By Robert Ducker
The old adage of “be careful what you wish for” must be on all central banker’s minds as we approach the end of 2021. For years, we have listened to central bankers discuss their plans to prop up inflation and often, fail to do so. At the other hand of the spectrum, we listened to those within financial markets discussing inflation as being a thing of the past, something that belonged to the 70’s and 80’s. Their view was underpinned by cheaper production costs brought about by globalisation and advances in technology. Some argued that inflation was under control following ex-FED chairman Volcker’s change in monetary policy during his term.
Notwithstanding this, central bankers persisted, cutting rates to zero (even negative rates in certain countries/regions) and announcing several asset purchasing programs. Core PCE in the US has averaged c. 1.8% since the turn of the century. To provide some context to this number, the average for the prior two decades stood at c. 3.9%, well above what we have seen over the last 20 years. Since April 2021, inflation has remained above target levels, and has averaged 2.6% over the past 12 months. The origins of the “great inflation period” of the 70’s and 80’s were mainly (1) policies that led to excessive growth in money supply and (2) oil price shocks (an exogenous factor).
Therefore, comparing today with history, COVID-19 has been this decade’s exogenous factor. Supply chains have been disrupted leading to a significant rise in production costs. Most economists are claiming that this is temporary and will start to fade over the next 12 months. Whilst we do not disagree with his view, we think that the risk that inflation is not transitory have been rising over the past months. We have also observed several companies highlighting inflation concerns during third quarter earnings call. McDonalds have hiked their menu prices to offset wage increases, while Amazon earnings were heavily impacted by rising wage costs and supply chain constrains. In Europe, Volkswagen noted that the semi-conductor shortage will persist for most of 2022, while also saying that they expect aluminium, plastics, and magnesium markets to be tight. It remains to be seen whether ultra-loose monetary policy will exacerbate the inflation situation, as it had during the 70’s and 80’s, though we think there are key differences to consider between then and now such as the collapse of the Bretton Woods system and the separation of the US Dollar from its last link to Gold.
Our base case remains that inflation will be transitory in nature, but we think investors should be planning for an eventuality of inflation persisting for longer. Most periods of inflation that remain persistently above central bank target will undoubtedly lead to higher interest rates. This implies that all else equal, from an asset class point of view, inflation should be a bigger risk for fixed income investors. This is because bonds offer a fixed nominal return throughout the maturity of the instrument, with no protection against surprises in inflation. On the other hand, equities are real assets, and their earnings and dividends should, at least theoretically, rise with inflation. Higher rates may also have consequences for the crowded growth trade due to the higher discount rate, and particularly those companies that are today not generating cash flows with their intrinsic value being derived mostly from future expected cash flows and very high growth expectations. We think these stocks would be susceptible to a re-rating in the event of higher interest rate environment (assuming economic growth forecasts remain sufficiently high).
We caution that equity performance during such periods depends on several factors. Firstly, equity performance will depend on how fast rates must be hiked. An aggressive rate hiking cycle could damage economic growth prospects and consequentially, be a negative for equities. Additionally, consideration needs to be given to the impact on economic growth prospects of an aggressive hiking cycle taking into consideration the size of central bank balance sheets. Secondly, equity performance during hiking cycles also depends on the level of yields at the time. A low starting point (i.e., where we are now, close or at 0%) makes us more comfortable with equities outperforming bonds. Finally, the driver of the rise in yield is also important in determining the performance of equities during periods of rising bond yields. Historically, equity investors have been much more comfortable with periods of rising bond yields due to rising inflation expectations.
To conclude, equities tend to perform relatively well during periods of rising inflation and consequentially, rising bond yields. Goldman Sachs calculate the average performance for US equities during periods of rising rates amounted to 9% since 1991. Of the 16 periods analysed, equities only delivered a negative performance 3 times.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.