The saturation point

Imagine you are making yourself a lemonade. You add one spoon of sugar to sweeten your drink, then add another one, and then one more...if you keep going like this, the sugar will stop dissolving in the water. This phenomenon is called the saturation point in chemistry. In the economy, the sugar that has stopped dissolving in the lemonade is the excess savings households have accumulated in the last two years. It is also easily comparable with the levels of debt governments have added to their balance sheets to save their respective economies from the brunt of the pandemic.

Now that economies have restarted, central banks have started to scale back the support by bringing forward the interest rate hikes and accelerating the taper of asset purchases. Central banks are not in a desirable position – if rates are hiked too aggressively it would hamper growth, and if not hiked enough, then there is a risk of inflation getting out of control. Unlike in chemistry, there’s no hard science to this. In the past 12 months, we have seen the expectations on inflation moving from “transitory” to ‘expected to be transitory’ and now to be more persistent.

When inflation first appeared, it was deemed consistent with a rapidly growing global economy. But now, inflation psychology has kicked in. In a recent consumer sentiment survey based in the US, consumers were asked about the most critical problem facing the economy, almost 90% cited inflation. The erosion in living standards due to rising inflation was among the most common concerns among consumers. 

“Economic events are substantially driven by contagious spread of oversimplified and easily transmitted variants of economic narratives.” – Robert Schiller

It is important to understand that while most consumers worry about inflation, they have only experienced low inflation with few short-lived spikes in oil prices. There is a big difference between being worried about inflation and not being able to afford living costs. But when consumers expect inflation, they become less resistant to paying higher prices, and employers become less resistant to paying higher wages until this self-fulfilling prophecy turns expected inflation into real inflation. Keynesian economists described inflation psychology as animal spirits, whereas behavioural economists pin it on our cognitive biases. 

Although the headline inflation numbers are large in size, they are still short in duration compared to the seventies. However, it is insightful to note that the high inflation narrative has materialised in the past based on adaptive expectations. Hence, it becomes increasingly critical to incorporate inflation risk in portfolio construction. 

The near-term outlook for global growth is relatively weaker as the pent-up demand wanes and central banks take away the crutches of policy support. The biggest distractions of the last two years– pandemic and a loose monetary policy are fading. The new challenge of creating a balance between inflation and growth has emerged. If the problem has changed, the solution must change too.

Markets are looking ahead and are pricing in an aggressive interest rate hiking cycle, which can provide a cushion for further surprises in the inflation readings. These assumptions have also created renewed opportunities in the fixed income markets for gradually adding duration in the multi-asset portfolios.

Removal of monetary support and mobility restrictions indicate that some hibernating industries will start to recover, such as travel and aerospace. There has been an accelerated recovery in travel, with carriers reporting strong demand across leisure, while corporate traffic is still improving.

Overall, the global economy is facing several headwinds like supply disruptions, persistent inflation, and the unwinding of monetary stimulus. There’s however one extremely critical factor that has the potential to resume the upward momentum of the markets i.e., the extra sugar from your lemonade.

The consumer is one of the most dominating forces that influence the economy, and let alone in the US, consumer spending makes up 70% of the annual GDP. US consumer is currently in the best financial shape of their lives by having 26% higher income and 33% lower debt than in 2008. There are strong indications that the excess savings accumulated by the households can act as a shock absorber against additional shocks and support the further expansion of the economy.