It's not inflation that will transition. It's everything else.

It’s not inflation that will transition. It’s everything else.

Mon 06 Dec 2021

Last week saw the highest equity volatility since March, when it was becoming apparent that vaccinations were ensuring the eventual end of the Covid-19 pandemic. Wednesday 1st December, in fact, ranks amongst the top 4% most volatile trading days since 1990. The reason behind it was news on the -possibly more transmissible- Omicron variant, accompanied by a set of unlikely hawkish remarks from Fed Chair Jay Powell.

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The Omicron variant was not much of a surprise. We have already seen many mutations of Covid-19, some of which had previously raised the alert. But a hawkish Fed? We haven’t experienced one since 2018. As the potential of a new outbreak emerges, Fed Chair Jay Powell surprised markets by insisting that the US central bank would accelerate asset purchase tapering in December. Instead of customarily intoning the ‘Fed Put’, as per usual in times of crisis, Mr. Powell  added fuel to the fire, causing stock markets to retreat on Tuesday. As our current investment thesis is underpinned by the perma-dovishness of central banks, we have to examine what this means for our portfolios.

The pandemic isn’t going anywhere

But first, let’s start with the pandemic, the undisputed driver of economic activity in the past twenty-four months. Almost two years into it, we have now reached the 15th letter of the Greek Alphabet’s 24 letters. Interestingly, ‘Nu’ and ‘Xi’ which precede Omicron were skipped; the former because it sounds like ‘new’ and could cause confusion and the latter because it is a homonym to the Chinese President’s last name. That means thirteen distinct variants have been uncovered in the past twenty four months, slightly more than one every two months. Even before Delta took the world by storm, promising to imperil the second Christmas season in a row, the world woke up finding it has to contend with another, potentially much more transmissible variant. At this pace, there’s a decent chance that the Greek alphabet will run out of politically acceptable letters before the pandemic is over. Or, to quote the eminent Dr. Fauci: “We will have to learn to live with Covid because we are not going to eradicate it”.

If we are to take science’s words to their natural conclusion what does this mean? It means that global trade, retail and in fact the whole of the services sector will have to forego half-measures and ‘wait and see’ adjustments and firmly consign 2019 to history. The only reason the pandemic hasn’t left significant scars on the global economy is that we have refused to change the way it works. But persistently fighting a rising tide could cause permanent damage. Operations managers are approaching the point where they have to overhaul global supply chains and adapt them for a world with much less business travel, labour mobility and in-person services, including sales. Such a transition will inevitably disrupt the global supply chain system, super-optimised and calibrated for a way of life that may not be available anymore. As with any change process, it can’t be expected to go entirely smoothly. Add to this picture the price pressures from China’s transition into a more consumer-centric model and supply inflation may be here to stay for some time.

 ‘Transitory’ has been dropped

On the face of it, then, it might sound wise and even timely that the Fed decided to drop ‘transitory’ from its vocabulary.

True wisdom, however, does not come from optimising predictions, especially after the event. As any person over a certain age knows, it comes from accepting what one can’t control.

Milton Friedman, the Nobel laureate economist and intellectual leader of neoclassical economics, famously proclaimed that ‘Inflation anywhere and everywhere is a monetary problem’. Remove excess money supply from the system and demand comes back down to meet supply, stabilising prices, the theory goes. This tenet has been the bedrock of central bank policies in the era of Monetarism (post 1971). On this aphorism, and Paul Vocker’s success as Fed chief in the 80s, central banks were given extraordinary powers and independence in order to fight inflation. Their basic tool? Interest rates. To reduce excess supply of money, policymakers just had to make it more expensive.

The model may work well for demand-driven inflation. If cheap credit boosts demand, then expensive credit would suppress it. But what we are experiencing is not demand-driven inflation. Prices go up because supply chains are broken, creating a vicious circle where uncertainty of delivery causes buyer behaviour to become erratic (ordering outside normal patterns), further destabilising supply chains and so on.

This is a phenomenon that central bankers have not had to deal with in the past. Oil supply disruptions in the 70’s are a poor analogy. 

The last twenty years saw a persistent drop in prices, as a result of globalisation. The unspoken truth amongst policymakers is that it was supply chain optimisation, not central bank policies, that kept prices in check. In other words, their basic mandate, inflation, has long been out of their control. Because it was going down, not up, no one bothered. Central bankers, instead, focused on maintaining financial stability by increasing banking oversight b and flooding financial systems with cash.

Let us not lose sight, then, of what central banks have evolved into by pretending they can still adhere to their inflation mandate. They transitioned their institution from ‘stewards of inflation’ to ‘risk enablers’ for financial markets. Central bankers should have learned that they have no control over prices, after a decade of ‘Japanisation’ of their economies, where they tried, and repeatedly failed to bring inflation up to 2%. Their attempts to lift the long part of the yield curve (to make money lending profitable again) and inflate away some of their countries’ soaring post-GFC debt simply did not work. 

The pandemic hasn’t demonstrably changed trend demand conditions. If somehow Covid-19 were to magically vanish tomorrow morning and global goods and services orders were to instantly normalise, do we have any evidence that the economy would not be as ‘Japanised’ as it was in 2019, and thus control of prices as elusive to central banks?

So why are they even trying? Why is quantitative easing, which has proved to be completely unrelated to general price movements over a decade, now linked  to inflation ? Why are interest rates, a mechanism designed to control demand, being used to fight what is clearly a supply issue?

Who are central bankers trying to convince? 

We think the answer is surprisingly simple: politics. To misquote Mr Friedman, ‘Inflation is everywhere and anywhere a political problem’. Inflation is a very visible ‘tax’ on consumer incomes. This causes incumbent governments to become unpopular, as Mr Biden recently found out. Elected leaders are ready to shoulder the political cost of taxes they impose, usually on a specific and targeted segment of the population. But inflation may wreak havoc across the board and seriously disrupt political planning.

Marc Bellmare is an economist at the University of Minnesota. His work shows that once price hikes hit the super-market shelves, the political environment can become toxic. Mr Bellmare found a strong link between the prices of food and protests, strikes and riots in many parts of the world between 1990 and 2011.  His findings do not account for the effect of social media and hyper-partisanship, which may amplify the effects.

So far, price rises were focused on a small part of the economy, namely energy and used car prices (as manufacturers struggle to deliver new vehicles due to microchip shortages). Gasoline and heating prices went up for some consumers (many are still on fixed or capped heating bill rates), but overall prices in the super-markets remained under control. This has began to change. Food inflation in the US is now 5.6% per annum. In the UK it remains controllable, 1.3% and so in the EU, 2.3%. But it has been on the rise.

This puts the onus on central banks now to demonstrate that they can control inflation and that their sole job is not to prop up asset prices. It is very likely that central bankers aren’t blind to the limits of their powers, but they are responding to inflation with more hawkishness to reassure both the public and their political superiors that they are in control.

It’s not just the US. Or the UK, where the newly installed Bank of England leadership has shown indecision regarding interest rates. Some countries, like Germany, are more sensitive to inflation than others. German CPI at 6% is now at the 95% percentile (top 5%) since the country’s post reconstruction in the 1950’s. German consumers are already disgruntled over negative bank rates for over five years and ignoring inflation is politically prohibitive, especially for a fragile and diverse new coalition government. So while the German government and central bank transitions have allowed ECB’s Christine Lagarde to maintain a very dovish stance, it stands to reason that they will quickly challenge her, if the country’s mainstream media are any indicator.

What it means for portfolios

Central banks remain independent. That independence, which is politically granted, will certainly come under scrutiny if inflation runs unchecked, for whatever reason. If we assume that recent, out-of-character movements from central banks are the product of political pressures, then independence has, de facto, already been somewhat compromised. With it, recent patterns for asset returns could change.

As for inflation? If interest rates aren’t the way to control it, we may have to learn to live with it, perhaps for a few years. Central banks will have to decide whether they are willing to let the mid and long-end yield of the curve adjust (which means 3-5 year rates over 3-4%) or face a permanent reality where the sole purpose of bonds as an asset class is capital appreciation because of institutional demand. 

Our base-case scenario remains that a sharp market downturn should reaffirm the ‘Fed put’, the promise that the world’s de facto central bank will unequivocally add to asset purchases whenever risk levels rise beyond comfort. 

However, we now find that the probability of a cyclical or even secular hawkish shift of central bankers is not infinitesimal anymore. It is an observable and quantifiable scenario. As investors, we should at the very least be prepared and positioned for more market volatility and different patterns for assert returns as we are entering, what is promising to be another interesting year.