Inflation falling but too slowly, investors are (too) cautious, Europe has catch-up potential

Chart of the week

The chart shows flexible (blue) and "sticky" (red) inflation. Flexible inflation looks at goods and services that are volatile in price and can rise and fall. This is electronics, for example. A notebook became more expensive because of more expensive transportation and the shortage of semiconductors, but is now falling in price again. This is not the case with "sticky" inflation. The fixed wages a company pays can rise, but rarely fall.

Why this is important

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Inflation has been high because of the Covid crisis, because transportation was not working, and because of the rise in energy prices. These cost drivers are now going down and inflation should fall. It is falling, but very slowly. This is because "sticky" inflation is now picking up. This inflation is very damaging to companies because fixed costs are rising. So, despite the somewhat low figures, it is too early to sound the all-clear on the inflation front. Inflation is likely to be with us for some time yet.
Consumption should slump

In a large survey, consumers were asked what worries them most. The results were sorted by income. Low-income consumers are most concerned about the rise in mortgage rates, while high-income consumers are concerned about the global and local political situation and fear that their investments will lose value. High-income consumers, on the other hand, are worried about the global and local political situation and fear that their investments could lose value.

Almost 70% of consumers said in the survey that they want to reduce their consumption. The response was about the same for all income classes. This is exceptional and so rare.

‍Investors are (too) optimistic‍

Every month, Bank of America surveys the world's largest investors about their investment policies and concerns. Since these investors are responsible for more than 70% of all volumes traded on stock exchanges, it is very important to observe them and understand what drives their investment behavior.

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Here, the major institutional investors were asked where they currently see the highest risks. They are still most concerned about high inflation and overly aggressive central banks. Concerns about the impact of the war in Ukraine are also high. But concerns about a global recession have diminished.
So what may most encourage investors to return to more aggressive investing is news that prompts central banks to raise interest rates less or a calming in the war in Ukraine. Such news has the potential to push the stock market up 3-5% in a day.

Here, investors were asked how high they think the central banks will raise interest rates to a maximum in the current cycle. Most investors now expect an increase of over 4%. In other words, almost a doubling again. This shows how much negative news is already in the prices. Things can't get much worse.

Here, investors were asked where they saw the biggest crowded trade. In other words, the investment where all investors are running to, but where most are likely to make a loss. As recently as June, this was investments in oil and commodities. They were right on that one. Almost all investors who got into oil or commodities at that point lost money. Currently, most respondents think that investors who are now still investing in the already very strong USD will suffer the same fate.

The USD is currently rising so strongly because:

Interest rates in the US are rising more than in Europe.

In big crisis situations, you always see a flight to the world currency, and currently that is only the USD. In the Covid crisis, this could already be observed. And after the Covid crisis, the money could not flow out of the USD, because seamlessly the Ukraine war unsettled investors.

As soon as one of the two criteria changes, we expect a lower USD.

Here, investors were asked whether they expect global corporate profits to increase or decrease. What is not surprising here is that the majority expect profits to fall, but the extent. More investors are negative than during the 2008 financial crisis, and it is even the most negative since the 1997 measurement.

We think the negative sentiment is too strong and exaggerated. It's almost impossible to get any worse. That's why we see prices going higher rather than lower.

But it is not only the large institutional investors who are very negative.

The chart shows a survey by the AAII (American Association of Individual Investors). It asked all members whether they expected prices to rise (bulls) or fall (bears). Here, too, the vast majority expect lower prices. The rise in optimistic investors that could be seen just a few weeks ago has come to an abrupt end.

But back to institutional investors and the Bank of America survey. Here, investors were asked how strongly they are overweight or underweight in equities (dark blue). Currently, more investors are underweight in equities than during the financial crisis, when many had expected a total collapse of the financial system. In light blue, the chart shows the annual change in the S&P 500. We expect it to reduce negative sentiment. As a result, the investment rate will rise and prices on the stock markets will increase.

Here, the large institutional investors were asked how high their cash ratio is. This is also very high. The question is not whether, but when these funds will flow back into the stock market.  

Europe has catch-up potential

In the medium and long term, companies' profits drive the stock market. If they do good business and increase profits, their value on the stock market also increases.

The chart shows the profit forecasts of the companies in the different regions.

From January 21 to March 2021, the profit forecasts for American and European firms have increased at the same rate. Since the spring, profit forecasts for European firms have continued to rise, but those for American firms have declined. Nevertheless, stock markets in the U.S. have risen more than in Europe.

So European companies have catch-up potential. Unfortunately, everything is overshadowed by the war in Ukraine. Many investors expect an energy shortage in winter and that entire industries will have to shut down. That's why they prefer to invest in the USA, where they also get more interest.

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