Key central bank chiefs speaking overnight at the ECB virtual Sintra Conference (the ECB version of Jackson Hole) maintained their recent narrative around inflation being “transitory”. Fed Chairman Jerome Powell had said earlier this week that supply chain constraints and higher energy prices might see a bit more persistence in inflation, although it would still return to its long-run average close to 2 per cent through 2022 and into 2023. That is more or less consistent with the FOMC median projections released following last week’s FOMC meeting. In this sense, the Fed is sticking to the “transitory” inflation narrative. Were it not of course we may have seen a lot more hawkish tilt from the FOMC last week.
At the conference, Powell reiterated that view, saying that the “current inflation spike is really a consequence of supply constraints meeting very strong demand, and that is all associated with the reopening of the economy” and while “it’s very difficult to say how big the effects will be in the meantime, or how long they will last, but we do expect that we’ll get back, we’ll get through that.”
ECB president Christine Lagarde echoed Powell’s message, arguing the current bout of inflation “is largely attributable to the reopening of the economy”, and adding that “we certainly have no reason believe that these price increases that we are seeing now will not be largely transitory going forward.”
Bank of England governor Andrew Bailey weighed into the inflation debate. Earlier this week, while conceding that UK inflation was likely to rise to slightly above 4 per cent, Bailey went on to say monetary policy should not respond to supply shocks and that tightening policy could hurt a weakening economy.
However, the Fed has consistently underestimated inflation through 2021. The same is true certainly of the BoE and, to a lesser extent, the ECB and a number of other central banks (although not the RBA).
Last week, the median projection of the Fed’s preferred core PCE measure of inflation was upwardly revised again for 2021 to 3.7 per cent (from 3.0 per cent in June and 2.2 per cent in March). The extent of these revisions on the surface wouldn’t seem to occasion a lot of confidence in the Fed’s ability to accurately forecast inflation. Nevertheless, bond markets appear accepting (although somewhat guardedly in recent times) of the “transitory” inflation narrative.
Inflation concerns remain
At a highly simplistic level, there might be some appeal in the notion that supply driven inflation shocks are axiomatically “transitory”. But that is not the case as evidenced by the stagflationary shocks of the 1970s. Back then, by accommodating supply shocks, monetary policy ratcheted up inflation expectations putting pressure on limited supply leading to persistent inflation and a weakening economy. In this context, Bailey’s comments look at least a little simplistic.
Even if the current circumstance is not completely redolent of the 1970s, there are some causes for concern.
For one thing, inflation pressures remain. The Cleveland Fed’s median and trimmed mean measures continued to accelerate through August to 2.4 per cent and 3.2 per cent, respectively – well above the Fed’s target.
Wage growth is running ahead of expectations spurred by geographic and skill-based mismatches between labour supply and labour demand as evidenced by a record 11 million job vacancies in the US Labour Department’s Job Openings and Labour Turnover Survey (JOLTS). This supports the notion that disappointing US jobs data may tell us more about supply issues than demand for labour.
There are structural currents driving inflation arising from the reversal of the two great structural trends that account for the deflationary tendency of the past three decades: viz. globalisation of labour supply and baby boomer workforce participation. Add to that a regulatory backlash against globalisation of markets and a Biden agenda, including higher minimum wages, strengthened unions, increased employee benefits and strengthened regulation which – while replete with laudable intent – serve to push up business costs and prices.
Price pressures also remain in goods that have higher weights in the core PCE, the Fed’s preferred inflation measure. The August core PCE is due for release Friday with expectations centred around a 0.2 per cent increase in the month taking inflation to an annual 3.6 per cent. A number greater than this has the potential to lead markets to question the current sanguine view of inflation that prevails in central banking (and market) circles.
Multi-asset portfolio challenges abound if inflation is more persistent
Given the forgoing inflation concerns, with bond yields close to historic lows, and policy rates approaching the ‘zero-bound’, it is reasonable to question long standing assumptions regarding the diversification properties of high credit quality nominal government bonds in a multi-asset context.
Nominal government bond yields have begun to creep up, indicating that the bond market may be rethinking its own sanguine inflation view. If, in the wake of persistent upside surprises in inflation, the Fed has to jam down hard on the monetary brakes, there may well be a significant correction in bond and equity markets.
Such a scenario looms as a major challenge for investors in the future, including how multi-asset investors react to a potential reversal of long-held assumptions regarding asset return correlation. That is, equity returns and bond returns become positively correlated in the worst possible way – in extremis, both deliver negative returns.
Clearly the search for differentiated portfolio exposures uncorrelated with conventional equity or bond beta looms as a particular challenge.
In the defensive space, inflation-linked bonds or absolute return/‘unconstrained’ bond funds are worth some consideration.
Gold or precious metals in general may also be a candidate even if gold’s traditional role as an inflation hedge is undermined somewhat by rising bond yields increasing the opportunity cost of holding gold. Commodity baskets, which are accessible to investors in ETF form, are another candidate, particularly if inflation is to be more persistent due to supply bottlenecks and even if individual commodity returns can sometimes be highly volatile.
Measured foreign currency exposures can also be useful. Higher US bond yields seem to have supported a higher USD of late, although it is very early days yet. The RBA lagging the global normalisation of policy rates may put downward pressure on the AUD, although stronger global activity growth and higher commodity prices might offset that.
Certain defensive equity exposures can also play a role (the Future Fund has in the past cited consumer staples as a good defensive type asset).
Of course, managers who can bundle these up into a coherent multi-asset defensive portfolio are also something to consider.
GSFM investment strategist Stephen Miller
