Six et c'est fini

Inflation dominates the investment backdrop but we have been reminded this week that COVID can still play a role in how the macro outlook unfolds. Higher rate expectations have been driven by inflation yet there is perhaps no strong reason to think central banks will need to do more than is already priced in. For investors, fixed income is likely to continue to deliver negative real returns unless exposures are successfully actively managed and include some inflation protection. For equities, demand, pricing power, and limits to how high long-term yields go are all positives. 

Preparing for higher rates in in 2022

The default investment strategy for 2022 has to involve accounting for interest rates potentially being increased in the UK and in the US. This is already priced in given the much higher than expected current and expected trajectory of inflation. There is no justification for central banks keeping interest rates at pandemic-crisis levels. The world is a long way through the pandemic and the global economy is operating at much higher levels of activity than it was when policy was dramatically eased in early 2020.  One could take the view that markets have already adjusted, bond yields think that the monetary tightening that is priced in will be enough to bring inflation down over the medium-term and equity markets don’t think the tightening that is priced in is dramatic enough to derail a bull market driven by super strong nominal GDP and earnings growth. If that view is correct, let the central banks crack on. Indeed, if we are about to experience another COVID-related shock to economic activity, it may be that too much has been priced in.

Inflation globally higher

The driver of higher rate expectation has been inflation. In the United States, the year-on-year change in consumer prices broke above 2.0% in February of this year and has been rising since. The average monthly increase in the consumer price index in 2021 has been just shy of 0.6% compared to just under 0.2% in 2019. Inflation rates are higher everywhere. In its October 2021 World Economic Outlook, the IMF projected consumer price inflation at 2.8% for advanced economies this year with developing economies expected to register 5.5%. Those averages disguise some eye-popping inflation forecasts in individual countries – Turkey at 14.6% this year and 16.7% in 2022 stands out. As a region, Latin America is expected to see close to 10% inflation next year while economies in Africa and the Middle East are already experiences double digit price increases.

But expected to ease in 2022/2023

In common with the consensus, however, the IMF projects an easing of inflation through 2022 and into 2023.  So does the bond market. I will repeat that the inflation-linked bond market continues to price distant inflation rates lower than near-term inflation rates. The break-even curves are inverted in the US and the UK. Short-term interest rate expectations have moved higher in recent months as inflation has smashed forward guidance, but long-term bond yields have been contained in an 80bps trading range (US Treasury 10-year) and are currently below the highs for the year. German bund yields have been in a 60bps range in 2021 and with the ECB the least likely of all major central banks (along with the Bank of Japan) to raise interest rates, long-term yields remain negative in the Euro area.

Assets and inflation

Investors need to have a view on two things for 2022. The first is what will be the evolution of inflation and the second is how to protect portfolios should inflation remain elevated, as it looks as though it will for a while. So far, fixed income assets have not done a very good job of protecting portfolio values from the rise in prices we have already seen. In the US the consumer price index is up 5.7% since December. A standard US Treasury index has registered a total return of -2.8% to date. An investment grade corporate bond index is down 1.3%. In the Euro area, consumer prices (all items) are up 4.1%, but total returns from a European government bond index, year-to-date, are -2.2% and from a standard corporate bond index in Europe, -0.5%. Real returns have been negative in high quality bond markets. They are likely to remain that way.

Inflation linked

The exception has been inflation-linked bonds. The total return on full market inflation linked bond indices in the US, UK and Euro Area has beaten inflation this year (6.4%, 7.6% and 6.8% respectively). Within fixed income this sector is likely to remain the best place to be and the shorter-duration strategies are most attractive in what I believe is the most likely scenario for inflation. At times there will be opportunities to buy government bonds but more from a tactical point of view. The net change in yields is likely to be positive over the next twelve months but history tells us this won’t be in a straight line. Limited supply and strong demand from duration hungry institutional investors will deliver periods where yields actually fall. If there is any sign that growth is starting to falter – perhaps because of COVID shutdowns - this will be an additional trigger to periods of better bond returns. Actively managing fixed income rather than a passive exposure to a bond index is the preferred bond strategy.

Credit rates below likely inflation

Corporate assets are still likely to be supported by positive fundamentals. Credit assets have not so far compensated for inflation and will struggle to do so in the first half of 2022. Spreads remain fairly tight and total returns are at risk from underlying yields moving higher, especially in the higher quality parts of the credit market. In emerging markets, much will depend on how policy makers deal with their own inflation problems, which tend to be higher because of the higher weighting of food and energy in inflation indices. Higher interest rates will undercut local currency returns, especially with a rampant dollar.

Earnings have been super-charged despite higher inflation

I often wonder if those that talk so negatively about bonds, inflation and central bank policy have any equities in their portfolios. Equities have generally outperformed inflation by a long margin for many years and this year has been no different. The total return from the MSCI World Index has been 25%. The combination of the strong recovery in final demand and increased investment, the push towards greater sustainability in many sectors and the greater fluidity in prices that has allowed many companies to exploit pricing power have all super-charged earnings. Strong earnings, low interest rates and accommodative policy settings have made it an easy decision to be mostly exposed to equities. The more effective vaccine roll-outs in developed economies has also contributed to a better performance of developed versus emerging equity markets.

Still positive for equities

The next year might not be quite as easy. Earnings growth will slow but overall demand should remain healthy. Policy will become a little less accommodative. Some margin compression may be seen if it becomes harder to pass on cost increases. However, on balance equity returns are likely to be superior to fixed income under the scenario that inflation remains elevated before easing back in the second half of the year.

Transitory for longer

The investment outlook depends on inflation. The global economy continues to be stressed by the relative strength of demand against a constrained aggregate supply curve. COVID is still impacting on supply chains and it is taking companies longer than expected to reduce order backlogs and deal with distribution logistics. The hope is that these tensions ease in 2022 with above trend demand for goods and below trend demand for services re-balancing going forward. However, high energy and food prices and evidence from many countries that real estate prices are rising rapidly are causes for concern. The real concern is what happens to wages and inflationary expectations. It’s a stretch to argue that a wage-price spiral of yesteryear will re-emerge. It’s not in the DNA of companies to sanction inflation-busting wage increases year-after-year. By the same token, fiscal largesse is unlikely to be permanent. The risk scenario for investors is that we go through an amplified but shortened business cycle – inflation is higher, monetary policy is tightened by even more than is priced in and, given debt levels, growth collapses into the next deflationary downturn. That is a much harder macro-environment to trade. If bond yields rise further, having some long-duration exposure at some point would at least help.

Six and out?

When the Federal Reserve (Fed) last undertook a monetary tightening cycle it started off, in 2015, with a view that the terminal Fed Funds rate would be 3.5%. By the time the Fed has finished tightening the terminal rate estimate was 3.0%. Now the best estimate is 2.5%. In 2018 the Fed stopped raising rates 50 bps below what had then become its terminal rate forecast. Using the same logic, on the fundamental assumption that it takes less in terms of rate hikes to slow the economy, then we are perhaps looking at a 2.0% potential peak in Fed Funds. The market has not quite priced that in yet but is close to doing so. Nearly six hikes are priced in – the Fed did nine in 2015-2018. Thus the path of monetary normalisation might not be that bad. The alternative scenario is one in which a massive policy mistake is made and the long-run neutral rate of interest is much higher, meaning a far more aggressive tightening cycle. So far, there is no evidence to suggest that this is likely to become the dominant scenario any time soon.

Nerves

It’s the weekend after the international break and that can only mean one thing for me – more Manchester United angst. If Ole is to survive, the Reds have to beat Watford in style and then make sure of Champions League qualification next week. Even that might not be enough if rumours of dressing room unrest are to be believed. I’d take Luis Enrique or Zizou but my hope is that the current management can turn things around. We are only nine points behind Chelsea with still 28 games to play. Could be worse, could be Leeds.