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I have a quandary. Do I focus on the COVID Indian variant? Dominic Cummings vs Matt Hancock? I have taken the decision that I cannot add much to the current news flow you already have full access to, so I will focus once again on changing market conditions.
Inflation printed higher everywhere in April. It is likely that headline year-over-year inflation rates will be above most central banks’ targets in the coming months. That will give some legitimacy to the idea that central banks are behind the curve and should start removing accommodative policy sooner rather than later.
Investors need to closely watch the month-on-month changes in consumer prices. Core consumer prices rose by 0.9% in the US in April and by 0.6% in the Eurozone and the UK. Those fighting the inflation corner will point to these higher monthly inflation rates to argue that we have entered a new regime of inflation dynamics, with costs rising in the household sector, with company’s referencing higher input prices. In the other camp, the argument will be that much of this is temporary, related to short term supply and demand imbalances and that existing output gaps and demographics will limit the longer-term inflation.
The pre-covid economic expansion was unusually long and unusual in that it was marked by a policy of financial repression. It took seven years for the US Federal Reserve (FED) to raise rates. During that time the yield curve was relatively volatile, but the trend was for it to flatten (from 2.84% in 2010 to 0% in 2019). By its own timeline, the FED has acknowledged this cycle will be shorter, likely ending in 2023.
Nothing is certain in this world, but investors are worried about inflation and the consequences for interest rates. Compared to previous cycles, central banks purchased much more of the outstanding amounts of government debt. There continues to be demand for long-dated high quality fixed income assets from pension funds and insurance companies. Together this might limit how much further bond yields can go while we can make the argument that when the FED and other central banks do start to move back to a neutral interest rate, that could still be a move of the magnitude of 1%-2%. Ahead of that happening, cyclical equities (such as financials and energy) will dominate. We will eventually arrive at a mid-cycle and monetary policy will be tightened. That will change market dynamics.
We now seem to always live in times of economic policy experimentation. The next few years pose challenges to central banks. The risk of fiscal dominance potentially constrains independence at a time when central bankers know they should be trying to reduce the pace of balance sheet growth (debt) and restore interest rates to “normal” levels. High levels of debt and the existence of what some call “zombie companies” complicate the situation. We have always had the view that, in contrast to a lot of the economics we have learned, the real world is characterised by moving from one disequilibrium to another. The paths between them are unpredictable. That is why markets do what they do, try to allocate capital based on trying to second guess those pathways. The signposts today are either higher inflation, higher interest rates or a continuation of financial repression and fiscal dominance with, as yet, unknown repercussions for financial stability and broader questions of equality. We would argue that there has never been a more sensible time to have professionals running your investment portfolio.
There will be no update next week as we have a half term break. In the meantime, we are keeping a close eye on market dynamics and for now I will sign off by wishing you an enjoyable and warmer bank holiday weekend.