Supply bottlenecks, a looming energy shock, and 3 reasons for optimism

As global supply chains remain stretched after the stresses imposed by COVID, fund manager Franklin Templeton recently assembled a handful of its economists to debate some of the key topics. Traversing the macroeconomic landscape, the discussion covered:

• big-picture issues of inflation, its underlying causes, and why they believe it’s here to stay
• surging energy prices and whether there’s a looming “energy shock” ahead
• labour markets in the US and in other developed nations
• China’s cooling economy, what it means for global growth expectations, the collapse of Evergrande and the broader shift in China’s property market.

Kicking off the discussion, Stephen Dover, chief market strategist, Franklin Templeton Investment Institute, asked whether the group were concerned about the prospect of “runaway inflation”.

“I agree much of what we’re seeing in terms of US inflation relates to supply effects. Looking at the crisis from the perspective of a natural disaster, we had a historic bust followed by a historic boom. We’ve never seen anything like this in recorded economic history,” said Sonal Desai, PhD, chief investment officer, Franklin Templeton Fixed Income.

Referring to supply-chain bottlenecks, they pointed to the enormous backlog of container ships clogging ports in the US, 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!),” said Dover.

Three reasons for optimism

John Bellows, PhD, portfolio manager, Western Asset emphasised the following three points:

1. Supply constraints are a big part of current inflation. Shutdowns won’t last forever
2. With fiscal stimulus behind us, so is the flurry of pent-up demand that boosted inflation in early 2021.
3. The type of inflation we’ve seen so far hasn’t been problematic because of longer-term disinflationary forces.

“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,” said Gene Podkaminer, CFA, head of research, Franklin Templeton Investment Solutions.

On the back of these views, Dover believes the “global kinks” are stalling the economic recovery. And while Bellows and Podkaminer were optimistic that supply chain hiccups will work themselves out, Desai is concerned about the rapidly approaching holiday shopping season. “If companies cannot meet demand, we could see higher inflation and lower growth,” she said.

Demand-driven inflation

One area of agreement between Desai and Bellows was that they expect demand-driven inflation to persist into 2022. But Bellows believes fiscal stimulus-driven demand is mostly behind us, while Desai points to the recent savings firepower of US consumers in suggesting consumers may begin spending more into next year.

The fixed income CIO, Desai, said no country matched the shock-and-awe combo of US fiscal stimulus (unprecedented in its size) and robust monetary policy. While Podkaminer said 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,” said Dover.

“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 labour supply.”

"Baffling trends" of the labour market

On the labour market more broadly, Desai said it presented some “baffling trends”

To understand the longer-term trajectory of inflation, Michael Hasenstab, PhD, chief investment officer, Templeton Global Macro, said it’s critical to look at labour supply and productivity. A key consideration of the group of economists was whether rising productivity from digitisation and automation – which has accelerated further during the pandemic – was fundamentally altering labour participation.

“We all agreed that this belongs on our pile of economic worries,” said Dover.

Also on the pile of concerns is the potential for oil and gas shocks as the recovery rolls on. The global surge in energy prices is the third supply-driven shock scrambling inflation forecasts.

Francis Scotland, director of global macro research at Brandywine Global, traced the supply imbalance back to climate activists and policies, like carbon taxes, that starve the energy sector of capital needed to expand supply.

Hasenstab said energy prices have so 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, he warned.

And while touching on the heightened tensions between China and the US, the group welcomed the cooling of China’s highly-leveraged property sector – most notably through the “controlled implosion” of the nation’s biggest real estate developer, Evergrande.

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,” said Dover.

“Despite mounting geopolitical tensions between China and the United States, all of us agree the digitisation of the US economy (especially fintech) is an incredible development that we will explore more in the future.”

To view the full discussion, click here to watch the videos and download the latest edition of Franklin Templeton’s Macro Perspectives whitepaper.