Higher Inflation and the dilemma for central banks
Mark Nash discusses the difficult choices facing central banks as inflation lingers and what it might mean for absolute return bond strategies.
The demand side of the US economy has been very robust. Fiscal spending by the Biden administration is massive and is supportive for growth at a time of low unemployment. This explains why the economy has held firm against higher interest rates.
Consumers have jobs and wage increases, and when inflation moderates, they will have real wage gains, which may provide strength into next year.
We are also seeing a supply side response to all this demand. The labour market is increasing, participation rates are going up and productivity is coming back. That’s what you need to deal with the surging demand — which includes fiscal programmes like President Biden’s Inflation Reduction Act, higher defence spending and capital expenditure related to geopolitical changes.
Higher for longer
The US Federal Reserve (Fed) has said that inflation will come down, though it might take longer, and that unemployment won’t rise that much. They see productivity gains helping to tame higher prices. Still, we think they will need to keep rates higher for longer given the strong growth — and the market needs to accept this.
I fail to see how you can get a recession. Given the stronger balance sheets since the Global Financial Crisis, we see it as harder for something to break and change the macro direction. However, the bond market breaking is a risk given the lack of demand for duration, quantitative tightening, massive fiscal spending, a strong US dollar and higher energy prices. Defaults will happen, zombie companies that overindulged on cheap credit will be taken out by higher rates, and some consumers on variable rate mortgages may suffer, but that will not change the global macro picture. The dollar will stay strong, and US risk assets look good.
In Europe and the UK the situation is more difficult. Demand is being hit from high interest rates and weakness in China, inflation is still far too high, and the employment picture is less robust. It’s something like stagflation. Europe and the UK will be impacted by higher oil prices and a strong dollar. If the Bank of England (BOE) and European Central Bank (ECB) stop hiking, their currencies will fall and make buying energy in dollars even more expensive.
Geopolitical change
China’s economy hasn’t managed much of a recovery since the Covid lockdowns and there are structural issues at play. China isn’t doing stimulus anymore; it is worried about debt levels and wants better quality growth. China investment supported the world for the previous 20 years but now the geopolitics are changing, and the impact is starting to be seen.
It’s time for everyone to do more for themselves. No more Russian energy for Europe or cheap goods from China. Nations are increasingly building capacities within their borders following the supply chain debacle caused due to reliance on China during the pandemic.
This should result in more capex and more fiscal spending in the west. Europe hasn’t done this very well so far. Eventually, we can get to a place where growth should be better, demand will improve and as long as countries can cope with that higher demand – with more workers and better productivity – all will be well. Inflation will never completely go away, however.
Race to the top
In a world where global goods are more expensive, it’s not a race to the bottom with interest rates and currencies — it’s a race to the top. This a new phenomenon. The central banks have a difficult choice now: they can protect their economies and accept higher inflation, or they can try to eradicate inflation and knock their economies down. The Fed is in a better position than the ECB or BOE.
Many investors today haven’t experienced these kinds of markets; they only know low inflation. Investing strategy has to be different now. Managing fixed income assets in an unpredictable macro environment calls for a lot of flexibility. The 60-40 portfolio model (60% equities, 40% fixed income) with long-only equities and bonds, used to be effective. Now it’s about relative value, bottom-up selection for stocks, credit and sovereigns and finding relative value. We see it as a new world and an excellent opportunity for absolute return strategies.
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