The idea that current inflation will prove moderate and transitory has come under renewed questioning, as last week’s data releases showed price pressures growing and widening.
Central banks worldwide were already struggling to adapt their messaging to economic and market realities, and this news adds to their difficulties. The nature of the inflation and the limited tools policymakers have to deal with it complicate the challenge.
As we note in our “Ten for 2022” themes, published last week, the resolution of inflation and policy uncertainty is likely to be among the most important determinants of market performance over the next 12 months. Given current levels of risk, we think it’s increasingly important to seek diversification against market volatility and rising prices.
Even before Wednesday’s Consumer Price Index (CPI) release, we saw signs of the shockwave to come earlier in the week. The New York Fed’s Survey of Consumer Expectations revealed 12-month inflation expectations at a series high of 5.7%. The U.S. Producer Price Index (PPI) came in up 8.6%, year-over-year. Even so, the CPI showing headline inflation at 6.2% was breathtaking.
It is the highest print for more than 30 years. You need to go back 40 years to find persistent inflation at these levels. Moreover, the data appear to have momentum: Month-over-month inflation is at its highest since 2008. There is growing pressure in prices that tend to reflect underlying trend inflation, such as housing and owners’ equivalent rent, which is rising at its fastest rate in 15 years. The Cleveland Fed’s “trimmed mean” and median CPI measures are at 40-year highs. U.S. five-year breakeven inflation expectations broke through 3% for the first time.
Outside the U.S., the latest inflation data paint a similar picture. Eurozone PPI inflation is running at 16%. Last Thursday, Japan’s PPI clocked in at 8%, yet another 40-year high, and China’s at 13.5%, a level last seen in the mid-1990s. South Korea’s import prices are rising at 35.8%, the fastest rate since 2008.
In short, current inflation increasingly appears neither transitory nor local.
Do We Think Central Banks Will Act?
The challenge for central banks is illustrated by a further list of records in rates and bond markets. Real yields at every point on the U.S. Treasury curve are at historic lows. We haven’t seen the real fed funds rate below -6% in living memory—not even during the 1970s.
That’s an indication of how loose financial conditions are. The risk is that they are dangerously loose and will need a sharp correction. The bond market responded to Wednesday’s CPI print by consolidating its expectations for a Fed rate hike next July and flattening the curve to levels last seen at the height of the pandemic crisis in March 2020.
Do we think central banks will act? We see only the European Central Bank pushing back unambiguously against the market. Others have acquiesced, suggesting a greater readiness to tighten. With its inflation target under duress, the Fed is buying itself time by tweaking its definition of full employment—but after the latest strong U.S. payrolls and “quit rate” data, it may be running out of road there, too.
On the other hand, as Bank of England Governor Andrew Bailey has put it, tighter policy cannot produce more truck drivers. When such a large part of the inflation equation concerns supply bottlenecks, achieving the right policy balance is fraught with difficulty: Do you crimp demand and risk triggering an unnecessary slowdown, or stand back and risk runaway inflation?
Cyclicals, Value, Income
The same uncertainty makes balancing an investment portfolio just as difficult. That said, we do think adjustments can be made to mitigate downside risk and weather higher inflation.
Runaway inflation has not been a friend to equities, historically. The S&P 500 Index broke a long winning streak as the CPI data were published last week. But the cyclical and value segments of the market that are less interest rate-sensitive outperformed, and the European and Japanese markets responded positively; we believe these exposures could be longer-term beneficiaries of an inflationary tailwind.
It’s also worth noting that equity income has tended to exhibit positive real growth. Regular dividend payers have also posed lower downside risk, historically. After a decade of underperformance, they are among the few relatively attractively valued parts of the market.
While we do not currently anticipate a disorderly selloff in bonds, with real yields at such extreme levels we think nominal yields are likely to continue to rise even if inflation begins to ease over the coming months. Here we think that investors need to be flexible and willing to venture into niche markets, such as short-duration credit, floating-rate loans, hybrid securities or China bonds.
A Bigger Menu
Most of all, in our view, last week’s data strengthens the case for “a bigger menu of nontraditional diversifiers,” in the words of one of our “Ten for 2022” themes. Private markets and certain liquid alternative strategies can play a role at a time when bond and equity valuations are stretched, but we also think it’s prudent to seek out investments with historical inflation-beating characteristics.
Commodities are one place to look: While energy prices appear to be easing, precious metals are responding positively to the underlying inflation trend, and this asset class could be a hedge against any further spikes. Listed and private real estate, made up of real assets with index-linked rents, have tended to stay ahead of longer-term inflation. Currency market strategies can also do well in inflationary conditions—with foreign exchange implied volatility potentially being an attractively valued entry point.
We think building exposures like these now could help to dampen the uncertainty, volatility and potential consumer-price sticker shocks of the coming months. While we ultimately anticipate higher, more persistent, but not overly disruptive inflation during this cycle, it still has the potential to unbalance central bank policy in 2022. To try to prevent portfolios from becoming similarly unbalanced, we believe thoughtful diversification will be critical.
In Case You Missed It
- U.S. Producer Price Index: +0.6% in October month-over-month and +8.6% year-over-year
- U.S. Consumer Price Index: +0.9% in October month-over-month and +6.2% year-over-year (core CPI increased 0.6% month-over-month and 4.6% year-over-year)
- U.S. Initial Jobless Claims: +267,000 for the week ending November 6
What to Watch For
- Monday, November 15:
- Japan 3Q2021 GDP (Preliminary)
- Tuesday, November 16:
- Eurozone 3Q2021 GDP (Second Preliminary)
- U.S. Retail Sales
- NAHB Housing Market Index
- Wednesday, November 17:
- U.S. Housing Starts and Building Permits
- Thursday November 18:
- U.S. Initial Jobless Claims
- Japan Consumer Price Index