Tapering in November, business as usual in December

The rising consumer prices recorded on both sides of the Atlantic since economies have re-opened suggest we may be seeing stickier inflation, possibly accompanied by a broad upward trend in interest rates. Though this kind of development has surfaced only a few times over the last forty years, it could become more menacing in the United States now that wages are contributing to the inflationary trend under way.

Such a scenario currently seems unlikely to materialise. But if it does, the effect on financial-asset returns will be so strong that we feel it’s well worth trying to explore the key factors at work. An end to persistent disinflation would force us investors to throw off the conditioned reflexes we’ve developed over the last few decades and learn to adapt to a changed environment.

For now, of course, this is just an alternative scenario. In fact, to keep it from occurring, a number of central banks have begun reversing their monetary policies in a bid to ease inflation expectations. Several of them – in commodity-exporting nations and a few other emerging economies – have already taken steps to push up interest rates in the past few weeks. The US Federal Reserve has meanwhile started winding down its asset purchases in November and has floated the idea of an interest-rate hike some time next year. As Fed Chair Jerome Powell has made very clear, his primary aim is to avoid unsettling financial markets; that involves letting them know well in advance what the Bank plans to do, how large the changes will be and at what pace they will unfold. If you take him at his word, you’d be tempted to assume that economic developments won’t throw any curve balls that could upend his plans or catch investors off guard. Tapering¹ in November, business as usual in December. End of story.

How nice it would be to share Powell’s assurance. The trouble is, the argument that US inflation – currently exceeding 6% – is only transitory in nature is beginning to look doubtful. Not only are a number of industries still saddled with supply bottlenecks, but it seems increasingly likely that the pandemic has brought about a lasting change in how Americans view work. The excess savings they’ve built up over the past eighteen months (equal to 12% of US GDP!), steadily rising valuations for financial and real-estate assets and growing concern about quality of life are apparently leading a good many workers to contemplate retiring early, having one member of the household drop out of the labour market or shifting into jobs with less constraining schedules. The fact that the workforce participation rate has remained stubbornly low – even as the number of openings for decent-paying jobs approaches record highs – provides an objective gauge of the decrease in available labour and the potential for future wage inflation.

In addition to bottlenecks in a number of supply chains and one of the strongest wage-bargaining positions for workers in decades, two other potential drivers of inflation are worth considering. The first one has to do with a change in the economic policy mix, with fiscal policy steadily gaining ground. By making greater use of public spending, governments can directly boost disposable income, particularly for households with a high propensity to consume. This gives fiscal policy an inflationary force that contemporary monetary policy has never managed to achieve. The second potential driver of higher inflation is today’s concerted push towards the energy transition, which may generate lastingly higher natural gas and oil prices, due to weaker investment in fossil fuels. Replacing them with other energy sources will take years and years.

It’s entirely possible that we’ll be seeing a wage-price spiral which could give inflation greater strength and staying-power than anticipated

So it’s entirely possible that we’ll be seeing a wage-price spiral which could give inflation greater strength and staying-power than anticipated, forcing central bankers and investors to follow its own, unpredictable pace.

Financial-market reactions to the first upticks in benchmark interest rates and the increasing prospects for tighter monetary policy in the United States have initially been much the same across the various countries affected. Short-term rates have risen more markedly (in some cases even sharply) than long-term rates, suggesting that investors believe central banks have the monetary cycle well under control, and expect GDP growth and inflation are heading for a soft landing. Traders are therefore betting on a scenario of perfectly orchestrated monetary tightening – one that will include a succession of rather swift hikes in short-term rates that central bankers will carefully calibrate to keep GDP growing at a reasonable clip, while anchoring inflation expectations somewhat lower. The Fed’s recent announcement was also well received by both equity and corporate credit investors. What makes that sign of trust so noteworthy is that equity markets currently stand at record highs, often with stretched valuations, while corporate bonds are trading at negligible spreads – likewise a sure sign of elevated prices. Because prices are so high, central banks can ill afford to make a mistake. If they hike policy rates too fast or by too much, they may trigger a sharp selloff of financial assets, and given how high debt levels currently are, it’s easy to imagine the collateral damage.

The fact that such an ominous outlook has barely caused a ripple in financial markets tells us quite plainly that investors feel the economy has yet to depart from its path of the past several decades – i.e., secular weak inflation that has no chance of bouncing back, therefore guaranteeing that interest rates will stay low. Those low rates are expected in turn to facilitate debt financing that can generate enough GDP growth to keep investors happy. Assuming such continuity, the risk most commonly associated with the necessary monetary-policy tightening under way is that it may lead to much slower economic growth. Forty years of disinflation have ultimately anchored GDP growth expectations at lower levels – or is it the other way round? In any event, no one finds it easy to break habits, especially when they’re so firmly, well, anchored.

The opposite danger – that central banks might react too little or too sluggishly and as a result lose control over long-term interest rates – doesn’t appear to be a major concern for market participants. Many observers view the rising yields on the short end of the yield curve today as evidence of active anti-inflation vigilance among investors. Similarly, coupon payments on inflation-linked bonds have jumped to heights not seen in twenty years or more, depending on the maturity. But given that the nominal yield on 5-year paper is 1.2% in the US while inflation is forecast to average 3.1% over the same 5-year period, such “active anti-inflation vigilance” somehow looks rather unconvincing. The truth is that the adverse effects of lastingly high inflation on fixed-income markets would be much greater than any positive effects from a return to the negligible inflation seen in recent decades. So there you have an unambiguous indicator of how investors are currently positioned.

Fairly clear guideposts for equity investing, much less so for fixed-income investing

The current outlook provides fairly clear guideposts for equity investing.
Assuming that inflation gradually eases once supply bottlenecks have been ironed out, and that economic growth doesn’t get undercut by tighter monetary policy, equity markets are likely to maintain their upward momentum – driven as before by growth stocks with good earnings visibility. And contrary to what their name suggests, those stocks don’t need high economic growth to do well. Suppose that central banks fail to engineer a soft, smooth landing and instead trigger a heftier economic slowdown than anticipated. In that case, those same high-visibility growth companies will still be turning in superior relative performance. It would take an out-and-out slump for more defensive stocks to carry the day, given their low sensitivity to the economic cycle.

An outcome that would be more thought-provoking – because it’s less intuitive – is our alternative scenario of persistent inflation. The closest thing to what that scenario might entail would be the era of the Nifty Fifty, extending from the mid-1960s to the early 1970s, when the first oil shock in 1973 brought the US bull market to a halt. Prior to then, from the 1950s to the mid-1960s, the country’s economy had experienced impressive yet non-inflationary growth that for the most part kept fixed-income and equity markets humming. Round 1965, inflation began trending upwards, driving 10-year bond yields into the 8% vicinity, but that didn’t stop the period’s premium growth names from achieving vastly superior price/earnings ratios. The stocks that did best in that environment, the fifty-or-so high-flying names that could easily shrug off inflation, were called the Nifty Fifty. They were to be found in sectors ranging from new technology – already – (Digital Equipment) to entertainment (Disney), from pharmaceuticals (Eli Lilly) to consumer products (Kodak) and to industrial conglomerates (General Electric). When the oil shock hit, those stocks were trading at an average of roughly 50 times earnings, compared with barely 10 for the rest of the equity market. Today’s tech giants, luxury-goods makers and pioneering pharmaceuticals companies can arguably claim to be their contemporary counterparts.

Due to their apparent ability to take any and all currently imaginable scenarios in their stride, this set of dazzling growth names unquestionably offers considerable relative value.

As an asset class, fixed income seems to be harder to assess. With long-term yields so low despite such high inflation expectations and such narrow credit spreads, there is little incentive to make bold investment moves, considering the risk of volatility inherent in this paradoxical state of play. Regarding the longer term, investors’ job will involve spotting possible signals that, after forty years of radio silence, inflation is squarely back in town. Those signals must not be overlooked, as they would call for an investment outlook geared to higher yields. Such an approach would be better equipped to create value than the scenario expected today by central banks of a reversion to lacklustre economic growth – propped up by more and more debt. Until such time as inflation becomes a cause for sleepless nights among savers (if it ever does), we plan to play it safe through a cautious but constructive stance on developed-world government bonds.