Professor Jeremy Batstone-Carr, European Strategist Raymond James Investment Services Ltd
The 25th anniversary of the collapse of Long Term Capital Management ushered in a transformative period of unconventional monetary policy.
Pandemic-era policies induced a sharp increase in the money supply, thus provoking inflation’s revival.
Central banks have raised interest rates in response, but inflation is not yet vanquished, reflected in financial asset pricing.
If price pressures diminish, as economic activity subsides, bond yields should fall. But if inflation remains “sticky” the stock market may yet prove the best hedge.
It was Peter Lynch, former manager of Fidelity’s flagship Magellan Fund and writer of the book “One Up On Wall Street” who once said “If you spend thirteen minutes a year on economics, you’ve wasted ten minutes!” It’s debatable as to whether that was ever entirely true, although it certainly served his purpose when managing the fund through the buoyant period for stock markets during the 1980s and 1990s, but it certainly is not true now. Twenty-five years ago, in 1998 and very much overshadowed in the general consciousness by a simultaneous Russian default on its sovereign debt, a giant hedge fund going by the innocuously named Long Term Capital Management collapsed, triggering a bailout by the US government to prevent a possible financial market melt-down. Shortly thereafter the Bank of Japan cut interest rates to zero and a year or two later embarked upon the then unconventional monetary policy now known as quantitative easing. The world’s largest central banks adopted the programme during the Great Financial Crisis, heading off the threat of an economic and financial market collapse but in so doing took hitherto little known monetary policy into territory only previously debated in economic textbooks. The policy galvanized financial markets and asset prices soared throughout this century’s second decade. Then COVID struck, a period during which governments and central banks worked in lockstep to mitigate the economic impact, giving rise, once the pandemic subsided, to a late-stage economic cycle like no other. Inflation, long dormant, resurfaced requiring a forceful monetary policy response. The question for investors now is, where do we go from here?
Is Inflation Reviving?
Policies adopted by governments and central banks to mitigate the economic consequences of pandemic-inspired lockdowns and their lasting impact on consumer spending are discussed elsewhere in this publication. However, what is also known is that the liquidity boost that proved so supportive to financial assets over the period generated a hyperbolic expansion of the money supply, an event a monetarist would have no difficulty in recognising as the precursor to an inflationary episode. Initially the world’s most important central banks stood back from raising interest rates in response to the inflation tsunami, describing rising price pressures as “transient”. But their resolve broke in late 2021, the Bank of England being the first to “break cover” and begin what we all now know to be the most aggressive concerted programme of interest rate hikes since the 1970s.
Monetary policy works with a lag, so the impact of higher interest rates on inflation only really began to be felt over the latter months of last year, but progressively thereafter. By June global headline inflation had almost halved from the near 8% peak levels of September 2022 to just 4.4% driven by falls across both developed and emerging economies and principally reflecting a fall in energy prices. Underlying inflation, excluding food and energy prices, proved much harder to shift, moderating from a peak 6% to just under 5% over the same period.
Simultaneously, Western developed economy central banks have been steadily reversing the quantitative easing of the past, running down replete balance sheets by selling bonds back to investors. The combination of liquidity removal through this quantitative tightening and higher interest rates is having a direct impact on developed economy activity which, having been subdued for months, is now showing increasing signs of slipping into contraction in the UK and eurozone and a sharper slowdown in the US. Few developments in economics are more certain to trigger an economic contraction than a decline in bank lending to the economy but, as a direct consequence of monetary policy decisions, that is what is happening.
And this will come as no surprise to central bankers either. Indeed, ECB President Mme Christine Lagarde even referenced the weakening in credit dynamics in her mid-September post-meeting press conference. The justification for raising interest rates by 5% or more in the UK and US, and to 4% in the eurozone may be all about suppressing inflation and heading off its nascent revival, but there is more to it than that. For all the talk of price pressures rekindling, data throughout the autumn should confirm that year-on-year inflation is trending lower, in large part a function of the basis effect as last year’s high levels drop out of the annualised calculation. As inflation falls, so real interest rates rise (interest rates less CPI inflation) and keep on rising. In the US real rates are as high now as they were in 2007 and they’re about to turn positive in the UK and Euro Area too. Thus, by holding monetary policy steady, as seems likely, central bankers have applied an ever-tightening corset around the real economy in a deliberate attempt to suppress demand.
In the financial markets attention has focused on rising sovereign bond yields. To some extent this partly reflects fears of a possible US government shutdown as the new fiscal year begins and in other part, increased bond issuance in response to rising debt levels. However, markets are spooked by inflation’s possible revival, most notably (but not exclusively) as the rising crude oil price results in higher fuel prices. As economic activity subsides and inflationary pressures diminish, sovereign bond prices should rise and yields fall back.
But what might happen if inflation really does prove irrepressible? What impact might this have on asset allocation and portfolio management? Over the past decade zero interest rates and fast-growing central bank balance sheets ensured that the stock market was the only game in town. Nothing, be it bonds, cash, commodities or real estate came anywhere near delivering similar returns. There really was no alternative. One pandemic and a series of rate hikes later the investing landscape has adjusted and sovereign bonds appear cheap relative to stocks. The typical justification for holding bonds in a diversified portfolio is to reduce risk by lowering volatility, while only marginally impacting on total returns. But government bonds might not deliver if inflationary pressures remain “sticky”. Other assets, such as corporate bonds, index-linked securities and commodities might have a lower Sharpe ratio (a formula that expresses investment returns compared to risk) but are far from risk-free and historically only deliver excess returns fleetingly. Thus, by a process of elimination, the temptation might be to add exposure to the stock market irrespective of the near-term outlook for the economy, especially so if the rollout of artificial intelligence truly does deliver a productivity miracle in the years ahead.
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