What a difference a day makes! Early February was marked by a significant change in sentiment with equities falling sharply, credit spreads widening and volatility (remember that) rising sharply to levels last seen in 2015. The positioning that had dampened returns in January, helped offset the volatility in early February. That said, February is still young, so more about this next month.
Implicit in my comments above is the idea that our returns could have been higher had we held more risk, particularly in the US where momentum has been strong and economic confidence growing. With the benefit of hindsight it is hard to argue with this idea. The reason we didn’t is twofold. The first is that these markets offered very little in the way of expected future returns with price gains over the last year or so embedding large amounts of future earnings growth into current prices. The second reflects the fundamental concern we have had for some time about inherent build up in underlying inflation pressure and the risk this posed to bond yields, relative valuations and policy. Early February gave us a glimpse of what could happen if this pressure continues to build as we expect.
To this end, the most significant development of late has been the ongoing accumulation of evidence supporting the idea that inflation is building. While it has been a little harder to see in the official “core CPI” data, plenty of other indicators are starting to glow. The rise in earnings evident in the recent January payroll numbers is challenging the sceptics who have argued that the Philips Curve is dead (i.e. that wages don’t rise as unemployment falls). While we concede that the sensitivity of wage growth to unemployment may have moderated, both history and empirical research suggests that once the US unemployment rate falls to around 0.5% below the non-accelerating inflation rate of unemployment (NAIRU) (or lower), wages will respond. Friday’s payroll data supports this idea. While analysis by anecdote is dangerous, the New York Times recently reported on the impact of the tightening US labour market, highlighting that in Dane County, Wisconsin where the unemployment rate is just 2%, manufacturers are hiring prison inmates on full wages to work in factories while they serve out their sentences. Clearly we are heading into problematic territory.
If this trend continues then we are at a pivot point in the post GFC economy. The liquidity bubble that central banks have built to support economies and asset prices over the last 10 years has been enabled essentially by the fact that excess capacity in labour and goods markets globally has kept inflation suppressed. Strong growth in the US (including additional unfunded fiscal stimulus) together with continued improvements in economic momentum in Europe and Japan have potentially worked off that excess capacity which is causing inflation pressures to rise. The disconnect between policy settings and the macro-economy though remains large. A weak US dollar, narrow credit spreads and high equity prices also imply that financial conditions remain very easy. If inflation pressures continue to build then pressure will revert to central banks to respond, and focus the spotlight even more intently on calibration of policy and its implications for the economy and risk in asset markets. Official rates rising globally and central bank balance sheets shrinking is not something we’ve seen for a while.
We have argued this point for some time with little reward to date. Clearly we need to work on our timing. That said, we recognise the futility of trying to be too cute with timing and prefer to position progressively as the risks build rather than nail the day (which is frankly more luck than skill). On this point we have been building inflation protection more directly into the portfolio. Some of this positioning has been more strategic and reflecting other mispricings (like our preference for cash over bonds) and some reflecting a more direct calibration of the portfolio to the potential for inflation surprise. We have reduced portfolio duration (now just 0.7 yrs in aggregate), added inflation breakeven positions and direct inflation linked bonds, cut our defensive curve flattening positions and added to our short position in A-REIT’s which we see as being a bond proxy, which like infrastructure assets, gained much of its return through the secular decline in bond yields. To be clear, we are not forecasting a return to a high inflation environment, but we are expecting higher inflation than we’re used to and higher inflation than assumed by investors.
As we saw in early February, the transition to this environment, while most directly felt in rate markets and rate sensitive assets, will also reverberate in equities as investors re-appraise their confidence in central banks and policy settings, review the discounted value of future earnings and compare relative valuations which are likely to make interest rate based assets relatively more appealing. Caution is still warranted.
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