Inflation – no easy answers

Fahad Hassan, CIO

The last few weeks have seen a reset of inflation expectations, as the US and Israel entered a conflict with Iran. The Strait of Hormuz, a narrow body of water responsible for 20% of the world’s seaborne oil supply, is effectively closed. Oil prices are materially higher and could go much higher still. Natural gas, a key input into fertiliser production, has seen a large jump in price, which in turn is causing an increase in food prices.  

Like in 2022, governments have limited options on how to address the cost-of-living impact consumers will face in the coming months. The playbook from 2022 is a useful way to think about portfolio construction and risk mitigation. 

Duration becomes dangerous 

The biggest lesson asset allocators learnt in 2022 was that bonds can keep you up at night. The sharp and persistent move in yields during that year wreaked havoc with multi-asset portfolios. Supposedly safe assets, like government bonds, were amongst the hardest hit. UK gilts fell 30% and have only recouped a third of those losses in the last three years. Inflation-linked bonds, another favourite of private client portfolios, fell 45% as rising yields more than offset the benefits these bonds garnered from higher inflation.  

Duration is a measure of how sensitive a bond's price is to a change in yields. All things equal, the longer the life of a bond, the greater its duration. Higher quality issuers such as governments and large profitable companies (investment grade) tend to issue longer dated bonds as it provides them with greater flexibility.  

These bonds have low to no risk of default, but through duration, they expose investors to large risks from changes in yields. Yields are highly sensitive to inflation rates and are the main gauge for fixed income investors when committing their savings. While the coupon of a bond is fixed at the time of issuance, its yield varies to compensate investors for the risk of inflation or default.  

While bond yields today are higher than they were at the start of 2022, they were clearly mis-priced for a sudden increase in oil prices. Two-year gilts started the year yielding 3.7% and now yield 4.2%. 10-year gilts were yielding 4.5% and now yield 4.8%. The dramatic move in shorter dated yields reflects a reassessment of the ability of the Bank of England to cut policy rates.  

The rapid move in government bond yields has knock on consequences for economic growth through higher borrowing costs for corporates and households. While the UK government may reluctantly find a way to help some consumers, it will not be able to protect the broader economy from the impact of higher interest costs.  

Cyclicals and small caps suffer 

One clear message from 2022 was how ill-equipped some cyclical and smaller businesses were for higher input costs. Not only did they not have pass-through provisions in their contracts, but they also suffered from a decline in revenues as consumers cut back on orders. The double impact of falling revenues and margins was dreadful for these companies and their profits collapsed. Many small businesses, unlike investment grade issuers, use bank loans or floating-rate debt to finance themselves. The cost of this debt resets very quickly and burdens smaller companies at their weakest point. While lenders can provide loan extensions or temporary waivers, smaller companies are often forced to sell prized assets and layoff key staff. High inflation exposes all the vulnerabilities of a small business at once. 

Liquidity matters 

It’s only when the tide goes out, that one realises who is swimming naked. We saw this in 2022, as property funds were shuttered. We have recently started to see private credit funds restrict client withdrawals from funds. This began before the start of the war in Iran. As interest rates rise and risk appetite dwindles, we should expect the situation in private credit, private equity and property to deteriorate. Like bonds, illiquid assets are hurt by a rise in the cost of borrowing.  

The “R” word 

This is where things get a bit more nuanced. While the rise in yields and inflation in 2022 impacted economic growth and asset markets, in the end the broader global economy didn’t go into recession. Default rates and unemployment only rose slightly, and through fiscal support and belt tightening, developed economies were able to recover. Emerging markets suffered bigger setbacks and have only recently regained a firmer footing.  

Corporate earnings in the US fell by 5%, one of the smallest peak-to-trough declines in profits ever seen. Credit spreads recovered sharply in 2023 and “Teflon Capitalism” became a talking point for market participants, stung by de-risking tendencies. 

The remarkable resilience of markets in the last three weeks in the face of ever-higher energy prices is rooted in this final lesson from 2022. Businesses and households coped with a radical shift in costs with remarkable ease and any setback in economic growth was short lived. I find this to be a dangerous premise, as it is rooted in post-hoc fallacy.  

“Together, creeping determinism and sampling bias lead common sense explanations to suffer from what is called the post-hoc fallacy.” 

― Duncan J. Watts, Everything is Obvious: Once You Know the Answer 

Creeping determinism means that we pay less attention than we should to the things that don’t happen. Just because we didn’t have a recession from the war in Ukraine, this isn’t a sufficient reason to conclude that a recession will not result from the war in Iran. Corporate balance sheets and by extension household resilience may have been far stronger in 2022 than it is currently. Even before the war started, we were seeing a slowdown in the hiring of new workers. Defaults in private credit were starting to go up. While these events alone may not be recessionary, they can quickly become concerning if higher energy costs and interest rates start to impact economic growth. 

It is important to recognise that recent events have meaningfully altered the odds of negative outcomes for bonds, smaller companies and less liquid assets. While a recession isn’t a foregone conclusion, we mustn’t ignore this possibility based on recency bias. Asset allocation should always reflect the latest data and aim to steer client assets away from the sources of greatest danger.