Macro Monitor: Big macro changes are brewing…
Macro Monitor: Big macro changes are brewing…
Mark Nash, James Novotny and Huw Davies discuss a busy outlook for central banks, as inflation surges and US real interest rates hit record lows.
The macro themes that now dominate have been in play for some time and recent global events have only accelerated them. The economic world post-GFC, characterized by low demand and weak inflation is over, in our view – this has huge implications for markets. Domestic labour and raw material resources are now the scarce assets that will force a financial power shift, something markets will have to price in over time. Most of all, monetary policy is still set for the ‘old world’ and needs adjusting, with inflation brought under control via increasing interest rates to tighten financial conditions, continuing to undermine asset market returns.
We are all hoping to see an end to the invasion of Ukraine, however we believe the reduction in geo-political risk is unlikely to materially change the inflation pressures in the global economy. US inflation is currently running at 8.5%, and this is before the full ramifications from Russia’s invasion of Ukraine are accounted for. We believe, though, that inflation is much bigger than any one factor, it is a multi-faceted and as-yet unchecked phenomena. One need only look at the current Federal Reserve policy rate of 0.5% to see just how much lower interest rates are compared to inflation. This is the case not just in the US but across the world, in fact the problem is arguably worse in Europe where interest rates are negative and Spanish inflation is running at ~10%.
We are all hoping to see an end to the invasion of Ukraine, however we believe the reduction in geo-political risk is unlikely to materially change the inflation pressures in the global economy. US inflation is currently running at 8.5%, and this is before the full ramifications from Russia’s invasion of Ukraine are accounted for. We believe, though, that inflation is much bigger than any one factor, it is a multi-faceted and as-yet unchecked phenomena. One need only look at the current Federal Reserve policy rate of 0.5% to see just how much lower interest rates are compared to inflation. This is the case not just in the US but across the world, in fact the problem is arguably worse in Europe where interest rates are negative and Spanish inflation is running at ~10%.
Central banks are going to be busy….
Inflation appears to be coming from just about everywhere. Supply chains remain in tatters, an issue that China’s new lockdowns will only exacerbate. Goods prices are still elevated (indeed they never really fell back) and service prices are now catching up, driven by resilient consumer demand. Commodities markets were already tight with pretty much all major commodity markets in backwardation, Russia’s invasion of Ukraine has further worsened the supply deficit, accelerating energy and food price growth. And as for the more traditional drivers of inflation – rent and wage growth – they are high and rising. Lower participation rates in western labour markets of older workers in the post-Covid world is significant. Worker power is increasing as labour shortages spread, turning the aging workforce argument for the bond market on its head.
The key worry for central banks is therefore that a wage-price spiral develops, and inflation expectations become de-anchored from the psychologically important 2% level. While growth has undoubtedly slowed in recent months, central banks will not be too worried. Don’t be fooled by the nominal yield curve and talk of a recession, the last batch of PMIs signalled robust growth and, with employment so strong, low consumer sentiment is likely to be giving a false negative, in our view.
Put simply, we think monetary policy is much too loose and policymakers need to start raising interest rates and fast. Real rates (bond yields minus inflation) remain well below zero, which is great for the Nasdaq, but not for lower income households who bear the brunt of higher prices.
The key worry for central banks is therefore that a wage-price spiral develops, and inflation expectations become de-anchored from the psychologically important 2% level. While growth has undoubtedly slowed in recent months, central banks will not be too worried. Don’t be fooled by the nominal yield curve and talk of a recession, the last batch of PMIs signalled robust growth and, with employment so strong, low consumer sentiment is likely to be giving a false negative, in our view.
Put simply, we think monetary policy is much too loose and policymakers need to start raising interest rates and fast. Real rates (bond yields minus inflation) remain well below zero, which is great for the Nasdaq, but not for lower income households who bear the brunt of higher prices.
Core inflation has surged
Cyclical inflation is rising too
Source: Bloomberg, as at 01.02.22.
Big macro changes are brewing….
Looking further out, government priorities have changed in recent years and the shift to become more self-sufficient has only been accelerated by recent events. Spending is set to ramp up to boost the green energy transformation, energy self-sufficiency, defence, and the onshoring of supply chains.
One can only speculate on what deglobalisation could mean for future inflation. Global trade as a % of GDP peaked in 2008 and has been falling ever since. The fallout from Russia’s aggression feels symptomatic of this wider trend, indeed the US-China trade war remains ongoing. If the trend continues, then the onshoring of supply chains will become more prominent as countries look to reduce their dependency on others for energy, food and raw materials more broadly. The implications of this could be profound, higher costs of production, margin compression, higher capital investment, more wage pressure and ultimately more inflation. As for commodities, a commodity premium may start to build as Western governments look for a reliable supply of energy and commodities, with the price of those supplies being secondary. Without Russian commodities, this leaves the western world with difficult choices, a fact best exemplified by Biden’s bizarre decision to send a US delegation to Venezuela.
This is a very different world to the one pre-Covid, with more fiscal spending and investment. In our view, real interest rates will need to move higher as, quite simply, everyone can’t spend at the same time. If the US tries to re-industrialize in even a small way, with no spare labour capacity the macro implications will be huge. Either a US productivity miracle occurs, or inflation will stay high and pressing.
One can only speculate on what deglobalisation could mean for future inflation. Global trade as a % of GDP peaked in 2008 and has been falling ever since. The fallout from Russia’s aggression feels symptomatic of this wider trend, indeed the US-China trade war remains ongoing. If the trend continues, then the onshoring of supply chains will become more prominent as countries look to reduce their dependency on others for energy, food and raw materials more broadly. The implications of this could be profound, higher costs of production, margin compression, higher capital investment, more wage pressure and ultimately more inflation. As for commodities, a commodity premium may start to build as Western governments look for a reliable supply of energy and commodities, with the price of those supplies being secondary. Without Russian commodities, this leaves the western world with difficult choices, a fact best exemplified by Biden’s bizarre decision to send a US delegation to Venezuela.
This is a very different world to the one pre-Covid, with more fiscal spending and investment. In our view, real interest rates will need to move higher as, quite simply, everyone can’t spend at the same time. If the US tries to re-industrialize in even a small way, with no spare labour capacity the macro implications will be huge. Either a US productivity miracle occurs, or inflation will stay high and pressing.
Growth slowdown?
Back to the here and now, we recognise that the path to higher global interest rates via high spot levels of inflation does have growth risks attached. China re-entering lockdowns in geographic areas that represent 25% of its GDP is naturally a concern, and it’s already damaging Chinese services activity indicators and contributing to inflation concerns. Fortunately, serious Covid cases are still low in China, which puts into question the longevity of the ‘zero Covid’ policy, just as the rest of Asia has followed the West in enjoying a Covid bounce. The cost of living crisis and high factory prices are undermining Western consumers and to a lesser extent businesses, but we see this as something governments need to address and not central banks. With such high levels of inflation, a growth downswing is needed to curb demand pressures, and so not something that central banks will react to in our view.
The problem for central banks is that inflation has risen so much but real rates haven’t kept pace. So, by doing very little, financial conditions are easing which is contrary to what all these hawkish central banks want. In the end it just means they need to raise nominal policy rates that much more to have an impact. We also question where the ‘neutral rate’ even is. Nobody, including the Fed, really knows. So as inflation and growth stay high we believe the market will attach a risk premium to front end rates until we get some clarity (falling inflation or growth coming in lower).
An inverted yield curve is to be expected in a high inflation environment. The real yield curve is a more accurate ‘recession indicator’ and it’s still upward sloping, suggesting that the central banks are still not doing enough. We see the yield curve talk as misleading, though, and the growth backdrop solid. The headwinds have been handled well so far, but we admit the next few months are a hurdle to get through for the global economy mostly due to the energy risks in Europe. We remain positive but mindful of risks.
For us, interest rates remain far too low in developed markets, especially in the US. For all the fearmongering about a US recession, the fact remains that the US has never entered a recession with negative real rates. Real rates are near record lows, and the US labour market is incredibly tight, making the prospect of a recession seem to us a distant prospect at best, at least until interest rates move substantially higher. In our view the recession that many are calling for is the wrong way to see things, as the world has now changed. A strong recovery and structural shifts have generated inflation alongside pockets of growth weakness. But it is higher interest rates, not lower, that are needed as the global economy transitions.
The problem for central banks is that inflation has risen so much but real rates haven’t kept pace. So, by doing very little, financial conditions are easing which is contrary to what all these hawkish central banks want. In the end it just means they need to raise nominal policy rates that much more to have an impact. We also question where the ‘neutral rate’ even is. Nobody, including the Fed, really knows. So as inflation and growth stay high we believe the market will attach a risk premium to front end rates until we get some clarity (falling inflation or growth coming in lower).
An inverted yield curve is to be expected in a high inflation environment. The real yield curve is a more accurate ‘recession indicator’ and it’s still upward sloping, suggesting that the central banks are still not doing enough. We see the yield curve talk as misleading, though, and the growth backdrop solid. The headwinds have been handled well so far, but we admit the next few months are a hurdle to get through for the global economy mostly due to the energy risks in Europe. We remain positive but mindful of risks.
For us, interest rates remain far too low in developed markets, especially in the US. For all the fearmongering about a US recession, the fact remains that the US has never entered a recession with negative real rates. Real rates are near record lows, and the US labour market is incredibly tight, making the prospect of a recession seem to us a distant prospect at best, at least until interest rates move substantially higher. In our view the recession that many are calling for is the wrong way to see things, as the world has now changed. A strong recovery and structural shifts have generated inflation alongside pockets of growth weakness. But it is higher interest rates, not lower, that are needed as the global economy transitions.
US real yields are at record lows
Source: Bloomberg, as at 01.03.22
How do we reflect this?
Our strategy has sought to mitigate again rising inflation by investing in inflation-linked bonds as central banks were slow to react to broadening inflation on the back of both supply problems and strong demand. The outright short duration positions in short-dated maturities which dominated our strategy reflect this view, mostly in respect of developed countries with stronger levels of growth potential and the ability for interest rates to rise the most. Corporate bonds are generally overvalued, in our view, given the repricing of risk-free rates that needs to occur and so we hold no corporate bonds and are shorting some credit markets into the summer. Emerging markets are favoured by us, as commodity-rich sovereigns are set to benefit from the commodity boom. With a more balanced global growth picture, high real rates and cooling inflation in many developing economies, commodity exporters should benefit which would result in an unwind of high fiscal risk premiums, leading to stronger currencies and lower long-end bond yields. Likewise, we believe natural resource importing countries and those more impacted by the war in Ukraine should see lower levels of interest rates and weaker currencies as they lag monetary exit with consumer and business sentiment impacted by higher inflation costs.
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