Investing in a higher inflation world

Global equities and bonds have had a tough start to the year. Coming into 2022, the valuations of both equity and fixed income markets were extended. As central banks have moved away from policy easing towards tightening, government bond yields have been pushed sharply higher. In turn, rising discount rates have placed downward pressure on equity valuations.

Equity and government bond returns typically move in opposite directions, offering diversification benefits in a portfolio. But it’s not entirely unusual for them to be highly correlated – particularly during and exiting extended periods of extraordinarily easy monetary policy, and in periods where central banks are fighting inflation.

Is central bank tightening priced in?

After the largest and fasted increase in government bond yields since the 1990s, it’s sensible to ask whether developed market central bank policy withdrawal and tightening is now ‘in the price’? Before we attempt to answer this question, it’s important to note that not all economies globally are in the same phase of the cycle. China, for example, tightened policy materially last year, has a headline inflation rate of 1.5% after adopting relatively orthodox and measured stimulus during the 2020 COVID shock, and is now easing policy to support a slowing economy. In our view, the US is the most important economy to focus on when seeking to answer this question because structurally it is the healthiest amongst major economies. US Treasuries also act as the global risk-free rate and influence asset prices across regions.

Developed market government bond yields rising

Source: Bloomberg to 30 April 2022.

Looking at the current state of the US economy versus the market’s pricing of Federal Reserve (Fed) policy, yields are much closer to where they should be now than six months ago. However, we believe pricing is not yet where it needs to be.

The US labour market is tight, with the broad U-6 measure of unemployment at 6.9%, close to its lowest level in decades, while there are nearly twice the number of job vacancies relative to unemployed persons. Nominal wages are growing at 5.6% year on year, notably above the Fed’s inflation target and at their fastest pace in decades.

The Fed has its work cut out

There is also considerable excess money supply in the US economy. Supply has been growing at about 20% per year following the COVID shock – a function of pandemic-related central bank and government stimulus – and at a rate of growth never seen before in available data. These dynamics, as well as the consequences of the tragic events in Ukraine (higher commodity prices and supply chain disruption), will continue driving underlying inflation, meaning the Fed has more work to do to fight inflation.

The Fed believes that the neutral policy setting (the rate of interest at which the economy is neither accelerating nor decelerating) is 2.5%, so theoretically taking interest rates higher than this would be tightening policy. However, we maintain an open mind because the estimate of 2.5% is based on guess work and anchored to the recent past, which may not be entirely relevant. The US economy was in a deleveraging cycle for much of the post-Global Financial Crisis period, with an additional headwind from declining working-age population growth. Structurally, the US economy appears to be in much better shape having deleveraged, and with the possibility of re-leveraging as the largest US population cohort, the millennials, continue to form households. Working-age population growth is now also less of a headwind.

As a result, there is a reasonable possibility that the Fed’s estimate of neutral policy may be too low. Until we see the market measure of US real interest rates¹ turn positive (at least 0.5 to 1%) and market expectations of inflation begin to decline (US 10-year breakeven inflation rate), it is implied that the Fed is not yet doing enough to rein in underlying inflationary pressures by slowing the economy.

We should also note that there is another major headwind for asset prices: quantitative tightening, or the shrinking of the Fed’s balance sheet. While quantitative easing increased the amount of currency in circulation, pushing up the price of relatively finite assets, quantitative tightening will shrink the amount of currency in circulation, weighing on asset prices.

Asset class correlations – where to from here for investors?

As the Fed and other central banks move to fight inflation, it’s likely that correlations between asset prices will remain high and volatility will be elevated. Beyond this period of inflation fighting, the path of inflation and asset correlations through the remainder of the 2020s will likely be conditional on how successful central banks are at taming this bout of inflation. If successful, then there are plenty of disinflationary forces globally, such as deteriorating demographics and technological disruption, to return us to a more benign inflation environment. However, if the Fed and other central banks fail to contain inflation sufficiently during this period, then we could be in for a decade of higher and more volatile inflation.

Historically, during periods of higher and more volatile inflation, asset classes have displayed a higher degree of correlation – struggling as central banks move to contain a bout of inflation, before rallying in tandem as inflation peaks and central banks move to ease policy. Time will tell as to which scenario plays out, but if it’s the latter, then asset allocation flexibility will remain particularly important in seeking to compound returns.

How we are positioned

The Ninety One Global Strategic Managed Fund entered the year with a lower-than-average exposure to both equities and fixed income, given extended valuations and the prospect of rapid policy tightening. Exposure to fixed income has been in markets that have already adjusted to their central bank hiking cycles and have considerable structural headwinds – implying that their economies can’t tolerate high interest rates. These include Korea and New Zealand. We have used the portfolio’s flexibility to hold a cash balance of approximately 30% year to date, which will be deployed into opportunities as and when we believe the Fed has taken sufficient action to contain the current bout of inflation. 

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¹ US 10-year Treasury yield minus US 10-year breakeven inflation rate.
² Annual consumer price inflation rose to 5.9% in March.
³ As at 5 May 2022.