Multi-asset allocation views: How durable is ‘transitory’ inflation?

In a previous column, we discussed a gradual move to monetary tightening by central banks, allowing for inflation to develop for some time.¹ Today, some central banks seem to be moving closer to tightening than others, creating potentially important divergences.

Already, we have seen surprise interest rate hikes in New Zealand and Norway among developed markets, as well as a slew of rate rises in emerging markets. Although the Bank of England created some confusion with its unchanged rate decision in early November, expectations for rate increases have risen smartly since the summer.

Meanwhile, the biggest central banks – the Federal Reserve (Fed), Bank of Japan (BOJ) and the European Central Bank – continue to emphasise to investors a more tolerant approach. Their plans to reduce bond purchases are well understood, but rate rises are apparently still some way off. So, while we expect continued inflationary pressure globally, it is important to note the policy divergence. Whether it can be sustained will be a critical theme for several asset classes as we approach the end of the year.

Figure 1: Market-implied short-term rates at end 2022

Source: Bloomberg, as of November 11, 2021

Stretched definition

The central bank definition of ‘transitory’ inflation is now stretching what most market participants expected when the expression was first used. One reason is a move from volatile to sustained drivers of inflation.

When the Federal Reserve started to talk about transitory inflation in March 2021,² most participants were thinking about the base effects that would come from the March 2020 collapse in oil prices: the Bloomberg Crude Oil index fell by 80 per cent in the year to April 2020, making it likely that even a modest rebound would see large year-on-year gains.³ It stood to reason such an effect would be transitory, petering out into early 2022.

Figure 2: Commodity prices, year on year (per cent)

Source: Bloomberg, as of November 11, 2021

The reality is proving more complicated. Firstly, price pressures are broadening across commodities and raw materials. As of the end of October, commodity prices were up 32 per cent for the year,⁴ according to the Bloomberg Commodity Index, outstripping the gains seen in equities and bonds. That has only happened twice since the 1960s over a full year, both times during the world oil crisis of the 1970s (in 1973 and 1979).⁵

Secondly, other production inputs have seen bottlenecks and shortages, such as shipping and, particularly in the UK, trucking. It creates a situation where many firms are running small inventories of finished manufactured goods and can then test what the market will bear in terms of price rises. For instance, industrial companies, which are highly dependent on raw materials and logistics, have been able to raise prices because their customers had no real alternatives. Some firms reported having already passed through three or four price increases to customers.^6,7

The key challenge from here is whether some of those shortages are more than just temporary inflation factors. Energy will likely only be a temporary factor unless oil prices continue to rise at exceptional rates, while gas prices could be dampened by a warmer winter in Europe, if the wind picks up in the UK, or through infrastructure improvements like the pipeline which opened in October 2021 to deliver gas from Norway to the UK.⁸

Some pressures on shipping could also only be temporary, particularly congestion at ports and atypically strong demand for goods. For example, when Chinese ports closed due to COVID-19 factors, it created major backlogs. Similarly, global goods demand has accelerated rapidly. US real household spending on goods has grown 15 per cent since the end of 2019, having averaged 3.5 per cent growth in the previous decade.⁹ That is disruptive for the inventory cycle and shipping, but will not last forever.

However, the legacies of underinvestment and its knock-on effects to the labour market create challenges. Shipping capacity is running a low rate of new orders relative to existing capacity, troughing below ten per cent of the total shipping stock before a modest recovery.¹⁰ That can be dangerous; as well as creating shortages when there is a big rise in demand, it also means that as some of that shipping stock depreciates, it can’t necessarily be replaced.

Workforce shortages have the potential to create a durable source of inflation. As goods start being unloaded, at US ports for example, who is there to unload the containers, to load them onto the railroad cars or trucks and get them moving? While labour shortages might seem most acute in the UK because of the recent situation with HGV drivers, there are similar situations on the continent and in the US.

“From service providers who do things for us as mundane as cutting our grass or providing janitorial services, to running our intermodal ramps: all of them are showing to us inflation pressure and it doesn’t look like it’s temporary,” said Union Pacific’s chief executive officer Lance Fritz in September.¹¹

There is also evidence that retail and hospitality sites in the UK are struggling to reopen because of a lack of staff. Whatever the cause, this is having an impact on prices because firms are offering higher wages to compete. The extent of this may be understated by wage data, as companies are using non-wage incentives such as signing-on and shift bonuses.

This could eventually translate from something central bankers are inclined to look through to something they cannot ignore. That may be why investors have started to reprice the probability of earlier rate rises by more central banks.

Central banks are starting to respond

Although this reappraisal is warranted by solid economic fundamentals, some of the language used by central banks may have added fuel to the fire. Several Bank members of the England's Monetary Policy Committee did not push back against market expectations, instead expressing comfort with the idea rate rises may come sooner rather than later.

While the latest meeting saw the return of the “unreliable boyfriend”, as the Bank failed to deliver a rate hike to match its tough talk, there were important hints at a changed landscape. The quarterly Monetary Policy Report, released alongside the rate decision, conveyed the Bank’s judgement the UK now has an inverted output gap, meaning the pace of economic activity might be running ahead of its sustainable non-inflationary potential. That constitutes a dramatic change from even just a year ago, when the talk was of large output gaps.¹²

Whatever happens with rates, it makes sense for investors to have repriced expectations, but that has had an impact on markets. It is putting a lot of upward pressure on bond yields, not just at the front end but also further along the curve. Gilts have sold off aggressively, even out to the ten-year point; at the start of 2021, ten-year Gilt yields ran at about 20 basis points (bps), and by 21^st October they had reached 120 bps.¹³

With similar moves across developed markets, this has been one of the most important market themes in 2021. We have been underweight duration, feeling economies were in stronger shape than investors were giving them credit for. We maintain these positions, believing this trend has further to run; the question is, where to?

The Fed and ECB are more patient

The Fed, BOJ and ECB are trying to keep the focus on managing their balance sheets and not actively encouraging discussions about when rates may rise. Policymakers in those banks are also expressing more caution, pointing, for example, to the slowdown of economic activity in China, or to expectations more people will re-join the workforce and keep wage pressures down.

But a key question for investors is whether central banks hold out or start raising rates. The active debate is whether the Fed may start to hike in the middle of next year – four months ago they were signalling there would be no move before 2023.

Though a key question for us too, our confidence in the recovery leads us to think that the risk central banks may move earlier, and keep going for longer, remains underappreciated by investors. Even as the pandemic’s resurgence slowed US activity in the third quarter, since vaccination programmes began COVID’s impact on the US economy has tended to delay rather than squash demand. We therefore expect stronger US growth in Q4 and into 2022.

Investment implications

Exactly how and when this plays out has two other implications. Firstly, it presents a challenge for risky assets. If safe-haven yields rise fast, it might weigh on growth companies’ sensitivity to interest rates. The logic is that companies whose main earnings potential is in the distant future, such as young tech companies, will see their valuations fluctuate more with the discount rates used to value those earnings today.

There is also a broader point in terms of opportunity cost. If investors could earn better returns by investing in relatively safe assets, it could lessen the appeal of risky assets. It is one of the reasons why have reduced our overweight equity positions, even though interest-rate levels remain low and supportive of risk assets.

A further implication is that, while we have become used to central banks moving in the same direction, more differentiation in the speed and extent of planned tightening is emerging. This could impact bond markets and currencies.

For example, if the Bank of England moves quickly to tighten while the Fed keeps a leisurely schedule, investors will debate whether the UK economy is strong enough to sustain that divergence.

If the UK were able to raise rates without severely hurting the economy, for instance, markets may put pressure on Gilts, and we could see Gilt yields catching up to US Treasuries.

These interest-rate differentials are often an important driver of foreign exchange markets. Again, if the UK could sustain interest-rate rises while rates moved more slowly in the US and EU, expectations could shift and sterling could benefit against the dollar or euro.

At this stage, the jury is still out, particularly on how robust the UK economy really is, but also about the policy outlook around the world. What is clear, however, is the expected pace of interest rate rises will be an increasingly important theme through the rest of this year and into 2022.