Posted 17 June 22
Interview with ausbiz, 16 June 2022
In the very short run, it is almost noise or variance - in the current situation, however, it is loud noise, idiosyncratic and a significant exaggeration. There is a BUT, though. It does not mean that the underlying factors are wrong, just the exaggerated reaction by markets. In this economic and market episode, and with exaggerated effect, is the sudden, sharp reversal in excessive monetary support through quantitative easing, historically low interest rates, and overly generous and ill-timed government spending.
Watch the interview and read the summary, below:
It is now well understood that US inflation in May was 8.6% for the prior 12 months, a significant number and ahead of market expectations. It underscored the job ahead for the US Federal Reserve in managing inflationary expectations. Why do inflation expectations matter? If inflation is temporary due to supply issues, then participants in the economy are likely to expect inflation to moderate, and they will form reasonable assessments about their wage expectations and future demand profile. On the other hand, where expectations for future inflation is higher than prior expectations, the economy risks these expectations being transmitted into participants seeking even higher wages, input prices rising and businesses increasing product & service prices (or absorb and lose margin).
In May's US inflation result, the rate of increase in core inflation growth moderated to 6%, but the headline was dominated by energy costs (up 34%) & food (up 10%). There are significant external factors (Russia/Ukraine/China COVID) impacting these categories, and arguably raising interest rates won't directly impact them as they are largely non-discretionary items. That said, prior to the Russia/Ukraine conflict, there was already advancing wages growth of over 5% and strong increases in shelter costs. This has now been compounded by external supply price increases and actual supply constraints. This creates the core risk - a cocktail for inflationary expectations, and that is a 1970’s problem. This is the bigger picture for equity and bond markets, and how central banks have and will address excessive inflation expectations.
In the late 1970’s, persistently high inflationary expectations where 'crushed' by Federal Reserve Chairman, Paul Volcker, who dealt with this with sharp, short, disproportionately large interest rate increases. With today’s central bankers having been fixated with wages growth, they are now faced with the Volker policy choice. It has arguably become their singular choice, and it is roiling markets in the short term. What are central banks ability to analyse the data and adroitly act? Historical performance says poorly. We had argued through 2H2021 that central banks should start an orderly process of at least moving to a neutral rate, but they remained fixated on achieving wages growth. The hubris extolled by the chief central bankers now sees the ghost of Volker re-emerge with last night's 75bp cash rate increase the beginning, and the Fed's plot of rate expectations now close to the markets peak of 4% (now 1.5% to 1.75%). Paradoxically, the labour market and wages growth needs to cool further, and the table below is instructive.
To deal and manage inflation expectations, wages growth needs to moderate from current elevated levels. For that to occur, unemployment levels will need to rise. This is predicated on a current stable participation rate of 62.3%, where pre COVID it had been over 63%. This is likely a reasonable assumption, though the key swing segment of over 55 year old's may start to return to some gainful employment (though the evidence suggests this is not occurring, but recent losses on wealth may see over 55's come back into employment). The recent observations in the green line with the green dot being now, indicate that to get back to 3.5% wages growth, the US will need unemployment at least 1% higher. Putting aside an increase in the participation rate, this leaves slowing the economy and increasing unemployment. Historical precedence says to achieve such an outcome would require a recession. The Volker shock.
As inflation invariably moderates through 2H2022, the residual risk of inflationary expectations is what needs to be curtailed. In Australia, we are less sure that the RBA’s mooted neutral cash rate of 2.5% is in fact correct, and it is in fact lower. At a 2.5% cash rate, a 25% to 30% fall in peak property prices would be catastrophic, and we think on balance, such a level of interest rate is more unlikely than not. Notwithstanding, the next few months will be hugely volatile for bond and equity markets as the blunt Volcker-like monetary policy measures are implemented. The lag effects of reduced economic activity will bite in 1H2023 and we think bond market yields will be forced lower and cash rates in late 2023 will need to be reduced.
Such movements are extreme but not unusual, but are disconcerting in the short run. Listed equity markets and bond markets are highly liquid and therefore reflect the short-term emotions and peculiarities of participants. For example, equity markets have been awoken to inflation and inflation expectations. Money markets and bond markets have been more a tuned to these risks, whereas equity markets operate with both over optimism and pessimism, and we are seeing this play out. All investment categories are adversely impacted, whether listed or unlisted. Listed markets just happen to be a liquid, live theatre where liquidity provides exits to ill-prepared and we assess, over leveraged investors. This is what exaggerates short-term movements, and needs to be looked through to first hold and then, in turn, rebalance upwards into the portfolio's high quality investments that are marked down due to this short term exaggeration (though whose fundamental causes we agree with and reflect in our strategy positions). Over the medium to long term, wealth transfers from the impatient to the patient. For over 35 years of managing our strategies, we are certainly the patient, but will assess risk and opportunity on its merits.
We see stabilisation in financial market conditions being led by the following conditions:
1. Moderating headline, core inflation & inflation expectations - independent of rate increases, we expected this in the 2H2022. With Volcker-like shock & awe interest rate increases, this becomes even more likely. Importantly, the Federal Reserve's forecasts for future cash rate expectations is now near the markets pricing for future interest rates. This will help to ease volatility in financial markets.
2. Inflation data - with expectations now more broadly aligned between markets and central banks, evidence of moderation in inflation growth will be required through 2H2022. If not, expectations will ratchet further upwards, and central banks will carried with them.
3. Monetary policy rate increases ceasing - as economic activity contracts and maybe 'flashlights' recession, central banks pause (especially in Australia which has high household debt where a 2.5% neutral cash rate is now likely wrong).
4. China’s COVID Policy loosens – this would improve input into world growth and greatly assist what has become a clunky supply chain. Accompanied to this would likely be significant stimulus, especially leading into the November Communist Party Congress to appoint Xi president for life.
5. A solution to the Ukraine/Russia conflict – improving supply and prices for oil, gas and primary produce, and generally refocussing the world’s attention.
6. Risk asset prices become highly attractive relative to the bond market outlook.
Photo by Pexels