PUTTING THE CART BEFORE THE HORSE…
However, before we sound the all clear on the deflationary pulse that has characterised markets since perhaps the 1987 Asian financial crisis, investors must brace for a period of volatility in inflation numbers, in both directions; the rate of change nature of markets versus investor expectations will ensure that. There will be some confounding waystations before arriving at any terminal inflationary destination.
INFLATION IS ALWAYS AND EVERYWHERE….
Perhaps one of the most recognised of economic tropes, is Milton Friedman’s stylised view of inflation of being it always an everywhere an monetary phenomenon, perhaps short changes the complexity of inflation and its dynamics. Gently rising prices are considered the lubrication of a well functioning economy, it’s when there is an acceleration in the prices of goods and services that causes greater societal harm. In fact, it is perhaps the fact that rising prices hits those who sit at the bottom of the socio-economic pile the hardest, and during a period when there is a pressing electoral pressure for governments to address income inequalities, the loins of central bankers globally are girded to adopt a very hawkish stance. An element of ‘one in the eye’ for the ‘haves’ rather than ‘have nots’ to level the scores somewhat.
THREE ASPECTS OF INFLATION
Within a capitalist system, it’s possible to interpret Friedman’s assertion in such as way as to suggest that inflation is a feature not a bug. Central banks have always relied on the intuition that the tools they have leads them to believe that they are adept at addressing inflationary outcomes, but they are rather less well placed as addressing deflationary turns of event. The current predicament will in retrospect be an important empirical data point in supporting that contention. In fact, it is concerns surrounding the ‘Japanisation’ of the US and European economies that have clouded the policy making elites’ thinking over recent decades, viewing the deflationary pulse as the dominant threat.
Lest we forget, there are limited politically acceptable options to tame the inexorable rising trend that is global debt, other than reducing it in real terms by inflating it away.
“Part of the great moderation in inflation and by extension interest rates, has been a grand bargain with China. China benefits from rapid industrialisation, the original workshop of the world, and whilst the middle class and its wages have been bottomed out, the costs of goods have consistently fallen cushioning the living standards of those disenfranchised Western workers.”
WHAT HAS KEPT DEFLATION SUBDUED FOR DECADES?
For decades, central banks have had the luxury of structural deflationary trends – those of manufacturing being mercesslelly outsourced to the south east Asian economies which offer the lowest marginal cost of production; an ageing demographic which are savers rather than spenders, a brake in its own right on global growth and finally the rapid technological advances that have made the global populace increasingly efficient, productive and well informed – all of which has driven prices of goods and services lower.
Part of the great moderation in inflation and by extension interest rates, has been a grand bargain with China. China benefits from rapid industrialisation, the original workshop of the world, and whilst the middle class and its wages have been bottomed out, the costs of goods have consistently fallen cushioning the living standards of those disenfranchised Western workers.
In that respect, whenever there was the threat of an inflationary burst, Central banks could quickly snuff it out with short tightening cycle, and before long the strong macro disinflationary dynamics would take hold of the reins once more. In 2022, for a number of well publicised reasons, this particular inflationary episode has not proved to be as transitory as those which have gone before it.
REGIME CHANGE
For last year’s words belong to last year’s language. And, next year’s words await another voice. And, to make an end is to make a beginning.” – T.S. Eliot
It is sometimes difficult to fathom the significance of the turning of the times during the heat of the battle. But it is undeniable that the times are a changing. Fiscal policy is now back in the driving seat, a just-in-time arrival for monetary policy makers continued reactionary function being typically expansionist. This unholy union has been the dye in the cast for an ultimately all together more inflationary environment. It is in the political milieu that the conflicts between markets, the consequences of capitalism and social tensions are ultimately resolved.
As we stand the inflation narrative is ‘entrenched’, those doubters have been brought into the inflationary fold. However, investing simply for an inflationary outcome at this point could be as damaging as being positioned exclusively in nominal assets, such as corporate bonds and sovereign debt, that have so suffered during the sell off in traditional fixed income. Investing is a second derivative game – always a function of the rate of change, rather than simply the absolute change.
That’s to say that we can also as easily foresee downside inflationary volatility, as much as we can pressures on the upside. Taken to its logical ultimate expression, societal, political and financial dynamics all point to an inflationary outcome, but the path to getting there will be fraught with prodigious swings between hellishly sticky CPI numbers and dramatic falls in these very same price levels.
Unfortunately, the pedestal upon which central banking has rested, that have been operated under for nearly 40 years, (before Bernanke), is being swiftly kicked at its base by Mr Market. Asset allocations have really only had two seasons to dress for – slowing growth, (and with it inflationary pressures), and a reflationary environment again with well behaved prices. It is the potential for a stagflationary condition set, or even robust real economy but with runaway inflation, which is posing a whole new raft of questions for investors.
In such an environment, having a ‘resilient approach’ means availing ourselves of all the tools available – hedging, downside protections, precious metal allocations, unashamedly holding high cash balances as dry powder for the inevitable fat pitches, as well as knowing when to loosen the risk constraints again and increase market exposure. The tried and tested approach of relying on bonds as the portfolio anchor and principal form of defence has simply put, not worked. In response, it’s tempting to take a view that positioning for the ultimate inflationary end game is prudent, but such an outcome will take years to fire in the macro economic furnace. As central banks perhaps are faced with few good choices, propelled by a political need to take the ‘no regrets’ policy choice, which means it is currently unacceptable to prematurely curb interest rate hikes. Perhaps they already readily accept a necessary recessionary outcome to rein in pricing pressures, even when the price paid in a hyperfinalised world means much lower risk asset prices. Investors will have to display a lightness of touch – be prepared to position for a narrative pendulum swing, perhaps taking on long duration risk, or long term bonds in size again, just at the point that institutionally strategic asset allocations to global government bonds may have been unceremoniously bludgeoned.
In short, static asset allocations will deliver return profiles that may be as volatile as the underlying inflation, interest rates and ultimately stock markets that they seek to derive performance from. Asset allocations will require a fleetness of foot that will need to be able to dynamically position for all four financial market seasons – inflationary, reflationary, growth and the dreaded deflationary.
“Asset allocations have really only had two seasons to dress for – slowing growth, (and with it inflationary pressures), and a reflationary environment again with well behaved prices. It is the potential for a stagflationary condition set, or even robust real economy but with runaway inflation, which is posing a whole new raft of questions for investors.”
– Testimonial
THE BREADTH OF INFLATION: EXPECTATIONS DRIVE VOLATILITY IN ASSET PRICES AND ECONOMIC CYCLE.
Shelter inflation accounts for approximately one third of US Consumer Price Index (CPI). It has been rising steadily through 2022. Tight conditions in the US housing market, in part on account of insufficient housing being built in recent years has kept CPI well bid. Still, we have witnessed inflation data reveal its very broad nature – that’s to say the other 66% of components making up the measure are also in the ascendancy. Consumers spending has been robust, meaning that this inflation is becoming structural. However, should tighter financial conditions put a handbrake on economic growth, the consumer ultimately will respond and throttle back its own spending.
DRIVING USING THE REAR VIEW MIRROR
And now we welcome the new year, full of things that have never been.” – Rainer Maria Rilke
Looking into the real view mirror, the tightening of financial conditions that the Fed have sought to spearhead, has not just crushed unprofitable technology companies, but of course driven the narrative pendulum swing towards value stocks over growth.
Perhaps one of the greatest victims will be the traditional 60/40 paradigm – although given the swell in concern at the point of writing, it is very due a renaissance or at least a period of outperformance again.
In recent weeks, the longstanding relationship between stocks and bonds is once again being called into question. The 60-day correlation between stocks and long-term government bonds has popped to levels rarely seen in the past 25 years.
All of the above requires a re-think on the part of investors. What has worked for so long, has met an abrupt unwind. As we move into a period of structurally higher cost of capital, it is not just higher volatility of the stock market, or even inflation or interest rates, yet that of the business cycle itself, investors need to contend with. The great moderation itself is overdue a reset, and that has implications for the asset management industry itself, as much as the asset allocation policies implemented within it.
Peter Drucker, the father of modern management thinking, said: “The greatest danger in times of turbulence is not the turbulence. It is to act with yesterday’s logic.”
The deck was perhaps always stacked against 2022. After years of ultra-accommodative fiscal and monetary measures, policymakers appear determined to take the training wheels off. Markets are looking down the barrel at an accelerated tapering, a rising Fed Funds Rate, and a relatively austere mid-term election year.
The training wheels have most certainly been taken off, and passive approach to a very active rate of change of key macro economic variables will likely prove inadequate.
