Free | Global Macro & Strategy

Chart of the Week: how inflation negatively affects the business cycle

One of the key themes of 2021 has been the return of inflation, after many years of absence. In fact, there would be an entire generation of people working in the investment industry who have never had to even bother with inflation as an issue thus far in their careers.

The question many investors ask is, so what ? For many years central banks have been trying to boost inflation from very low levels, so why should we worry about it.

This week’s Chart of the Week shows why.

The chart below shows the correlation between the ISM new orders index (the orange line), and the blue line which is a leading indictor of inflation (i.e. a leading proxy of inflation), but with a lag. Note the inflation indicator is inverted on the chart, so a falling line is actually rising inflationary pressures.

Inflation does have some immediate effects, however it takes many months for rising inflation to start to impact major data points and flow into the real economy. It slowly reduces the real consumption power of the consumer and acts as a gradual financial tightening in the system (similar to how rising interest rates would). Understanding these dynamics and how it then affects other leading economic indicators provides us with some valuable risk management tools.

So why are we looking at how it affects the ISM new orders? Because this is one of the Conference Board’s key leading economic indicators, it acts as a good proxy for the business cycle, and its correlated with stock market returns.

As you can see from the chart, even though inflation has only been hitting the headlines this year as it has shot above the Fed’s target, inflationary pressures (the falling blue line) have actually been gradually building for some time now.

The bottom line

If this relationship holds, then this chart is telling us that whilst we may have another final leg up here, in late 2021 / early 2022 the inflationary pressures of the past year and a half will really start to weigh on economic activity and affect the business cycle through 2022. We will absolutely need to ‘watch this space’.

 

Author: Graham Parkes
Macro analyst & editor of The SMSF Investor

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