May 2021

The battle ground for investors for the remainder of 2021 looks likely to be US inflation, and the associated trajectory of interest rates. Interest rates after all were the saviour of growth assets in 2020, the Fed triggering an almighty equity market recovery inconceivable without its heavy handed intervention.

In the first note in our inflation series we cover the key issues and estimate forward returns on fixed income.

US CPI MoM changes: latest reading of 0.8% most significant since 2013 taper tantrum

The presence of upward readings on inflation has started with the elevated print for April CPI, of 0.8% MoM, significantly above consensus and the highest monthly increase for years. The debate around rates depends upon where one stands with regards to nature of the elevated inflation prints, and their persistence.

Of course, the pick up in inflation isn’t surprising; firstly, base effects, namely the fact that prices were so depressed a year ago as the lockdown hit that a “return to normal” will inevitably involve a significant increase in prices; second, fiscal stimulus.

To understand the role of fiscal stimulus in driving inflation requires a thought experiment: if one were to distribute one million dollars into every bank account in Australia, what would happen to consumer prices? While the magnitudes are naturally a good deal smaller, there can be no doubt as to the inflationary nature of government payments. And this differs necessarily from monetary stimulus, which favours the wealthy with the capacity for increasing their debt to equity.

Now that there is a unanimous acceptance that some inflationary pressures are inevitable, the key issue remains whether these pressures will abate in 2022, or the pre-cursor for a more prolonged and structural rise in prices. For asset allocators on a five-year view, this is the key question.

Inflation is typically associated with negative equity market returns (plot of annual equity market returns (vertical) vs CPI % change (horizontal)) 1973-

The layout of this red hot debate is as follows:

In the red corner: By describing inflationary pressures as transitory, the Fed is alluding to the fact that many of these elevated CPI prints are quarterly one-offs, that will eventually mean revert and drive the index back down to where it has been since the end of the GFC. This perspective justifies their stance on monetary policy. In addition to this, they have stated a shift towards outcomes and away from forecasting in setting monetary policy.

In the blue corner, by contrast we have many institutional investors, mainly hedge funds. Their views are being aggressively vocalised on podcasts and tv interviews, are staunchly of the view that the one-offs could become into structural issues, as the electorate become increasingly addicted to policies favouring mass handouts. This looks akin to the early 70s period, and much of the commentary alludes to this.

Inflation (horizontal axis) is also typically associated with lower profit margins (vertical axis)

Our base case remains that inflation is transitory. The risks however to being wrongfooted are enormous. This is because, as we mentioned, the Fed is focused on outcomes not forecasts.

This means they will wait for inflation to surprise majorly on the upside before acting to fend it off with rate rises. And by then, much of the damage might have been done. Company profit margins will get crimped by wage rises and increased input costs, and disposal incomes for many of the less well off in particular evaporate as the cost of basic items rise. This is the key downside risk for markets.

US Fed Funds Rate (Vertical) typically keeps up with CPI (horizontal) basis, Fed has signalled it will wait to raise rates till after the event?

Q1 2022 looks to be the key data period to determine the stickiness of CPI data. By that stage, the COVID crisis and lockdowns will be rolling out of sample, and we will start to get a sense of whether the supply-demand imbalances have started to reach an equilibrium, or whether 2021 was a sign for what was likely to come – and ultimately whether the red corner or the blue corner is right.

Up until that point, we expect numerous inflation scares to continue, as anxiety levels reach fever pitch. This is especially true of northern hemisphere economies, where lockdowns and distress have been far greater, and where the demand and associated inflation impulse in the second half of 2021 is likely to be strongest.

The US yield curve illustrates how investors are pricing in the trajectory of rates over the next 15 years: we have super-imposed where we think the yield curve should trade, and where it does trade. Despite the sell-off in February, bond market duration looks overbought. As a result, we think it will underperform cash and Australian duration – which is priced far more fairly.

The current US yield curve (orange) is expected to shift up over the next five years (grey) according to the market, our view is that this shift and steepening could be more pronounced (yellow)

In contrast the Australian YC looks much more fairly priced, right on our long term projections.

In Summary, we have a preference for Australian sovereign bonds, although are expected returns are low over global bonds. Global bonds are still not fully reflecting the economic recovery we expect in 2021 let alone any inflation. We have global bonds sharply underperforming cash.