Commentary: Inflation and the great reset


Market Outlook

Over the last year or so we’ve made consistent reference to the mismatch evident between policy settings (both fiscal and monetary) and economic outcomes. How could an economy like the US, growing at nominal rates above 10% pa, justify official policy rates of close to 0%? While in Australia, the gulf between the nominal economy and the official cash rate was a little less stark, record low unemployment rates appeared to be equally inconsistent with emergency policy settings prevailing. Markets though were unrattled by this tension, comforted by the fact that a little inflation (and transitory inflation at that) was a good thing and that central banks had shown little interest in addressing this mismatch.

More recently though, it’s become increasingly evident that something is breaking and the imbalance between economic outcomes, asset pricing and policy settings is fracturing. Inflation is now a reality and as a growing list of central banks (including now the RBA) are publicly recognising the challenge, it won’t abate unless policy responds. Curbing inflation hasn’t been a challenge for central banks in over 40 years (longer than the careers of most market practitioners and central bankers). In fact, for the last decade or so, the issue has been not enough inflation, with even moderate targets consistently failing to be reached. Now, achieving a controlled moderation in the rate of inflation to around 3% (the ‘goldilocks’ outcome) will be equally difficult, given the complexity of the global economic and geo-political environment and the lagging nature of monetary policy changes.

There are strong arguments to suggest that we are at the start of one of the most fundamental shifts in the policy environment (and policy settings) and market dynamics since at least the GFC, and more likely since the disinflationary boom of the 1980’s began, and this may only just be starting to be reconciled in asset markets.

The plan unravels

The fault lines that had opened-up through the March quarter continued to widen in April, with market focus shifting more to contemplating the impact of high and rising inflation on policy settings, future economic outcomes, and market pricing. While central bankers, including Jay Powell of the US Federal Reserve (Fed), attempt to convince the market that they have the task in hand, history is not on their side. It was only recently that the Fed again expressed its policy framework to target inflation on average through the cycle. Their hope was that by keeping the emergency settings in place, modest rates of inflation would be generated. Unfortunately, it lost relative control as the layering of pro-cyclical fiscal and monetary stimulus boosted demand. At the same time, supply shocks impacted energy markets and COVID-19 continued to disrupt supply chains - the perfect inflationary storm.

What makes the challenge of policy adjustment so acute is how pervasive the low / no interest rate environment had become. We have argued for some time (too long) that policy settings had extended valuations across the asset spectrum and that once we saw inflation this would likely unravel. This was most obviously true in debt markets where low yields were directly and indirectly driven by central banks through emergency rate settings or through direct purchases of assets to impact the shape of the curve. It also influenced equity markets – particularly at the speculative end where quality businesses were less favoured than speculative ‘growth’ stocks, and went further into direct assets – whether this be Australian house prices, or global infrastructure projects. Exceptionally low interest rates distorted discount rates and relative yield comparisons. The net effect has been (and probably still is in many cases) reflected in the broader mispricing of risk.

Another way of looking at this is that the strength of returns in recent years was both temporary and a ‘pull-forward’ of future returns and these returns are now normalising. The much talked about ‘lower return environment’, which had left us with egg on our faces at times over the last couple of years, does seem to have finally turned up.

Causes for optimism

Oddly, I’m cautiously buoyed by what’s happening. This is clearly not because of the weak returns we are seeing across the spectrum, but because we are starting to see a recalibration of risk premia that’s more akin to current realities. Markets can adjust quickly and while we are currently still in the throes of a transitional environment from low to high inflation and from no to higher interest rates, I would expect there’s more volatility to come and, if markets are true to history, they will also probably overprice the likely implications of this adjustment. The extent of the adjustment is very evident in government bond markets where yields in Australia are at levels not seen in eight years or more. A 3% yield for a three-year Australian government bond is starting to look attractive.

As outlined above, our central thesis is that the adjustment we’re seeing still has more to play out. We are in the very early stages of the policy adjustment cycle and uncertainty (in fact unknowability) is extremely high. This alone suggests risk premia need to be rebuilt. One example is that we do not know how the Russia / Ukraine war will resolve. It appears unlikely to dissipate any time soon, and there remains the risk of a broader conflict (or nuclear escalation); albeit we do not know what odds to put on this. From a more fundamental perspective, we know that the gap between inflation and interest rates is wide and will need to close, which means the risk of overtightening (or potentially deliberate overtightening) remains high. Recessions are typically caused by central bank mistakes, so I do think it is wise not to take too literally the ‘everything is in hand’ rhetoric of policy makers.

To be fair, we haven’t navigated the adjustment as well as we would have liked. This was partly because the inflation story surprised even us in its voracity, and partly because the nature of the adjustment (both rising bond yields / falling bond prices and falling equity markets) has made it challenging to find good opportunities both from a return perspective and a hedging perspective. Critically though, we have reduced our broad risk positioning significantly, mostly through significant reductions in equities (down to circa 20%), credit (we have been out of global high yield for some time) and we are reducing our investment grade corporate exposure in favour of cash (as a store of value and now low risk yield). At the margin we have increased exposure to government bonds as we’ve marginally increased duration as yields have risen. We’ve also favoured Australian equities for some time, and this has been rewarded on two fronts. First, the commodity rally has supported the Australian market generally and second, from an alpha perspective the stocks the team have owned (and importantly not owned) have led to positive stock selection alpha.

One thing to highlight that we did get wrong, was that in searching for a good downside risk hedge, we favoured the Japanese yen (JPY). The sharp fall in the JPY has reflected the policy imbalance between the Bank of Japan and other central banks, which saw the yen weaken sharply. This negatively impacted performance and we have since materially reduced this position.

In summary, we are defensive and have built up cash, but are not in a hurry to deploy it. Some good opportunities will lie ahead as yields rise, risk premia are rebuilt and being active at both the asset allocation and stock selection levels are rewarded again.

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