Taking Stock Autumn 2022

Investing in a higher inflation world

How will central bank policies impact global equity and bond markets? Iain Cunningham shares his views on US policy measures to fight inflation and global market conditions, while Peter Kent and Adam Furlan examine the outlook for SA fixed income assets.

May 24, 2022

8 minutes

Iain Cunningham
Peter Kent
Adam Furlan
How will central bank policies impact global equity and bond markets? Iain Cunningham shares his views on US policy measures to fight inflation and global market conditions, while Peter Kent and Adam Furlan examine the outlook for SA fixed income assets.

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

Figure: 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.

Supply has been growing at about 20% per year following the COVID shock.

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.

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.

There is a reasonable possibility that the Fed’s estimate of neutral policy may be too low.

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. 

An SA fixed income perspective

Peter Kent, Co-Head of SA & Africa Fixed Income, and Adam Furlan, Portfolio Manager, Fixed Income

While inflation has spread rapidly across the globe, South Africa’s inflation rate has been relatively contained. For the first time in nearly two decades, our inflation is tracking below the global average. Consumer price inflation (CPI) has remained within the South African Reserve Bank’s (SARB’s) target band of 3-6%. However, higher oil prices and supply disruptions sparked by the tragic events in Ukraine are creating upward inflationary pressures on the domestic front.

For the first time in nearly two decades, our inflation is tracking below the global average.

Against a backdrop of higher global and local inflation, the SARB has embarked on a rate-hiking cycle, steadily adjusting monetary policy towards a more neutral setting. We saw a gradual increase in interest rates from their low levels, with three 25 basis point hikes in the repo rate (November 2021, January 2022 and March 2022). However, with inflation risks materialising and CPI now expected to breach the ceiling of the target band in the third quarter,2 the SARB hiked the repo rate by 50 basis points in May. Another 50 basis point rate hike is likely in July, given the upside risks to inflation.

CPI is expected to breach the ceiling of the target band in the third quarter.

The resilient rand has helped to keep a lid on inflation. However, tighter monetary policies in developed markets (DMs) and a waning appetite for emerging market (EM) assets have resulted in bouts of rand weakness. The SARB will keep a close eye on inflation drivers such as international oil prices, local food prices and currency movements, as it considers how best to combat inflation without crippling the economy. We expect the SARB’s policy decisions to remain data-dependent, with the central bank focusing more on second-round effects than temporary price shocks. Notwithstanding rate hikes, we anticipate that SA economic growth will return to pre-pandemic levels by year-end.

SA bonds continue to offer an appealing long-term income opportunity for investors.

How we are positioned

Against a backdrop of higher inflation and rising interest rates – both locally and globally – we remain cautious in our positioning of the Ninety One Diversified Income Fund. We have increased our offshore exposure to mitigate some of the local and global risks. Furthermore, we have reduced our allocation to South African assets, lowering exposure to SA government bonds and listed property whilst maintaining an allocation to inflation-linked bonds – to protect the portfolio from upside inflation surprises. However, local bond yields remain attractive not only versus cash and inflation, but relative to DMs and EM peers. An investor can earn a yield of around 10.5%3 on 10-year SA government bonds – which is well above inflation. Given high real yields, we believe that SA bonds continue to offer an appealing long-term income opportunity for investors, which we will look to add back to the portfolio when global market risks dissipate.

We have a well-diversified portfolio that, when combined with active allocation, is designed to provide some protection against the multitude of local and global risks but also to participate in upside from bond market rallies. This investment strategy has helped us to deliver attractive real returns to investors.

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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.

Iain Cunningham
Peter Kent
Adam Furlan

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