It may be difficult to remember, but in the midst of the global financial crisis and long after, QE wasn’t really trusted by markets. For the next five to seven years, almost until 2015, most money managers did not trust the bull market and remained underweight risk. They paid with underperformance and the rise of passives. Then, we began to wonder what could ever stop the Quantitative Easing juggernaut. The answer was always simple: inflation.
Last week saw US inflation hit a 40-year record of 6.8%. The fine print says that the bulk of the price rises focuses on energy prices and cars/trucks. And also, that it is supply, not demand-driven, which means it would respond very differently to interest rate hikes. However, once a number like that hits the headlines, details are forgotten and things happen quickly.
It is difficult to find a participant in today’s market who remembers what this kind of price pressure even feels like. Last time inflation was running this hot, the Cold War was raging, personal computers had not been invented, ‘Chariots of Fire’ was named the best movie of the year and Ben Cross was the hottest name in acting. Meanwhile, an unlikely Hollywood actor named Ronald Reagan had freshly occupied the White House. Interestingly enough, however, the present incumbent in the Oval Office, Joe Biden, was already a 10-year Senator from Delaware. His memory of how inflation brought down his party’s President, Jimmy Carter, should be vivid, as he sees his own approval ratings slide for the same reason.
In the last twelve years, monetary accommodation ballooned and central bank assets for the US and the EU rose nearly eight times. All they achieved was a meagre 1.5% inflation. Policy leaders fretted about deflation and tortured their intellects about how to normalise the yield curve again and turn money lending into a profitable operation once more. They talked rates up; they tried to stoke inflation expectations but to no avail. The yield curve remained flat as a pancake. It took a global pandemic and the biggest post-war supply chain shock to see inflation.
Inflation might not necessarily always be a monetary problem. It is, however, always and everywhere a political one.
Since 2008, the US central bank has exercised a dominating amount of control over the prices of all assets across the risk spectrum. It was not just its ability to throw trillions into financial markets at the push of a button. It was the threat that this posed to short-sellers. No one wanted to be caught with short positions at any time when the US central bank would decide to start printing. So, they were long.
The Fed’s freedom to print money at will, in all probability, shall be soon tested. And with it, the cornerstone of the last twelve year’s financial paradigm.
For one, with inflation that high and wage pressures exacerbating and eating into corporate margins, the Fed’s compulsion to raise interest rates, i.e. make money more expensive, is growing. QE, which in essence makes money cheaper, can’t really exist in a rate hike cycle. Next year will feature a more hawkish Fed, so these sorts of decisions will be made easier.
To be sure, raising interest rates and stopping QE has more of a psychological effect than a real one. Inflation, not rates influence consumer behaviour. Rates are a signal that ‘we are doing something about it’. The signal is politically expedient and might serve the purposes of policy makers across all branches of government, especially during a mid-term election year for the US. But raising the cost of money in the US by a fraction does very little to speed up the production and transferring of goods from Asia. Demand driving orders is not the result of credit-induced exuberance but rather panic, as wholesalers and retailers are running short on everything as a new Covid-19 variant becomes dominant. So, in all probability, no matter what the Fed does, this bout of supply-side inflation will remain firmly outside its control.
What does this mean for investors?
In the coming investment committee, we will fully assess the rise of risks against valuations and market momentum. The Fed’s ability and willingness to suppress any sort of equity and bond market risk in the last twelve years is, at the very least, compromised by surging inflation. However, we don’t believe there’s sufficient reason to panic.
For one, there’s still plenty of money in the system. Since September 2019, the Fed’s balance sheet went from $3.7tr (already considered a huge balance sheet), to $8.6tn. A 130% rise in two years, which added another $4.9tn to the global financial system. More than $10tn have been added by the four major central banks (US, EU, China and Japan). For investors, that huge liquidity pool constitutes the most potent financial safety net in history. It will take years for that money to be fully integrated into the financial system. Fiscal stimulus in the US and China ensure more money for the real economy. So does the almost $2tn in Private Equity dry powder.
And, overall, money will remain cheap. Raising interest rates 1% or so, sends the message but does not make money materially more expensive. If central banks really believed that this sort of inflation could be fought with higher rates, then we would already be experiencing a 7% interest rate. With global Debt-to-GDP skyrocketing to 356% over the past two years, government debt-to-GDP over 110% for many developed markets, and fiscal easing on the way, materially raising the cost of capital is simply not an option.
But what about QE?
We have to accept that QE’s use was also, mostly, psychological. Short term market operations might still be used to bail markets out of trouble. But with inflation running that high, adding trillions of long-term money into the system within the space of months at first whiff of market distress, is probably out of the question, even if it’s just for politics.
Should investors be worried?
Equity investors should get used to more volatility, and may well experience an equity re-rating and lower valuations in the next few months. This is more so for funds heavily exposed in tech, where valuations have risen disproportionately to the rest of the market. Focusing on fundamentals and being selective about managers will go a long way into preserving wealth.
Bond investors will have a more difficult time. High liquidity gives hope to traders that they might still find someone to take their holdings out of their hands at an even higher price. But the bulk of fixed income investors, who tend to hold the asset to maturity, is in trouble. Either they will lose a steady stream of money in real terms over the next few years, or they will experience a sharp correction in prices. Real returns (yield minus inflation) are deep into negative territory. Assuming 3% average inflation over the next five years, an investor in the five-year US Treasury note yielding 1.27% would experience an assured loss of 1.75% per annum, or 8.5% of their overall investment. Because no market can operate under an assured loss assumption, the probability for a sharp price correction (so that annual yields may rise) is climbing fast. Central banks will still remain a big buyer of debt, but adding no new money into the system would allow yields to drift upwards. We are already deeply underweight bonds and considering ways to mitigate the impact of a possible re-rating event on those that we do hold.
Why the case for remaining invested still stands
The end of QE and the end of the current paradigm, however, is not a disaster. The money already printed is not going anywhere and it can continue to fuel markets for a long time.And QE’s withdrawal will be handled with care. Inflation may be catastrophic in an election year, but so is a market rout, with US households having a record 41% of their total assets in equities.
It may even prove a blessing in disguise, as it could return long-gone sanity to investment markets. To be sure, a post-QE and post-rerating world, is a different, more volatile, world. Volatility may be uncomfortable, but it is also the mother of opportunity. Investors will see traditional strategies, like the 60/40 equity/bond portfolio, working again. Overall, this should reduce risks, or at the very least, make them more manageable. Shorting markets may, on occasion, pay off as a strategy. Shorting capitalism over the longer term, never does. And while we expect a tantrum, or more than one, we believe financial markets will outgrow QE, much like humans do: by learning, sometimes the hard way, that even if things occasionally go south, is not the end of the world.
Inflation momentum will recede. But prices may remain elevated.
There’s a strong possibility we may see the end of the episode soon. But supply chains could take long to mend and overall price levels could remain elevated versus pre-pandemic numbers.
Weekly Market Update: Inflationary pressures may be moderating. Supply chain pressures aren’t.
Equities in most major markets posted losses last week with global stocks down -0.4% in Sterling terms, as inflation concerns, supply chain issues and rising coronavirus cases dampened investor sentiment. US stocks were up +0.1% with growth stocks exhibiting solid gains, outweighing the losses in more cyclical firms. European stocks were down -1.8%, as countries within the region started imposing restrictions to curb rising Covid-19 cases. UK stocks were down -1.6% amid CPI inflation figures hitting a ten-year high, while EM equities fell by -1.7%. The US 10Y Treasury yield was down 2.2bps finishing the week at 1.548%, while the UK 10Y yield was down 3.5bps reaching 0.880%. In US Dollar terms gold lost some of its previous weeks’ gains, down -1.3%, while oil was heavily down -6.2% to $76 per barrel.
Weekly Market Update: Operations Managers are the new economists
Equities in most major markets posted minor gains last week with global stocks up +0.3% in Sterling terms, as inflation concerns seem to have stemmed a previously strong investor sentiment. US stocks were up +0.2% as multi-year high inflation data offset positive news on employment data. EU stocks were up +0.2%, despite Covid-19 cases surging in most countries in the region. UK stocks were up +0.7% while EM equities rose by +2.2%, driven by China’s announcement that it would propose easing measures to aid indebted real estate firms. The US 10Y Treasury yield was up 11.0bps finishing the week at 1.561%, while the UK 10Y yield was up 6.9bps reaching 0.914%. In US Dollar terms gold posted solid gains for the second week in a row, up +3.1%, while oil was down -0.1% to $80.4 per barrel.
Weekly Market Update: Was it a good idea for the BoE to surprise markets? Probably not.
Equities in most major markets posted gains last week with global stocks up +3.3% in Sterling terms, amid continued strong investor sentiment. US stocks were up +2.0% on the back of positive earnings surprises, a dovish Fed meeting and strong employment data. EU stocks were up +3.2%, with the ECB insisting that rates will stay low for the near future. UK stocks were up +1.0% as the BoE unexpectedly kept interest rates unchanged, which caused Sterling to fall -1.4% against the US Dollar. Globally, consumer discretionary and IT were the best performing sectors while financials and healthcare were the worst performing. The US 10Y Treasury yield was down 10.6bps finishing the week at 1.455%, while the UK 10Y yield was down 19.0bps reaching 0.845%. In US Dollar terms gold was up +3.4%, while oil was down -1.3% to $81.2 per barrel.
Seen from a bird’s eye view, the Fed has turned more hawkish in preparation to taper asset purchases. As a result, markets are now more prone to respond with volatility to rising risks, of which there’s no shortage: From soaring natural gas prices to impaired supply chains threatening consumers and businesses; from a new status […]
Weekly Market Update: Port congestion isn’t dealt with interest rate hikes
Equities in most major markets edged higher last week, partly offsetting the previous week’s losses, with global stocks up +0.3% in GBP terms. US stocks were up +0.4% despite the disappointing jobs report published on Friday. European stocks were up +0.2% amid high volatility while UK stocks were up +1.0% despite the BoE’s new Chief Economist raising the alarms on inflation’s persistence in the coming months. Globally, energy stocks outperformed all sectors for a fifth week in a row, posting solid gains of +4.9%, followed by financials, utilities and materials. The US 10Y Treasury yield was up 15.0bps, finishing the week at 1.612%, while the UK 10Y yield was up 15.6bps reaching 1.158%. Sterling rose by +0.5% against the US Dollar. In USD terms gold pulled back by -0.6%, while oil was up by +4.1%, reaching $81 per barrel.
Fight the Fed… when it’s hawkish (and a few words about Germany)
Stock indices in most developed market regions rebounded strongly after Monday’s acute sell off amid fears of Evergrande’s default - global stocks were up +0.7% in GBP terms. EU stocks were up +1.7% despite business activity losing steam, while US stocks rose +1.0% after recording their biggest daily drop since May 12th, on Monday. UK stocks rose by +1.0% as the BoE announced that rates will be unchanged; however holding a more hawkish stance. Globally, Energy stocks continued their upward trend posting solid gains of +4.0% followed by financials, IT and consumer discretionary. The US 10Y Treasury yield was up 8.9bps finishing the week at 1.453%, while the UK 10Y yield was up 7.4bps reaching 0.922%. Sterling fell by -0.4% and -0.3% against the USD and the Euro respectively. In US Dollar terms gold rose by +0.2%, while oil was up by +3.4%.
The UK’s energy market and its broader implications
Much of the recent news in the UK has been devoted to the spike in household energy costs and the potential collapse of the number of providers in that market from around 50 to 10 by the end of winter. In fact, since writing this first draft of this piece 2 providers have gone bust, leaving more than 800,000 customers without a provider. Of itself this is an interesting topic: it seems remarkable that rising wholesale gas prices can rupture the UK energy market and reduce the number of energy providers by 80%. For us the more relevant question relates to the wider economy and how energy costs can impact consumer demand and inflation, which contributes to our discussions when deciding asset allocation. This blog post aims to explore the former and explain the Mazars Investment Team thinking on the latter.
You can relax. The Fed has no intention to fight inflation (yet).
With inflation pressures coming mostly from the supply side, there is little the Fed can do to curb it. Interest rates are tools best used to cool down the economy during a mature, credit-driven economic boom. They are not designed for a recovering economy and much less for one still under the threat of a pandemic.
Quarterly Outlook: An investor’s inflation and growth playbook
Investing during the past twelve years has been underpinned by a basic principle: market participants have been encouraged to take risks, mainly to offset the trust shock that came with the 2008 financial crisis (GFC). Each time equity prices have fallen significantly, the Federal Reserve, the world’s de facto central bank, would suggest an increase in money printing, or actually go ahead with it if volatility persisted. Bond prices, meanwhile, kept going up, as central banks and pension funds were all too happy to relieve private investors of their bond holdings even at negative yields. Market risk was all but underwritten.