In this week’s video insight Roger discusses how the fate of equity markets now hinges materially, but not solely, on the employment picture and the how central banks navigate the very serious choice they have to make between inflation or recession.

Transcript 

Roger Montgomery:

Immigration. It’s the most convenient solution to the wage pressure now being felt across the developed world, the pressure that could entrench inflation through a wage/price spiral.  You may have noticed, hoped-for immigration is not ramping up. From the UK, to the US, New Zealand and here, the world is awash with jobs and nobody to fill them. Consequently, business are forced to pay more, workers and unions are demanding more, and already high supply-led inflation justifies the demands for growth in real wages. 

So, what happened?

Well, you might remember during the worst part of the COVID pandemic, Australia was one of many countries that offered fiscal support to those out of work or underemployed. Here in Australia it was JobKeeper that kept the economy humming. Temporary visa holders however, including international students, and casual workers who hadn’t been employed for 12 months were notably excluded from the program.

More than a million people in Australia were on temporary visas and they were excluded from the government’s support payments; that’s about 500,000 international students, 140,000 working holidaymakers, 120,000 skilled temporary entrants, 200,000 bridging visa holders (who were largely partner visa applicants or asylum seekers), and more than 16,000 temporary protection visa holders (commonly referred to refugees).

In the absence of support many simply went home and many of those may not want to return. Meanwhile, those that do want to return, or visit for the first time, face egregious airfares thank to limited airline capacity and international air travel operating at about 40 per cent of pre-pandemic levels.

The longer the situation persists the sooner inflation ceases being solely a supply chain issue­ – out of the control of central banks ­– to a more endemic demand-led issue central banks will be forced to act on more harshly to control.

The fate of equity markets now hinges materially, but not solely, on the employment picture and the how central banks navigate the very serious choice they have to make between inflation or recession.

The US Federal Reserve is very focused on inflation which is currently at 8.6 per cent. Just recently, The Federal Reserve’s Chairman Jerome Powell said it will not let the economy slip into a “higher inflation regime” even if that means raising interest rates to levels that put growth at risk.

The U.S. central bank has moved to a do-whatever-it-takes approach with Powell saying “The clock is kind of running on how long will you remain in a low-inflation regime … The risk is that because of the multiplicity of shocks you start to transition into a higher inflation regime, and our job is to literally prevent that from happening and we will prevent that from happening”.

Thanks to that very tight labour market, demand remains strong and supply chains cannot cope. Consequently, what was previously thought of as being transitory inflation, is becoming entrenched. Higher wage demands come next and following that…a wage price spiral. A slowing economy is necessary to bring down demand, and a recession, in particular for the US and Europe, may be unavoidable as the US central bank leans towards killing inflation at all costs.

Meanwhile the liquidity that was injected into the financial system and economy during the pandemic is being withdrawn. US QT ‘officially’ started in June, but the ‘effective’ global balance sheet has already shrunk by US$1 trillion since December 2021. In such an environment – money literally being sucked out of markets – it is difficult for asset prices to rise materially or sustainably.

And none of that addresses heightened geopolitical risk or a potentially collapsing Chinese economy.

Great returns come from buying at low prices and I have presented widely elsewhere on the blog about the arithmetic of investing in growth amid compressed PEs. It may just be that even lower prices are possible.