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A rock and a hard place: Navigating changing policy


The US Federal Reserve delivered a .75% hike in policy interest rates at its June meeting. The step taken in reaction to the May inflation reading, which was higher than anticipated, sent shocks across asset markets. Investors now expect US policy rates to hit 4% early next year, a full 1% shift versus the end of May.


The Bank of England (BOE) increased its base rate by .25% to 1.25%. The BOE’s more tepid approach recognises the structural weakness of the UK economy. UK inflation could hit 11% this year despite a likely recession starting in the second quarter.


Synchronisation:

Inflation has re-emerged as the primary driver of asset prices as lockdowns, pent up demand and a savings glut have caused a synchronised jump in demand throughout the world.


As we transitioned from redecorating our homes, to buying consumer electronics, eating out, to going on holiday, each of those industries has struggled to cope.


Hyper-cyclicality has consequences for suppliers as well as consumers. Consumers must be willing to pay the higher prices to facilitate an increase in capacity. New capacity is rarely created in a vacuum and comes with the risk of a sudden downturn in demand or too much capacity arriving at once.


Add to this, the meddling of central bankers, and you begin to understand the challenges faced by corporate managements. These complexities raise the risk of missteps creating uncertainty for providers of capital. Equity multiples therefore fall to enhance expected returns for the providers of capital.


Structural fault lines:

Central bankers around the world have been called to arms by the Federal Reserve. The Fed’s aggressive actions, while designed to contain US inflation, have the knock-on consequence of exporting inflation to the structurally weak. These are countries, with large amounts of dollar debt and current account deficits. As US interest rates rise investors move money to dollar assets in search of yield. A devaluation of the local currency ensues, and this causes local inflation to accelerate as tradable commodities are dollar denominated.

Countries that can match the Federal Reserve in raising interest rates can avoid the outflow of capital. The lackadaisical approach of the Bank of England, European Central bank and the Bank of Japan to inflation pressures highlights the structural weakness of their respective economies.


The BOE, has highlighted downside demand risk ahead of its own inflation targeting mandate and the ECB has been drawn into containing bond market fragmentation even before it starts raising interest rates.


Emerging markets will face dollar funding challenges, with oil and commodity exporters reaping the benefits of elevated prices in the near term.

Supply shortages

Russia’s invasion of Ukraine and subsequent embargoes on Russian exports have created supply constraints in several commodity markets. These constraints are hitting up against a robust global demand, pushing up the price of a wide variety of basic goods. Higher commodity prices embolden producers, as they can guarantee the price they receive through forward contracts. Food producers can substantially alter the supply of highly priced grains and these markets should be the quickest to readjust. Metal supply is harder to change but isn’t facing the same near-term demand boon as a slowdown in China is reducing metal demand. This leaves oil and gas where there are few near term solutions, particularly for Europe. High oil prices have historically yielded higher supply. Prices above a $100 financed US shale production, Canadian oils sands and deep offshore rig activity. The current spike in energy prices undoubtedly cause a supply response. The pace of the response however is muddied by the longer-term shift in energy demand.


Recession alert

Central banks lack the tools necessary to contain supply driven inflation. They can however contain runaway inflation by stifling demand. Rising interest rates have already started to impact consumer demand, and UK and US retail sales have started to fall. US housing construction fell sharply in May as homebuilders adjusted to falling new home demand. Consumers through out the world face cost of living challenges and central banks further pressuring the propensity by increasing the cost of debt financing. Corporate profits are likely to come under pressure as economic growth starts to contract.


Being the ant:

At high tide the fish eat ants; at low tide the ants eat fish – Thai proverb

As the Federal Reserve wrestles with inflation, slows the global economy and quashes ebullient investor sentiment, it is important to recognise that expected returns are meaningfully higher in a wide variety of assets.


At the start of the year, we embraced the safety of the US dollar, removed emerging market exposures and reduced allocations to high yield debt. We maintained a shorter duration exposure to global and corporate bonds, helping portfolios weather the sell of in bonds. These steps have allowed portfolios to perform in line with broader benchmarks even as the falling tide has unearthed areas of weakness.


The fall in bond prices and the looming recession have caused a significant widening in credit spreads. US investment grade credit spreads are already wider than they were in 2018 and high yield spreads in Europe are at June 2020 levels. Forward looking returns for these assets, even adjusting for higher defaults, are consequently far more attractive.


We spent most of last week talking to fixed income managers about where they see opportunities in their asset class. The advantage of a forward-looking approach to investing is that you can deploy resources to where they can create the greatest impact.

By proactively reducing complexity and unintended sources of risk in portfolios we have given ourselves the ability to feast on higher expected returns over the next five years.

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