One of our team’s favourite activities is reading the AI-generated headlines (they must be AI-generated, surely!) of the intra-day market commentaries on Bloomberg and CNBC. On 1 March, for example, the headline read ‘Stocks, Bonds Drop as Traders Recalibrate Rate Outlook’, having us believe that ‘traders’, having carefully parsed the economic data, the speeches of central bankers and myriad other variables, fine-tuned their interest-rate outlook and consequently adjusted their fair-value estimates for the S&P 500 Index by 30 basis points. We find this endlessly entertaining: the unnecessary frequency of the reporting, the feeble grasping for causality, the complete failure to convey any information of value. Good times.
However, the ‘recalibration’ in question is worth thinking about, and we are fortunate that Bloomberg’s John Authers has done much of the thinking for us. In a 15 February newsletter, he lays out some interesting facts about the recent US inflation report.
The US January CPI inflation overall came in much as expected, but with some interesting details below the surface, chief among them its composition. Price inflation for goods appears to have been transitory, as many were predicting. However, it was shocking enough to make its way into the minds of people – as a result, wage negotiations now include a significant inflationary component, and hence services inflation (services are labour-intensive) is picking up.
We have been saying that inflation is ultimately a matter of the mind: it exists because we think it exists. While it is relatively easy to bring down commodity inflation by cooling an economy or adjusting supply, it is much harder to stamp out the concept of inflation from the mind of a population that has begun to factor it in. Importantly, services inflation makes its way into the core measures of inflation that central banks like to look at (core inflation excludes the most volatile commodity-related components). Core US inflation is now running above the headline for the first time in years.
Another way to look at this is the helpful gauge produced by the Atlanta Federal Reserve, which separates the ‘flexible’ and ‘sticky’ components of CPI. Sticky items are those whose prices are slow to change, and they typically include such things as children’s clothes, auto repair and insurance costs, medical services and public transport. While flexible components have come back down to trend, sticky components are close to the highs.
How long it will take to bring this sticky component back down to acceptable levels will dictate how long central banks will need to maintain their current tough stances. What we can say is that expecting a quick reversal is probably optimistic.
It scarcely needs to be said that this matters to investors. Markets are notoriously bad at recognising turning points, especially when the previous environment has endured for over a decade. We recently read some interesting statistics (courtesy of Ninety One’s Multi-Asset team) about the most likely operating assumptions of today’s investors. If you have been in the market for:
- 7 years, you have never seen a positive German 2-year yield.
- 11 years, you have never seen US equities underperform the rest of the world for any great length of time.
- 14 years, you have never seen value outperform growth in developed markets (based on MSCI indices) for a sustained period.
- 26 years, you have never seen a Bank of Japan policy rate above 1% (nor, for that matter, have you ever witnessed sustained Japanese equity outperformance).
- 33 years, you have never seen double-digit OECD-wide inflation.
- 40 years, you have never seen a cycle peak in the US 10-year Treasury yield surpass the prior cycle peak.
- Over 120 years, you have never seen US Treasuries lose money in a US equity bear market.
The year-to-date market rally appears to have relied on the assumption/hope that inflation will quickly dissipate, so interest rates will come down, and therefore let’s pile back into the growth/meme stock bubble. However, it is worth asking whether the environment has permanently changed. What if interest rates above zero are here to stay? What if a bond (not to mention a savings account!) is once again a viable savings instrument? What are the implications for the way we should invest going forward?
Of course, we have our opinions, which are mostly centred around the vague notion that the valuation one is prepared to pay for stocks is going to matter much more than it has over the last decade. We also think that the idea of ‘bond proxies’ in equities is fast-approaching its expiry date: after all, when you can buy an actual bond, why do you need a proxy? But this is just us. One thing we are quite sure of is that if there is a regime change, the market is going to recognise it slowly, and it will pay to get ahead of it.
