Supply shocks, stalling growth and inflationary surprises

In this Macro Perspectives, we explore potential policy shifts in 2022, labor dynamics, oil and gas shocks, and the implications of slower growth in China.

    Stephen Dover

    Stephen DoverChief Market Strategist, Franklin Templeton Investment Institute

    Sonal Desai, Ph.D.

    Sonal Desai, Ph.D. Chief Investment Officer, Franklin Templeton Fixed Income

    John Bellows, Ph.D.

    John Bellows, Ph.D. Portfolio Manager,Western Asset

    Michael Hasenstab, Ph.D.

    Michael Hasenstab, Ph.D. Chief Investment Officer, Templeton Global Macro

    Gene Podkaminer, CFA

    Gene Podkaminer, CFAHead of Research, Franklin Templeton Investment Solutions

    Francis Scotland

    Francis Scotland Director of Global Macro Research, Brandywine Global

    Introduction

    Inflation is currently a more pressing concern than most other macroeconomic factors due largely to labor shortages and supply-chain disruptions. Our economists are questioning whether inflation could prove longer lasting than initially thought—with some taking a contrarian view versus the prevailing market “transitory” sentiment.

    In this edition of Macro Perspectives, we explore potential policy shifts in 2022, labor dynamics, oil and gas shocks, and the implications of slower growth in China.

    Below are a few highlights of our conversation:

    I feel a little bit like a Cassandra1 but, for quite a long time, we have felt that inflation will have more legs than others originally anticipated. We don't think that inflation will come down sharply in the first half of 2022. We believe we're seeing the beginnings of what really does look and feel and smell like second-round effects, and those tend to have more staying power.

    Sonal Desai

    Longer-term disinflationary headwinds could re-emerge once we get past the pandemic—like globalization and technology. There’s been a significant amount invested in technology over the last year. The potential of that productivity boost allows for a little cooling in price pressures.

    John Bellows

    The labor market is probably the most important dynamic to watch, and it has been a bit of a surprise. It’s a supply shock that could affect longer-term inflation dynamics—but it’s probably still a bit early to know.

    Michael Hasenstab

    As an investor and market observer, I need to ask myself what inflation is telling us. Like the difference between good and bad cholesterol—there's also good inflation, led by unexpected demand, and bad inflation, caused by supply constraints.

    Gene Podkaminer

    We have a very serious energy price shock taking place right now, and it's starting to reverberate—the inflation effects are beginning to be felt in a real way. I don’t think alternative energy is equipped to respond to this shortage.

    Francis Scotland

    I hope you find the discussions in Macro Perspectives better inform your decision-making.

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    Stephen Dover, CFA
    Chief Market Strategist,
    Franklin Templeton Investment Institute

    EXECUTIVE SUMMARY

    Cooling growth meets rising inflation

    Since publishing Macro Perspectives in August, global economic growth has cooled from extremely high levels, while inflation has surprised on the upside. Each day, new inflation-related data are debated and added to the giant jigsaw puzzle that’s macroeconomic forecasting. All five of the Franklin Templeton economists I recently spoke with agree inflation appears less transitory; they’re looking for clues on how persistent inflation may become.

    So, what’s changed since our last roundtable discussion this past summer? A triple supply-side whammy comprised of supply chain disruptions stretching from Shanghai to Los Angeles, frustrating labor shortages, and surging energy prices. Throw in significant policy shifts in China, slowing Chinese economic growth and the evolving Evergrande meltdown, and you’ll understand we had a lot to discuss.

    Below, I’ve highlighted parts of our conversation about supply shocks and subdued growth momentum. Let’s start with the demand side of inflation: Will a back-to-normal economy unleash US consumer demand and force an earlier-than-anticipated US interest-rate hike?

    Demand-driven inflation: If there was a clear area of agreement between John and Sonal, it’s that we are experiencing demand-driven inflation that is likely to persist into 2022. They differ in the path forward for US consumer spending. John thinks fiscal stimulus-driven demand is mostly behind us, while Sonal points to the recent savings firepower of US consumers and believes they could begin spending more into next year. As Sonal rightly reminded us, no country matched the shock-and-awe combo of US fiscal stimulus (unprecedented in its size) and robust monetary policy.

    For Gene, demand-driven inflation is a welcome problem to have. Like good cholesterol, this type of inflation typically occurs when a healthy economy heats up and runs a little too hot. Central banks can tackle this by raising interest rates. Supply-driven inflation, however, poses more difficult challenges. Like bad cholesterol, supply driven inflation often takes longer to resolve and risks becoming chronic if left unchecked. If there’s something that keeps economists up at night, it’s supply shocks, especially if caused by disruptions in the labor supply.

    Not-in-time delivery: The first supply-side shock boosting inflation—global supply-chain bottlenecks—is easy to spot with the naked eye. Francis pointed to the enormous backlog of container ships clogging ports in the United States, Europe, and Asia. Having spent years perfecting just-in-time deliveries to amplify capital efficiencies, abrupt shortages of key components—like semiconductor chips—means factories cannot match consumer demand. (Good luck ordering the newest iPhone!)

    These global kinks are stalling the economic recovery. Whereas John and Gene offer optimism that the supply hiccups are plain to see and will work themselves out, Sonal worries about a difficult holiday shopping season. If companies cannot meet demand, we could see higher inflation and lower growth.

    Labor shortages: When it comes to supply shocks, Michael thinks labor supply and productivity are key to understanding inflation’s trajectory. During our conversation, all five economists expressed bafflement and fascination (their words) at the unfolding labor dynamic. Case in point: with the recently super-sized US unemployment benefits behind us, the anticipated surge of labor reentering the workface hasn’t materialized, despite millions of US job openings. Is rising labor productivity from digitization and automation fundamentally altering the skills and contours of labor participation?

    In Gene’s view, answering this question will take economists years to unpack. Ultimately, government policymakers, not just central bankers, should help promote workforce skills that complement a high-tech driven economy. In the near term, Michael’s team is closely watching market data to see if rising wages transition into a permanent labor shock. We all agreed that this belongs on our pile of economic worries.

    Oil and gas shocks: The global surge in energy prices is the third supply-driven shock scrambling inflation forecasts. Francis traces the supply imbalance back to climate activists and policies, like carbon taxes, that starve the energy sector of capital needed to expand supply. Greener sources like wind and solar energy lack the scale to meet global demand. In the United States, John notes shale-oil production remains tepid despite the recent price surge.

    Compared with pre-pandemic capacity, roughly half of US oil rigs remain offline, due partly to company downgrades and higher costs of capital. In terms of strange climate-related impacts, Germany is shutting down its zero-carbon nuclear power (29.5% of its 2020 energy mix), which forces it to largely replace it with coal-fired sources.2 As Michael reminds us, energy prices have thus far played a relatively small role in terms of US inflation. Not so in Europe, where energy has an outsized impact on inflation. Higher diesel prices could spark visceral reactions at the fuel pump, embed wage increases and trigger more inflation, creating yet another worry.

    A welcome cooling: China’s leveraged property sector, including the slow-motion implosion of its largest real estate developer (Evergrande), has been top of mind for global investors. And yet, our economists think the bigger story is China’s new “common prosperity” regulatory framework and economic slowdown.

    Representing 20% of the world economy, China is rotating the foundations of its economy away from debt-driven growth. This has naturally translated into a cooler Chinese economy, which John believes can take some heat out of the global economy. Given the three supply-side shocks, that cooling could be a welcome sedative. For Francis, China’s slowdown helps explain the strength of the US dollar. Despite a big deterioration in the US current account and trade deficits, the US dollar remains buoyed (for now) against a backdrop of decelerating external growth, most notably in China.

    To close our discussion on a note of optimism, we end with Francis and Michael comparing recent technology-driven productivity gains in the US economy with peers like Japan. Despite mounting geopolitical tensions between China and the United States, all of us agree the digitization of the US economy (especially fintech) is an incredible development that we will explore more in the future.

    ENDNOTES

    1. The Cassandra complex is a psychological phenomenon in which an individual's accurate prediction of a crisis is ignored or dismissed.

    2. Source: Appunn, K. “The history behind Germany’s nuclear phase-out,” Clean Energy Wire, March 8, 2021.

    WHAT ARE THE RISKS?

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