Client Update - 1st October 2021
The consensus view remains that the increase in inflation being experienced around the world is transitory. The dictionary definition of transitory is technically “not lasting nor permanent”, therefore how long can inflation keep rising and still be deemed transitory?! It should be acknowledged that collectively economists, investors and policy makers have been surprised by the speed and extent of the increase in inflation and the supply side disruptions that are behind it. That shows how complicated the world economy is.
Who could have possibly foreseen the ongoing need for workers to quarantine because of Covid-19, the disruptions in energy markets and shortages of heavy goods vehicle drivers – amongst other things? Equally, I think we need to be somewhat humble about what will resolve these issues and how long it will take. All Covid-19 restrictions are unlikely to be completely lifted anytime soon. Changes in consumer and corporate behaviour will affect supply in labour and product markets and in services for some time to come. Shortages of all kinds of goods are likely to persist for at least a few months until firms can re-establish effective supply lines. Inflation might be transitory – but for some time!
For financial markets all of this can impact on the macro-economic data and undermine investor sentiment. Perhaps the most troublesome development would be a monetary policy mistake. Central banks might react to the rise in inflation above their targets by rapidly shifting to a more hawkish stance and raise rates before economies can cope. Both the Federal Reserve (Fed) and the Bank of England (BoE) continued to prepare markets for the end of super-accommodative policies. This certainly reflects a massive switch in sentiment considering that it was not that long ago when negative interest rates were being considered.
The current rhetoric would suggest that rather than make a mistake, central banks are most likely acting responsibly. They are not suggesting a very rapid move back to long-term “normality” (2.5% Fed Funds in the US?) and markets are not pricing in anything too draconian just yet. Equally the chances of a policy mistake in allowing inflation to run too high for too long is not likely. What is generating some angst in markets at the moment is changing expectations on the timing, not on the direction or extent of future rate moves.
For now we should go with the idea that the central banks have got it right. An early withdrawal from quantitative easing followed by rate increases would be something that could quite quickly be reversed if inflation and growth fell back quickly or financial markets reacted badly. Given concerns about global levels of debt, this is a realistic scenario. The “let inflation run” scenario is unlikely given just how long monetary policy makers have been waiting for inflation to pick-up. Surely, they have a good plan to deal with that.
More recent attention has focussed on the Chinese property sector and the potential for contagion to other sectors and markets. Yet by the end of the week markets have started to respond more positively and danger signs have been averted, for now. At least the usual seasonal pattern of higher market volatility around the Autumn equinox appears to be holding.
The core view should probably be that we are moving to a modestly higher rate environment. It is interesting to note that the Bank of England has form when it comes to shifting the sentiment in global interest rate markets. In 2003, the Bank was some eight months ahead of the Fed in raising rates. Ultimately it tightened less than the Fed but got in there first. History never repeats itself but there are echoes.
Central bankers have set out how they want to “normalise” monetary policy for some time. That process could start soon. The realisation of this has the potential to provoke some volatility in rates and equities. Yet the medium-term outlook is still benign. Unless policy makers get it wrong, rates will remain very low for some time to come and there remain plenty of opportunities for investors.
Whatever you may be up to, do have a lovely weekend.