By Anthony Halls
In our view, either inflation will dissipate of its own accord (the global economy adjusting to equilibrium), or the world’s central bankers will raise interest rates until inflation falls. We prefer the former scenario because the latter likely comes with an economic recession - which is unappealing.
2022 has been the worst year for financial markets for decades. According to some records, the sell-off in global bonds (the rise in global interest rates) is the worst since 1788 - the year after the US Constitution was created, and the year before the French revolution. Data is, of course, somewhat iffy from back then so one wonders about its precision; however, it is certainly the worst year for fixed interest so far in the modern era.
Equities too have had a very poor half year (as has nearly every asset class). Even cash is down in real terms because deposit rates are so far below inflation. Usually, bonds are a diversifier from equities (i.e. one works when the other doesn’t), but not this year. 2022 has seen the biggest simultaneous drop in both major asset classes since 1976 – another attention-grabbing sound-bite from a long time ago.
Looking back to go forward
What else was happening back at the end of the 70’s / early 80s?
- Central banks were aggressively tightening to bring inflation under control – led by Paul Volcker the Chair of the US Federal Reserve
- An ongoing war between two major commodity producers was disrupting commodity supplies and exacerbating inflationary pressures
- Rising interest rates had induced a valuation-based sell-off in equities – even though profits were holding up, rising rates lifted the cost of capital and valuations came down
History may not repeat but it can rhyme. The current global situation eerily resembles the start of the 1980s. What was the outcome back then?
- Central banks over-killed inflation and caused a deep recession
- Equities had fallen with rising rates, but the recession saw profits falling and equities fell a further ~10% or so but bonds rallied (interest rates fell).
We thought at the start of this year that interest rates would continue to rise into 2022 largely because we could see inflation bounding along. We thought some of it was transitory (supply side shocks that the global economy would adjust to) and some not so transitory (climate change and de-globalisation). Inflation though has been stronger than we expected, extended by ongoing supply chain disruption due to Covid (still) interruptions and Russian war-mongering. This latter has driven energy and basic food prices very high this year.
Where are we now?
So, with inflation running hot and employment markets apparently strong, the world’s central bankers have lurched into tightening mode. Their mandates generally include maintaining stable and low inflation, with an eye to good employment stats. Unemployment is low and so, under their mandates, they must attack inflation. Indeed, most economists (and central banks are chock-full of such creatures) believe recessions are a necessary and distasteful medicine that is better than the long-drawn-out pain that is an extended bout of inflation. So, they’re more than prepared to risk a recession to curtail inflation. Unfortunately, a recession will likely cause rising unemployment, but that is tomorrow’s potential problem while inflation is today’s actual problem.
But are we really going into recession; are we really re-visiting the 1970s stagflation era? We don’t think so – although, with global monetary policy tightening now in full swing, the risks of doing so are much larger than they were six months ago.
Stagflation is generally a combination of high inflation but stagnant (i.e. the stag bit of stagflation) economic growth, along with weak employment statistics. This is a very rare phenomenon as most high inflation periods are caused by excess demand, which itself is usually a feature of strong economic growth. This time (as with the few previous periods of stagflation) the high inflation is largely caused by supply chain disruption (whether from the pandemic or Vlad’s war) rather than excess demand. However, economic growth has been positive – spurred along by the ultra-easy monetary policy of the last few years – and we have witnessed rapid substantial swings in demand.
The ripple effect of Covid
With pandemic disruption (widespread travel lockdowns and working from home) demand swung from services (like dining out and holidays) to durable goods (like household goods and cars). The huge swing in demand during the depths of the pandemic was faster and greater than supply chains could keep up with – the easy monetary policy and emergency fiscal largesse meant that consumers still had plenty to spend, and they did. So, the price of goods went up because the demand for goods out-stripped supply, as did the price of shipping goods and the price of warehousing goods.
Now the borders have largely re-opened, and many economies have started returning to life as it used to be - and demand has swung again. People want to get out and about, but supply chains are still disrupted (especially for food and energy). So, services prices are rising rapidly too now – this can be particularly seen in airfares and care hire prices (hire companies depleted their fleets during the pandemic and are now desperately trying to restock as demand returns). On the other hand, many businesses over-ordered stock during the strong period of goods demand and are now left holding high inventories as demand swings back to services – this will be a headwind to inflation for the period ahead.
Hence, we have hot-spot inflation rolling through various sectors because the world economy is in dis-equilibrium. That inflation though is taxing the consumer dollar and causing demand destruction – hence the risk of recession, exacerbated by the world’s central bankers. To believe inflation will remain this high one must believe we will either get a significant rise in demand or that the world remains in dis-equilibrium. There is already early evidence of a cautious consumer, so an unheralded rise in demand seems very unlikely – at least from the usual suspects.
Medium-term dis-equilibrium though, that is less unlikely – although still unlikely. To an economist or a rationalist, the global economy will eventually adjust to the shocks of the pandemic and the war and return to equilibrium. The cost of doing business will stay higher than it was pre-pandemic, but it should recede from current levels. Under this state, inflation dissipates to more moderate levels and economic growth will be slow but not stagnant. Interest rates too wouldn’t go much higher and may drop a little. Dis-equilibrium could continue for longer though if there are more geopolitical disruptions or a worldwide resurgence in the pandemic… or if governments around the world don’t lock away the chequebook.
The pandemic gave politicians around the world a taste for fiscal spending, something that most governments have been cautious with for decades now. Most pandemic fiscal support programs have finished and currently, fiscal contraction is becoming a headwind to global inflation. But this may be one of the long-lasting effects of the pandemic: politicians had the perfect excuse to spend, and they did, and they liked it. They will probably find the temptation to do so again – whether from re-distribution aims for our widespread social imbalances, or from rising defence spending to counter the Russian bear, or whatever the excuse. In effect, we think the previous decades of fiscal rectitude could well morph into more active fiscal policies – and they will be blunt instruments just like the tools of monetary policy. This means we could be entering a period of disinflation (driven by technology and demographics) combined with unpredictable inflationary spikes as fiscal policy lurches from project to project.
Looking forward
What does it mean for the immediate future? We think the immediate peak has been passed (inflation, interest rates, commodity prices) and that further aggressive monetary policy tightening could create a recession. But central bankers tend to be quite bright and they’ll ease off the brakes once the evidence of easing inflation is apparent. So, our central case remains a slow economic period but not a full-blown deep recession. In that environment, portfolios need to own strong business franchises with strong balance sheets – some reliable earnings growth and not much gearing.
So what does this mean for investors? The rollercoaster ride will continue for the foreseeable future and the key, of course, is going back to revisit your long-term investment objectives. If uncertain seek some qualified financial advice and if your constitution is strong, it maybe a good time, given the values of stocks and bonds are cheaper, to invest a little more.
Disclaimer: Anthony Halls is Head of Investments at Mint Asset Management Limited. The above article is intended to provide information and does not purport to give investment advice.
Mint Asset Management is the issuer of the Mint Asset Management Funds. Download a copy of the product disclosure statement here.
