As inflation rises, will central banks blink?

A complex picture

Yet the BoE’s November decision wrong-footed markets, and shows the inflation picture is more complex than it appears. While investors fret about inflation becoming entrenched, some statistics point the other way. European gas and Chinese coal futures are falling. Core US personal consumption expenditure – a favoured measure of the Fed – appears to be peaking. Despite solid US jobs growth in October, employment remains way below pre-pandemic levels, implying slack in labour markets. As winter looms in the developed world, the risk of Covid disruptions – and hence weaker demand – has not gone away. Added to this, emergency fiscal stimulus, including support for ‘furloughed’ workers and boosts to benefits, is gradually being withdrawn. We think inflation should start to ease in 2022, taking some of the heat off central banks.

Meanwhile, expectations of 2022 rate hikes in the US and Europe look premature to us. While both the Fed and the European Central Bank (ECB) acknowledge that inflation could be higher for longer, the ECB has pushed back on markets’ rate rise timeline. The Fed has repeatedly stressed that the bar for raising rates is much higher than that for tapering asset purchases. Reaching maximum employment still looks some way off. Raising rates to stave off higher inflation expectations looks more an emerging market imperative than one for countries with a history of price stability (and in Europe, of persistent inflation undershoots). We believe the first Fed and ECB rate hikes will come in 2023.

In many ways, the balance of risk could even be skewed the other way: that the Fed and the ECB delay hiking for longer than is prudent. In the last 18 months, both have made changes to their inflation-targeting regime that can imply leaving inflation below – or above – target for longer. Both have been criticised in the recent past for prematurely hiking rates (the ECB in 2008 and 2011, the Fed in 2015). We project a later rate “lift-off” for the Fed, but more hikes cumulatively over time than consensus estimates currently forecast, with the US rate cycle peaking at 2.75% in the latter half of the decade.

A test of nerves

The coming months will be a difficult balancing act for central banks, as they wait to see how prices – and employment – evolve. There is no playbook for a post-pandemic recovery. Policymakers will be painfully aware of high asset prices, and the need to wean economies off free money. As the recovery continues, emergency monetary support in the form of asset purchases will be slowly withdrawn, with fiscal policy delivering more targeted help to those in need. In China, fiscal, not monetary, policy should be the economy’s main support next year, a former monetary policy advisor notes. We will return to the topic of fiscal policy in a future CIO Viewpoint.

Meanwhile, the stakes for central banks are high – hints that Australia was about to scrap its yield curve control led to a 50bps move in three-year rates over two days. Sharp repricing of market expectations can cause big damage, as the 2013 ‘taper tantrum’ demonstrated. Central bankers must pay more attention than ever to clearer guidance and messaging, to avoid the criticism of “unreliable boyfriend” that was once levelled at the Bank of England. It is a difficult balancing act to pull off, but the Fed’s launch of its tapering programme in November – with barely a murmur from markets – is an encouraging sign.

How should we be investing?

With this in mind, we favour remaining fully invested, and take a constructive view on risk assets. With volatility potentially rising, hedging strategies could become more relevant. In fixed income, a backdrop of persistent inflationary pressures and rising rate expectations favours our current defensive duration stance. We prefer to take credit risk in emerging market hard currency debt and high yield.

Equity markets remain untroubled by the rise in short-term bond yields; US markets hit fresh highs after the Fed’s November meeting. Rising inflation is historically better for investment portfolios than stagflation, which was markets’ concern after the summer. Nor does an analysis of S&P500 total returns suggest that a rising rate environment is necessarily bad for stocks: from 1961-1966, rates rose 325bps and the index returned 37%; from 2003-2006 they rose 500bps, with a total return of 39%. As long as rates rise for the “right” reasons, i.e. reflecting economic improvements, equities can continue to do well. We remain overweight equities, favouring sectors and regions with more cyclical and value-exposed assets with catch-up potential, e.g. UK and small caps.

Perhaps the biggest impact of recent developments could be on currencies, where volatility remains below historical averages, partly because of the impact of coordinated central bank intervention. As global growth gradually slows and high monthly inflation data could see markets continuing to price in a 2022 Fed rate hike, we have turned more constructive on the US dollar. Going forward, more divergence in global monetary policy –among developed markets, and between the developed and emerging world – could bring clearer catalysts for a range of currency pairs. And as the tide of central bank liquidity gradually ebbs and growth slows, active management of portfolios’ risk exposures becomes even more important.

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