This week saw China’s May producer price inflation surge by 9% year-on-year, raising concerns it will feed both near-term domestic and international consumer inflation. As if to prove the point, the latest US data shows the May headline rate of consumer price inflation reaching an annual rate of 5% compared with 4.2% in April, easily beating market estimates of 4.7%; Core Personal Consumption Expenditure (Core PCE), the inflation rate ‘smoothed’ by eliminating volatile food and fuel prices from the calculation (notwithstanding people buy food and fuel habitually however volatile prices are) checked in at 3.8% against 3.0% in April and a recent low of 1.3% in February. Core PCE is the rate of inflation the Federal Reserve focuses on when considering monetary policy in the context of its target of 2% as an average.
Also of interest is that, despite the US suffering its greatest annual economic shrinkage in a century in 2020 (-3.5%), in nominal terms the recovery has been such that by the end of the first quarter of this year, not only had the shortfall been made up but the economy was actually bigger at $22.1 trillion than the $21.8 trillion recorded at the end of 2019. Moreover, and few seem to have commented on this yet, this has been achieved against an unemployment rate of 5.8% in the aftermath of the pandemic, in comparison with 3.6% pre-pandemic. A rate below 4% is what economists traditionally view as “full employment” with the balance not seeking work, unable to work or deemed unemployable. As the economy opens up again new job vacancies are also rising steeply, 9.3m recorded in May, nearly a million more than in April. If nothing else, the pandemic has produced a significant spurt in productivity but if vacancies remain unfilled for too long then scarce sufficiently skilled labour will eventually become a constraint to growth while competition for good quality people potentially forces up wage rates.
Back with headline inflation, these high numbers reflect two dynamics at work: 1) the effect of surging raw material prices which we have discussed often as the global economy recovers, the momentum being with the countries leading the vaccination programme; and 2) for most, April/May 2020 represented the low point of the pandemic recession, accentuating the weakness of the comparator figures when comparing today’s prices with a year ago. That second factor becomes mathematically less relevant as time progresses and the comparators become less extreme; it remains to be seen whether the first factor is transitory or if it has duration.
Fixed income investors have other preoccupations
With their direct linkage with interest rate prospects, sovereign bond markets have so far taken the news in their stride. If anything, and counterintuitively, US Treasury yields have been declining of late, down from 1.70% on May 20th to 1.43% on June 10th, three weeks later.
With the annual rate of inflation now running at 5% in the US, and the Federal Reserve deposit rate set at a positive rate of 0%-0.25%, the real interest rate after adjusting for inflation is minus 4.75%-5% (in round figures, deposit $100 now in an interest-bearing account and in a year’s time the equivalent purchasing power of that cash will be $95 having been eroded by 5%).
So, what is going on that those investors who until very recently were worried about accelerating inflation and were selling Treasuries (when prices go down, yields go up) in anticipation of higher interest rates, are now doing the opposite when inflation proves a reality? Three principal factors are at work: first, as time marches on and Joe Biden’s presidency inexorably heads towards the mid-term elections in November next year, rightly or wrongly there is a growing perception that his multi-trillion dollar fiscal expenditure plans might be unfulfilled, constrained not only by deeply resistant Republicans but also threatened by a number of moderate Democrats who are increasingly worried about the ramifications of burgeoning levels of national debt and its affordability (essentially the so-called ‘reflation trade’ runs out of time and road raising the possibility that recovery stutters and the Fed is forced to make further commitments to quantitative easing through its bond-purchasing programme). Second, a related but technical factor: traders who had sold Treasuries short in anticipation of booking a profit when buying them back at a lower price are now covering those positions to mitigate against the risk of losses as bond prices rise again, which in turn forces prices higher. Third, far away in China, authorities worried about an over-heating economy and runaway inflation are actively constraining access to credit in order to temper the fires. Credit finance is a key lubricant of economic growth and, historically, evidence suggests that choking off the supply of credit too quickly not only applies the economic brakes but may even throw the economy in to reverse. Were that to be the case with its knock-on effect on the global economy, again the likely monetary response from the central banks and particularly the Fed, would be to resort to stimulus again.
Janet Yellen’s tank finds Jay Powell’s lawn again
Against this backdrop, the irony is not lost on us that US Treasury Secretary Janet Yellen took it upon herself last weekend to tell a press conference after the G7 Finance Ministers’ meeting that yes, in the long-run inflationary policies might lead to higher interest rates, but we must not worry because “higher interest rates are good for society” (more accurately good news for depositors, less so for borrowers). Old habits clearly die hard: having recently strayed into Fed territory with her $1400 per adult “Stimmy Checks” totalling $390bn drawn on a Fed account but contributing directly to the monetary supply (control of which is the Fed’s job), it is no business of the Treasury Secretary to be offering opinions on the future trajectory or benefits of higher interest rates without the inference that she is deliberately and mischievously leading the witness. The Fed is independent of government; monetary policy is its responsibility while the Treasury looks after the fiscal side; Yellen better than anyone should understand the risks of parking the Treasury tanks on the Fed’s lawn.
Such complexities and conflicting messages are difficult waters to navigate safely. In fixed income the Merlin Portfolios largely invest in strategic bond funds where nimble, expert, specialist managers have the ability to access the full spectrum of instruments ranging from sovereign bonds, through high quality Investment Grade and down in to the riskier High Yield sector; they also invest in a variety of geographic areas. The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
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