R-Star Wars

One parallel we can draw from nearly every inflationary process we study is that they are not linear, but instead occur in waves, with higher highs and higher lows each time.

There are two main reasons for this. Firstly, the conditions that lay the groundwork for inflation don’t fade in just one wave. The deflationary forces of integrated markets, cheap labour, cheap goods, cheap energy and cheap capital, have been disappearing for years. Secondly, the policies and the appetite needed to deal with inflation don’t appear after just one episode. Interest rates must usually be hiked – and stay tight – through some economic and market pain. For this to be palatable, people must hate the pain of inflation more than they hate the pain of dealing with inflation.

There are three important drivers of inflation: inflation expectations, fiscal policy, and the balance of power between companies and workers.

The recency of an inflation experience can be extremely important in ‘priming’ a population to expect a price movement in a particular direction. Anchored inflation expectations work in both directions. Today we have a population that has a recent inflation experience at the forefront of its mind and despite a fall in the inflation rate, consumer prices are still nearly 25% higher than they were pre-covid.

We can usually identify a keen political appetite for governments to spend as well as a procyclical interaction with monetary policy. In the gold standard era, fiscal policy was mostly balanced in peacetime, and it was governed and offset by monetary policy to keep overall price stability. The experience of the 1970s was that loose fiscal and loose monetary policy caused inflation, before Paul Volcker solved it in the 1980s with tight monetary policy. In the 2010s in the West tight fiscal policy dominated the loosest monetary policy ever seen to produce a decade of 1% inflation.

Our view: since the end of the gold standard US governments have been prone to making use of the magic money tree. Loose fiscal and monetary policy in 2020 and 2021 resulted in inflation. Today, the budget deficit as a percentage of GDP remains larger than any outside of a crisis since 1946. Governments will keep spending big until inflation presents a constraint.

The balance of power between capital, workers and taxpayers is a fundamental driver for structural inflation. In the US and the UK, the bargaining power of labor is increasing. Total working days lost to strikes is at one of the highest levels since the late 1980s. Strikes including the Screen Actors Guild, Boeing, United Auto Workers and healthcare workers, among others, have been highly publicized. Many have led to significant pay rises – 8.4% per year for the next four years in the case of Boeing. The inference is clear. Nominal wages have not been keeping up with inflation. Workers are angry about that and feel they have the upper hand in negotiations.

Today, we think the foundations for a second wave of inflation are laid. Inflation is not yet at target and unemployment is hardly a problem. Asset prices are at all-time highs. Equity risk premia indicate a level of risk appetite not seen since 2000. Credit spreads are as tight as they have been since the global financial crisis. This is the environment in which the Federal Reserve has elected to cut interest rates (starting with 50bps, no less!), whilst corporate earnings are rising (doing so for the first time since 1986).

We have made the case previously that the Fed is a ‘paper tiger’. It talks like a tough institution, keen to hike. But if presented with any kind of stress in markets or the economy, our view was that it would cut quickly. Inflation was first revealed to be above target in March 2021. It was only 12 months later, with inflation running at 8.5% and unemployment at 3.6%, that they began a hiking cycle. Late to hike and now fast to cut at a time of elevated levels of risk taking.

Asset prices matter because this is the first time where hyperfinancialisation has been so deeply entrenched into the US economy in an inflationary regime. This can prove reflexive. Management teams make recruitment decisions based on their share price, companies pay employees in stock and fund buybacks with debt, consumers take cues from their portfolios going up and spend more money as a result.

Central bankers have a difficult tightrope to walk. If asset markets keep rising, a second wave of inflation, the preconditions of which are already there, is a high likelihood. If asset prices head down and the economy follows, we know from recent evidence that policymakers will push hard against a recession. The Fed – and asset markets – are heavily reliant on inflation staying low and rate cuts coming as a result.

We believe we have left behind the regime of no inflation risk and the emergence of a second wave would have significant implications for portfolios.

We think a second wave of inflation is not a risk to dismiss. A quantitative lookback through history can help determine the portfolio implications of such an inflationary regime change.

Our Head of Investment Strategy, Teun Draaisma, studied just this when co-authoring a 2021 paper titled The Best Assets for Inflationary Times. The research looked to accurately define the inflationary regimes that have persisted over the last 100 years of market history and assess their impact on a variety of asset prices.

These regimes capture both the level and direction of inflation, leaving four quadrants to be understood. Importantly here, the ‘inflation’ environment – when inflation is both high and rising – is by far the most difficult for asset allocation. Equities and bonds tend to struggle. Traditional diversifiers such as gold and oil do not have consistent success. A diversified basket of commodities is one of the few strategies that can appropriately protect portfolios.

These times of inflation come with much more volatility in both economic variables and politics, and a less stable environment for taxes and rates makes it harder for businesses to invest. It is no surprise that peaks and troughs in equities closely align to the troughs and peaks in inflation over time. It is a force that matters.

Perhaps most important is the impact it has on stock-bond correlations, which become positive when inflation is high, making bonds no longer effective diversifiers. This can produce the sort of devastating portfolio outcomes we saw in 2022 as inflation risk takes the market by surprise.

Asset markets are unprepared for a return to the inflation quadrant, yet we believe the groundwork has been laid. Fiscal and monetary policy is being eased nearly everywhere, labor market and immigration issues are top of the ballot list, and animal spirits have been unleashed. The damage a second wave would cause, much like we saw in 2022, would be severe. In a world of inflation volatility, a portfolio cannot be invested for just one outcome. Asset allocations must be active, and careful management is needed to protect against the risk of inflation.