The war in Iran is an inflation shock. So far, we have only seen the effects of this inflation shock in cross-asset pricing. As energy prices remain entrenched at these higher levels, we will begin to see the economic effects. The temporal template for an energy shock is as follows:
Stage I- Cross-Asset Price Shifts: Global equity and fixed-income markets respond to the spike in energy prices. These shifts are near-immediate, reflecting correlations and relative-value trading.
Stage II- Inflation Shock: Energy prices shift, if sustained, begin to make their way to the consumer, and to measured inflation (CPI, PPI, PCE, etc.). This pass-through occurs relatively quickly, with energy prices passed through to consumers within approximately one month.
Stage III- Demand Response: As consumer prices and measured inflation trends become sustained, real demand responds. This process takes several months as the economy digests higher prices and consumers and businesses adjust their activity based on their current financial conditions and expectations of the future.
Stages I and II are still ongoing. Stage III is potentially ahead of us. We see some of the first signs of Stage III in our latest estimates for real employee incomes:
Our latest estimates for March showed real employee income decreased by -1.05%. Now, these estimates are subject to a significant margin of error. As such, they may overestimate the extent of weakness. The last time we experienced such a significant move in our estimates was in January 2022, which we find somewhat analogous to today. Regardless of the accuracy on the magnitude, our estimates are consistent with the direction of the pressures. Extrapolating the current rate of weakness, the future path of real incomes may well be recessionary:
For now, a recession is not our expectation. But the risks have risen significantly. We write this so readers can prepare their portfolios for that potential outcome. If you would like to leverage our process for doing so, you can find what we offer linked below.
Until next time.