14 Oct 2021
Inflation is the topic that has dominated the market discourse this year, and if anything that has only intensified in recent weeks. To discuss this topic, we brought together Ariel Bezalel (Head of Strategy, Fixed Income), Ned Naylor-Leyland (Head of Gold & Silver) and Talib Sheikh (Head of Strategy, Multi-Asset) to examine the implications for their asset classes.
“For all the talk about the higher inflation prints, it’s quite incredible to me that the 10-Year US Treasury yield is still just around 1.5%, plus there are multiple trillions of dollars worth of government bonds and even some corporate bonds on negative yields.
I remain of the view that this inflation pick-up is transitory, although it has been a little more persistent so far than I had first expected. Nevertheless, the world continues to experience disruption driven by tech companies and I believe that will go into overdrive over the next decade. There is also the demographics issue, where contracting workforces and stagnant population growth is a common theme around the world, including in China now. On top of that, $40 trillion has been added to the global debt pile in the last year alone, which continues to dampen growth and inflation.
A lot of the inflation we are seeing today is due, in my view, to the disruption to ‘just in time’ supply chains from Covid. When supply chains normalise and companies ramp up production to meet demand then I think inflation should reverse.
That’s on a medium term view, but looking to the rest of this year and into early 2022, if anything I see signs of a global economic slowdown that could also put the brakes on inflation (China appears to be slowing, and perhaps quite rapidly). Biden has also not kept signing blank cheques as some assumed he would. Washington is still very divided, Biden’s infrastructure bill has been watered down and now his big social spending bill is in question. All these things combined present the risk that central banks, led by the Fed and perhaps the Bank of England, could be tightening policy into the teeth of a slowdown.”
“One aspect of the ‘is inflation transitory or sticky?’ debate that interests me is Jerome Powell’s failure to define transitory inflation at a rather amazing FOMC Q&A session recently. It reminded of the ‘temporary’ suspension of the gold window by Nixon in 1971. Indeed that temporary suspension is still in place 50 years later!
I would also say that central banks are unlikely to ever declare inflation to be persistent and rising, since the relationship between central banks and the bond markets often feels like a carefully managed dance. Markets are led by narratives more than anything else, and these words are more about managing that narrative than what’s going on in the real economy.
Personally, when I look at supply/demand dynamics for raw materials, especially with the drive towards green technology which will require additional natural resources, I am unconvinced that we can see a sustained rowing back in prices for physical assets. The world has a limited and dwindling amount of physical resources and an ever-growing amount of credit money. To me, therefore, this current system will always see deflation in money and credit, and inflation in goods, services and real assets.”
“The most honest answer I can give to the question of whether inflation is transitory or not is: I don’t know. I feel in good company saying that, as central banks clearly don’t know either. The change to flexible average inflation targeting means central banks have gone from being forecast-driven policymakers to outcome-driven. They’ve said they’re not going to move interest rates until they’ve seen the whites of inflation’s eyes. That’s not unreasonable given that after the Global Financial Crisis inflation significantly undershot expectations for many years.
I think about the economy at the moment as one of those snow globes, where you shake it and the snow swirls like mad. Everything in the economic system feels up in the air right now, there’s a lot of chaos and we aren’t sure how it’s going to settle. To my mind, however, the risks are to the upside. Taking the UK as one example, recently there were more job openings than ever before, wages are growing at 8%, and house prices are rallying at 20% a year. I’m starting to think these effects will be more persistent than central banks currently seem to think.
Are we going to go back to an inflation environment like the 1970s? I think that’s unlikely due to all the structural strands that Ariel highlighted. But I think the idea that the disinflationary environment we saw following the GFC will continue is a risky one, because the situation now is very different to where we were in 2008.
As a multi-asset investor, I can afford to be very selective about taking risks. Equities – which is an asset that can ultimately grow its income streams in this incredibly unique world – can do well from here, in my view. There’s a debate to be had about the NASDAQ, which has done very well in part due to its very long-dated revenue streams, but as inflation appears more persistent investors might shorten the time horizon of revenue that they’re prepared to favour, and if so that could bring the likes of value stocks and dividend stocks back to the fore.
Areas where I feel more nervous include government bond markets. One of the things that worries me is that the negative correlation between core government bonds and risk assets could break down. We saw a bit of that in already in March.”
“Breakeven rates in the US are actually pretty elevated at the moment, at around 2.4%. This tells me that the market believes that the Fed will hit its inflation target over the next decade. I think as the market realises that the inflation pressures are transitory, breakeven rates will come back down, and that will be the catalyst for yields to go even lower in the US. So on a risk/reward basis I still like the opportunities in US Treasuries, as well as in Australian and New Zealand government bonds where yields are higher than elsewhere in the developed world. I also think that Chinese government bonds (currency hedged) are an interesting place to be as China grapples with its own debt problems and similar demographic challenges to those faced in the West.
In our team we favour a barbell approach to allocating capital to fixed income in this market. On the one hand we like some government bonds as I just mentioned, while on the other side there are opportunities – if one is very selective – in credit markets. There is a lot of money coming into credit, a hunt for income, and corporates on the whole are in pretty good shape thanks to a lot of government support in the West. That means we see default rates as staying low for some time.”
“What we’ve seen in the last 12 months is that sterling and dollars look better to the bond market than they did previously. In the current ‘hold-it-together’ environment that we’re in, the central banks are trying to be completely level with their guidance and don’t want to move a muscle if they can get away with it. The market will either get over-dovish or over-hawkish relative to that. Over the last twelve months what we’re had is a market that is focused on being slightly hawkish.
The other things that matter now are leverage, momentum and narrative. Narrative being the most important, and that’s still focused on tapering and tightening. When I think about real interest rates (it’s nice that everyone talks about that now and it’s not just us gold bugs) while they are low I do see them as mispriced to the upside.
The assumptions necessary to justify the recent performance of gold and silver markets are: 1. inflation is just transitory; 2. tapering is coming soon, and; 3. rate hikes are also coming. If just one of these assumptions falls away, then gold should rally. Personally, my view is that it is more likely that all three assumptions are wrong than all three are right.
The catalyst for the market consensus to break could be energy prices. I’ve been saying it for years, but I think we’re re-living the 1970s cycle and that it will end with real rates falling off a cliff, a massive move for gold and silver, and a monetary rescue operation. I’d say we’re moving in that direction more obviously now.“
The value of active minds – independent thinking:
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