Frogs Will Get Boiled As Regime Change Is Coming

By Mark Cudmore, macro strategist and the global managing editor of Bloomberg’s Markets Live team

Inflation angst: we ain’t seen nothing yet.

Within less than 24 hours, the world’s three largest economies — the U.S., China and Japan — each released inflation data that shattered consensus forecasts and showed prices rising at the fastest pace since at least the early 1990s. Actually the highest print in more than 40 years in Japan.

The fourth-largest economy, Germany, also confirmed inflation at the fastest pace since the early ‘90s, but that release didn’t surprise economists as it was the final print and the beat had come with the preliminary estimate. Germany isn’t letting the side down though — it recently confirmed the highest producer price inflation on records that go back to 1977. This from the country where policy makers famously fear inflation more than most!

And yet markets don’t really seem to care too much. Sure, U.S. yields and the dollar both surged, while stocks tumbled. But there’s no panic about the enormity of what we’re seeing. Barely anyone even bothered commenting on Japanese PPI coming in at 8% y/y this morning, versus 7% estimated. And revisions ticked higher too.

The metaphor of frogs in a pot of water has never been a more apt analogy. For those unfamiliar, the idea is that a frog put suddenly into boiling water will instantly jump out, but a frog put in tepid water that is gradually brought to the boil will not perceive the danger and hence be cooked to death.

A year ago, if you had told any investor the inflation prints they would be seeing today, there would have been disbelief and uproar. The median estimate for U.S. 2021 full-year inflation stood at 1.9%. Even before Wednesday’s data, that consensus had climbed to 4.4% — an almost unbelievable shift.

Instead, with the inflation dial gradually turned higher all year, the marginal change now fails to shock and we’re not registering the full ramifications of a return to an inflation regime not seen for decades. We’re still focusing on rate of change when we’ve finally reached a point where levels matter.

What’s bizarre is that we listen to economists on this issue. Today marked the 11th month in a row of Japan PPI beating consensus forecasts! It was the ninth in a row for China PPI. They’ve underestimated seven of the last eight U.S. CPI prints, although NONE of the 70 economists surveyed by Bloomberg anticipated the 0.9% m/m increase in CPI Wednesday — the highest prediction was 0.7%. And yet their “expertise” is still guiding too many people in markets. You almost couldn’t make it up. It’s like the frogs trusting the chef who put them in the pot on whether they will be OK.

What does this mean for markets? Volatility, for a start. We have a dislocation between economic reality and the economic framework that is priced across assets. The problem is that you can’t just sit on inflation plays because there’s a collective denial out there from economists, policy makers and too many in markets.

Bonds will suffer, but we’ll swing from bouts of curve flattening to steepening. The risk-reward ratio of overpriced momentum stocks now has negative appeal, but some other equity sectors can still perform. Currency markets will see some extraordinary dislocations as FX will be a key outlet for economic imbalances.

And I’m not convinced that crypto is the wonderful all-purpose hedge that many would have you believe. How does it fare if real yields move higher, risk-limits get cut amid higher volatility, consumer disposable income gets squeezed and meme/momentum stocks are suffering?
The inflation genie is out of the bottle. The immediate path for markets is difficult because the shifting reaction function of big central banks is still in play. It’s not suddenly going to get easier: the year ahead will see immense asset-price dislocations.