The sources of inflation are numerous: the “bullwhip” effect through the supply chain due to scarce inputs and bottlenecks in transportation; reduced global migration bringing in fewer skilled workers; increased internal migration exceeding the capacity to deliver homes and services to those who demand them; and finally, long COVID, early retirements and vaccine mandates are all contributing to a significant reduction in the workforce in countries like the US.
Central banks are rapidly realising they need to lean against these inflationary trends. Supply issues in goods, labour and services are persistent and worsening. The only way to reduce inflationary expectations becoming self-reinforcing will be to reduce demand until supply issues can be corrected. Raising interest rates is the main tool central banks use to temper demand, but the effect is most pronounced when interest rates are above a “neutral” rate. Given the extraordinarily loose monetary conditions since the onset of the COVID crisis, the neutral rate is considered to be several rate hikes above current levels in most countries and as the old joke goes: “If you want to get there, I wouldn’t start from here”.
Central banks appear to be in a hurry to get to a point where their policy supports more balance in demand and supply, but the adjustment is already proving painful for some investors. We are all hoping the policy adjustment will not lead to what one former Australian Treasurer in the 1990s determined was “the recession we had to have”.
Markets are reacting to the uncertainty. Higher interest rates will quickly pressure companies on very high valuations or where the quality of profits is low. We are seeing this already in the very weak performance of some share indices and investing styles. However, there remains strong growth in most parts of the world.
Companies that provide the inputs to growth and those less sensitive to cost pressures are doing very well. Banks, energy companies, mining companies and high-quality subscription service companies are examples of recent outperformers in global markets. Some may suggest that recent volatility is an opportunity to buy popular companies at lower share prices. We don’t think so. After more than 10 years of “secular stagnation” and investors crowding into growth-related investment themes, we believe there could be a long way to go in a global repositioning for an inflationary and rising rate environment that favours companies that offer more value and resilience.
Despite the uncertainty in the developed world, one exception to the trend of central bank policy tightening is China. Financial conditions there are now easing and asset prices have already cheapened significantly through the course of 2021. In recent policy meetings, the Chinese government shifted its stance to a focus on growth stability. Given the level of growth currently, this implies adding stimulus and easing financial conditions versus the tight stance in 2021. The benefits of this policy adjustment should accrue to some of the more discounted assets in the region, such as Asian high yield bonds and Chinese equities; however, risks remain significant. China aims to transition away from a property investment driven model for growth and yet much of economy still depends on growth in this sector. If policy smooths this transition over a long time, then we see opportunities for investors to benefit from the loosening of financial conditions in China in the coming year.
The year 2022 has started with great inflation and growth uncertainty. With the addition of rising interest rates, investors in bonds and many parts of the equity market are experiencing losses and we think expected returns will be meagre in the coming years. Even cross-asset diversification is doing little to protect portfolios in what has led broad market buy-and-hold strategies to increasingly look like a busted flush. In this environment, portfolio flexibility is paramount. Managers who can implement global or focused strategies, who can benefit from market declines or volatility, and can combine strategies across asset classes toward a target return may be best positioned to deliver consistent returns to investors during a period when buy and hold may not.
Gerry Fowler is an investment director, multi-asset at abrdn.
