of the emerging market countries — fuel shortages, businesses shutting early, [enforced] working from home. The market narrative will have to move from higher inflation to, oh no, this is no longer a high-growth environment.

Brij Khurana, a bond portfolio manager at Wellington, thinks it makes sense to add duration in this environment:

[Duration] makes sense in the US in particular, when you think about consumer balance sheets. They are still very strong, but markets have dusted off the playbook in 2022, when we had another commodity shock [from the invasion of Ukraine] . . . but the household sector’s starting place is much worse than in 2022 in terms of the strength of the jobs market and the amount of fiscal stimulus on offer . . . duration is attractive globally [too], we have been adding outside the US in particular, because those markets are pricing in much more tightening [in the UK and Europe], and that could be priced back out if growth slows.

James Athey at Marlborough agrees that there is too much policy tightening priced in the UK and elsewhere, and argues that the long end of the rate curve has room to fall, too, making longer-term bonds an interesting value propostion relative to stocks:

There is still a significant amount of term premium in longer yields as a result of all the shocks, fiscal incontinence and inflation from the last few years. Thus, government bonds are pricing an awful lot of bad news for fixed income investors. Conversely equities and credit are still within a whisker of cyclically extreme valuations . . . cyclicality is expensive and defensiveness is cheap.

As always, there are people taking the other side of the trade. Greg Peters of PGIM is not enthusiastic about duration:

I worry less about a recession shock given the tremendous amount of stimulus in the system with the prospect of more if we show economic weakness . . . the Administration will do whatever they can to boost growth . . . I also think the [Kevin] Warsh Fed story has been put too much on the sideline as I believe he will view this as a supply shock story and the Fed’s easing mandate is undeterred. So to me, rates are attractive in the front end, but I continue to fret about the back end.

What is the data to watch for confirmation that growth has begun to slow in the US? We’ll have our eyes on the timely spending data released by the banks and card networks, and especially on initial jobless claims. They have been trending down, but if that trend reverses, it will be a sign that the job market has gone from stagnation to contraction:

There are plenty of good reasons to believe that the long-term, secular trend in interest rates is higher, not lower — especially at the long end of the rate curve. In the short and medium term, however, duration is more interesting than it has been in a while.

One good read

Trouble in Tinseltown.

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