VIDEO TRANSCRIPT:
Gold has beaten both stock and bonds in 2025 so far.
Gold’s surge reflects concerns that inflation, barely defeated over the past year, might raise its ugly head again.
Will gold bugs be proved right?
How will Trump’ s spending cuts and his tariff war net out for US inflation?
Which countries are ahead of the inflation curve and which behind?
How should you invest your money right now?
….
January was not a good month for global inflation
Among the biggest economies in the world, inflation generally came in stronger than expected (Chart 1)
This was especially so in the case of Japan and the UK (Chart 1)
The notable exception was India where inflation surprised to the downside (Chart 1)
Was what happened in January an anomaly?
Wall Street spent most of 2024 playing catch up to declining inflation (Chart 2)
Will the balance of risks for inflation shift to the upside in 2025? (Chart 2)
….
Among most of the advanced economies, year-over-year inflation seems to have bottomed (Chart 3).
The January inflation readings in the US, UK, Canada, Australia, Japan and the Eurozone were all at or near their highest levels over the past 6 months (Chart 3)
Even when we strip out the effect of food and energy prices, the picture does not look better.
Core inflation is stuck at around 3% in the Eurozone and in the US and close to 4% in the UK. (Chart 4)
Strikingly, core inflation in the UK and Australia are at the same level as in Brazil and Mexico and higher than in India (Chart 4)
In a way, it is not too surprising that developing countries are not doing worse than developed countries regarding inflation and many are doing better.
Central banks in developing countries have been willing to keep real interest rates higher and for longer than those in developed countries (Chart 5)
However, if developing central banks are working hard to earn their stripes, they are not getting much respect from the bond market
5-year inflation breakevens for Brazilian, South African, Mexican government bonds are much higher than their French and British counterparts (Chart 6)
If we use the difference between 5-year inflation breakevens and the current level of inflation as a proxy of inflation risk premium, it is clear that risk premium on emerging market debt is very high in both absolute and relative terms (Chart 7)
Perhaps unjustifiably so in some cases. (Chart 7)
In the past, the higher EM risk premium would have reflected the relatively fiscal positions between developing and developed economies
However, today, the likes of Indonesia, Mexico, Brazil, and South Africa have smaller primary deficits as a share of their GDP that are smaller than those of Japan, the US, France and the UK. (Chart 8)
We have seen a convergence in inflation and fiscal positions between rich and poor countries.
This convergence may well become even more pronounced in 2025.
This should favor emerging market fixed income assets (Chart 9).
…..
Inflation remains higher than before COVID in most parts of the world
But the flip side is that the labor markets are tighter than they were before the pandemic.
Indeed, most G20 countries have unemployment rates that are not just below the norm but substantially below the norm. (Chart 10)
This is as true in Brazil and Mexico as in the eurozone and Japan (Chart 10)
Lower unemployment rates, which usually equal higher wage growth and lower productivity growth, tend to lead to higher inflation.
Some countries are more successful in beating this economic trade-off than others.
In this respect, it says a lot about just how poorly managed is the British economy that it has an average unemployment rate but an above average inflation (Chart 10)
As I talked about in an earlier video, Britain has gotten only the bad parts of leaving the EU without any of the good (thumbnail).
It is truly an indictment of Brexit, which I supported, that the UK economy is not only underperforming the likes of Brazil and Mexico, but that it is even underperforming the Eurozone.
The Bank of England is also not helping.
Indeed, cutting interest rates in the face of strong wage growth is a sure recipe for disaster. (Chart 11)
In contrast, Mexico has the same level of core inflation as the UK but with an employment that is 40% lower.
My guess is that Mexico will be rewarded by the bond market. There is a lot of room for real interest rates to go down.
….
What about the US in 2025?
US inflation stopped falling almost as soon as the Fed started cutting interest rates last September (Chart 12)
This is a reminder that the Fed does not have a crystal ball
What will the Fed do now that inflation expectations are climbing once again (Chart 13)
And 2-year inflation breakevens are at their highest level in 2 years (Chart 14)
It goes without saying that the Fed cannot make a U-turn without looking stupid.
But the Fed also has good reasons to be concerned about Trump’s tariff threats
It is almost certain that businesses will be quicker to react to any increase in tariffs than during the trade war under Trump 1.0
COVID proved to businesses that they can get away with raising prices when everyone else is doing it.
The Fed has not said so explicitly, but I suspect they would agree with me that the pass-through from tariff into inflation will be much higher this time around than in 2018 and 2019.
Also, last time around China was the main target of Trump’s tariffs
This time Trump is threatening to go after all trading partners, large and small
The potential product categories to be covered under new tariffs are also much wider
What all this means is that if a trade war were to break out, there will be less room for substitution
If there is any comfort for the Fed right now is that the stock market seems to have become more sensitive to trade war talks than the bond market.
If an all-out global trade war were to result in a significant correction of the stock market, the resulting tightening of financial conditions would help provide an offset to the shock to inflation, thus reducing the need for the Fed to raise interest rates.
This is why a trade war is more bearish for stocks than it is bearish for bonds, at least at current levels of the stock market and inflation risk premium in the bond market.
Two weeks ago I was less concerned about the risk of an all-out tariff war
This was because I thought the European Union would do anything and everything to keep Trump engaged in the Ukraine war
Including giving into him over their trade disputes
I am now less sure
Trump’s pivot to Russia and his promise to reduce commitments to NATO are straining trans-Atlantic relations, making a trade war more likely
I think this is very bearish for the stock market, especially the German stock market. (Chart 15)
Bonds will benefit from the negative growth impact of a trade war and from their safe haven status.
I continue to think that bonds will outperforms stocks over the next 3 months, at least on a risk-adjusted basis.
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