- We believe most of the supply chain issues today are transitory in nature. However, the biggest challenge pointing to at least some level of structural inflation is the shift in the mindset of workers, which is likely to result in higher wages and unlikely to be transitory in nature.
- We think that most of the underlying inflation pressures are transitory in nature, but “transitory” is likely to be a multi-year process as we recover from supply chain issues.
- Financial markets today don't just represent a return to normalization. They represent perhaps a new paradigm: one of significantly depressed rates, ongoing government stimulus, and higher multiples across the world.
The question of whether inflation is transitory or structural is the crux of what financial markets and central banks today are currently grappling with. We have been notably below trend inflation for at least the last decade within the U.S. and the eurozone. Japan and some other countries have been experiencing this for 20 plus years. In fact, Japan even faced deflation.
Coming out of the Covid experience we believe most of the supply chain issues today are transitory in nature. However, the biggest challenge pointing to at least some level of structural inflation is the shift in the mindset of workers, which is likely to result in higher wages and unlikely to be transitory in nature. For decades, we have seen a move away from the power of labor towards the power of capital, and many workers are reluctant to go back to low wage jobs without relatively solid and forward career progression. Covid accelerated this swing.
In the U.S., there is notably stronger stimulus from the Democrats in power than under the Republican party, with a substantial infrastructure plan as well as possible additional social fillip in the works. In the EU, stimulus has been injected into economies for years now, and in China, there is a movement towards what is being called common prosperity.
Such stimulus will feed through to inflation, but we caution that this is likely to be viewed by the Federal Reserve as “good” inflation and a return to what they want to see in terms of changing social dynamics in the economy. So, in short, we think that most of the underlying inflation pressures are transitory in nature, but “transitory” is likely to be a multi-year process as we recover from supply chain issues.
Today, the U.S. consumer balance sheet remains robust, with household debt still at a lower level than before the pandemic, although Q2 2021 showed an increase in credit card debt. Even corporate balance sheets, though they are elevated, show a strong ability to service that debt. We don't believe that a potential small incremental move up in underlying borrowing rates is likely to bring the growth to a significant halt.
Tapering and the idea of higher U.S. rates (nearly two Fed interest rate hikes are now priced into 2022 on the back of supply driven inflation, rather than transitory inflation) are proving to have a profoundly negative impact on emerging market asset performance. This is most notably true with high yield EM sovereign/corporate credits where the market has been “Offer Wanted” and many participants fear a liquidity crunch.
As a global system, we've fought the last two slowdowns in growth with a significantly elevated level of debt and leverage. If we're to see strong growth continue, it's unlikely that it comes with notably higher rates, as higher rates typically act as a brake on growth. However, given the likelihood of higher wages this time around, we are likely to see elevated inflation compared to pre-pandemic levels. In fact, inflation ran notably below trend for over a decade leading into the pandemic, and thus, to central banks and the Fed in particular, it's unlikely to be a challenge if it runs just slightly above trend for some years to come.
Despite the pressure around the globe and in the U.S. from higher inflation and the questions surrounding its transitory nature, rates remain relatively contained. There has been a flattening in the U.S. yield curve since the spring of this year, with long rates falling modestly, while front-end rates moved up.
It has often been stated that fixed income is ballast to an equity portfolio, and so it has been in a low rate, low inflation environment. Typically, when fixed income zigs, equity markets zag. But in a rising rate environment, and in a rising inflation environment, that may not be the case. As interest rates rise, fixed income is less defensive, and perhaps, equity multiples compress, and equities themselves drop. The way we're thinking about this in our multi-asset portfolios is first and foremost reassessing the risk and return that fixed income can have. Today, that means maintaining an underweight duration posture. As rates rise and potentially slow the economy, an increase in duration can rise right along with it.
Today, we think investors are best served playing more defense from a rate perspective, focusing on consumers with strong balance sheets through asset-backed securities such as securitized auto loans and mortgages that represent that market. Although we currently retain an underweight duration stance, we do believe that as rates rise and the economy normalizes, we'll want to step into what we believe are relatively neutral levels of duration so that we position the portfolios to have a natural balance and act as an offset to other risk global assets.
On the equity side, we don't want to be too underweight risk. There are both significant positives to a healing economy and workers returning to offices and other worksites, but there's also some risk as we transition to whatever the new economic paradigm is.
Equity indices in most parts of the world sit notably higher than they were going into the pandemic, so financial markets today don't just represent a return to normalization. They represent perhaps a new paradigm: one of significantly depressed rates, ongoing government stimulus, and higher multiples across the world.
We are relatively neutral on our equity allocations and our overall risk budget, while retaining a defensive posture in fixed income. We don't try to time the economic cycle, but we want to make sure that we're well-equipped to step into any weakness and take advantage of opportunities when they come forward.
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