The latest market moves might seem puzzling for those who do not work in fixed income markets.
On the one hand, in June, the U.S. delivered another set of above-consensus Consumer Price Index (CPI) data, with headline inflation reaching a new peak at 9.1% y/y. On the other hand, government bond yields in the longer maturity segments did not make further dramatic moves, and long-term inflation expectations, as priced by the markets, actually declined. The well-known 5y5y forward Inflation expectations measure, which is closely watched by the US Federal Reserve (Fed), is hovering only slightly above the Fed’s 2% target.
Consumers also are starting to shift their outlook, with long-run inflation expectations tracked by the University of Michigan consumer survey falling from 3.1% to 2.8%. A decrease of -0.3% might seem small, but in the history of the survey (running since the late 1970s), it is in the 96th percentile of one-month negative revisions.
Supply and demand shocks
We believe that what markets and consumers are quickly starting to price in for inflation makes perfect sense. We think inflation worries may well be a thing of the past.
The current inflationary episode started as a combination of supply and demand shocks. Consumer goods were the first engine as COVID restrictions changed consumption patterns in an already complex environment for supply chains. We now see significant improvements to the disruptions, with the Supply Chain Pressures Index, as compiled by the NY Fed off around 45% from its December ’21 peak. Demand for consumer goods also starts to look shakier with the erosion of purchasing power from consumers and the build-up in inventories (flagged by many businesses) pointing towards the demand peak being well behind us. The investor Michael Burry (The Big Short) has recently come under the spotlight in tweets where he highlighted the potential for goods disinflation and the “bullwhip effect,” whereby small fluctuations in retail demand can cause bigger changes at the wholesale and manufacturing levels. We have been arguing in favour of the potential for deflationary forces across goods for a long-time, and we see a simple explanation for that: consumers have bought too much stuff!
Commodity prices past peak
Then came the conflict in Eastern Europe, and commodities became the true engine of inflation. Here things are easier to understand. While war uncertainty still lurks, prices for most commodities are now experiencing significant declines: Industrial Metals are down approximately 40% from their peak, agricultural commodities -19% and energy -18%. This substantial decrease in commodity prices should gradually feed through to CPI numbers and will help to cap expectations.
Finally, the latest wave of inflation came from services and especially from the shelter/housing component of the CPI. The increase we have seen in rents in the US is the consequence of a long-running red-hot property market, and it is a structurally lagging indicator, given rents are usually contracted every 12 months and the nuances in the Owner Equivalents Rent computation. Things might be more complex for housing going forward. Higher mortgage rates (now around 5.75% as tracked by the Mortgage Bankers Association) have brought down housing affordability and new mortgage applications. This will have a consequence on housing demand, and while inventory for new houses is still relatively constrained, the number of single-family homes in the US currently under construction is the highest since 2006.
Ultimately and unfortunately, however, the best possible medicine for high inflation is usually an old-fashioned recession. In our past articles, we have been pointing to many forces pushing towards a slowdown. Those forces, such as a decline in real incomes, tighter financial conditions and negative wealth effect are still there. What has changed is market consensus and Fed stance towards a recession. What had been described as a remote possibility is now slowly becoming the base case. On a merely technical standpoint, Europe and even the US may well already be in a recession.
The consequences are very simple: we might have already seen peak yields for this cycle. The market quickly adjusted to the new consensus view, with a strong inversion in the 2y10y segment of the US Treasuries yield curve and with Fed Funds Futures pricing rates peaking at 3.5% by the end of ’22, to then actually decrease already in the second half of ’23. Historically, and especially in recent years, Fed pivots have been even more abrupt and sharper than this. As the inflation genie goes back into the bottle, the specter of recession will probably become the next focus of the Fed, changing the narrative.
Keep it simple
How should fixed income investors deal with all of this? We would argue that keeping things simple might be best. With an upcoming recession and no material change in secular demographics and technological trends, government bond yields (especially in the US, Australia, South Korea and New Zealand) look quite attractive both on a total return and from a growth hedging perspective. The slowdown narrative has influenced credit markets as well. While investment grade and high yield credit spreads, as tracked by broad indexes, still look below recessionary averages, we have been seeing more value in the BBB and BB rated space lately — especially in dislocated sectors such as Real Estate. We believe that as things turn more complex for the global economy, differentiation between high quality and more uncertain business models will start to be discounted by investors.
Notwithstanding the uncertain outlook for global growth, it is an exciting time to be a fixed income investor, with yields back at levels not seen in more than a decade.
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