Anthony Halls Head of Investments Mint Asset Management
In a stark case of ‘be careful what you wish for’, back in 2020 inflation was below central bankers target ranges, and they were asking their governments to loosen the fiscal purse strings to help get things going again. Fast forward to now and inflation around the world is above most central bank’s target ranges, and is at levels not seen for many years.
The rapid rise in inflation through 2021 caused global interest rates to rise from their lows, and rotation within equity markets from long dated growth stocks to cyclical stocks. So, will this continue in 2022?
The short answer is Yes, but not to the same extent. In the USA, the price indices for all the main broad categories increased and came in above expectations on both month-on-month and annual measures. US CPI is at a 39-year high, with analogous levels across most developed economies. The momentum of price increases is strong into the New Year and is becoming increasingly broad based.
A confluence of factors have combined to drive up inflation – some of them transitory and some of them not. To the extent the causes are transitory, then inflation should dissipate going forward. This was the great market debate of 2021. Initially, policy makers welcomed the advent of some inflation. Central bankers were deliberately slow to react, wanting to cement in an economic recovery from the pandemic; and there was a fairly widespread view that most of the inflation is transitory – caused by temporary demand swings, easy monetary policy and fiscal spending. The view was that the end of the pandemic would remove the transitory factors. This may well prove to be the case, but the pandemic isn’t over and the extending time of the ‘transitory’ factors and especially the broadening signs of inflation and inflation expectations is pushing central bankers to tighten monetary policy.
There used to be three major factors depressing inflation – central bank mandates, globalisation, and the tech revolution. These factors have been reversing course in the last couple of years. With inflation (in 2020) below central bank mandates, monetary policy was not a depressant and conversely was trying to stimulate inflation. The globalisation pendulum had swung with the rise of trade nationalism in the USA and China, and the tech revolution is a slower burner these days – more an evolution than a revolution.
So, the stage was set for a bounce back in inflation. All we needed was a catalyst. As it happened we got two major catalysts: Covid (hopefully transitory) and Climate change (not transitory).
Covid had struck and politicians had heard the siren call of the central bankers to spend – and the tax payers’ cheque book took a hammering [note to young people: until recently, cheques were a form of promissory note written by people to buy things instead of using cards/afterpay/bitcoin]. Covid related support has meant that, in aggregate, there is plenty of income circulating in the world economy looking for a place to be spent.
Beyond the monetary and fiscal responses, Covid also had another profound effect – borders closed, labour flexibility and movement were constrained, and there were supply chain disruptions and shortages. At the same time, demand did not fall (thanks to, some extent, the monetary and fiscal efforts) and demand switched from services to goods – instead of tourism, people spent on wine, cars, home improvements, more wine. So, just when the supply of goods was disrupted, demand for goods went up and we had a Covid induced inflation impulse. As the world learns to live with Covid, some degree of normality will return and the supply shortages will be gradually resolved - gradually. Some of the demand for goods will swing back to services. This is the transitory bit and we think this will be a headwind for inflation later in 2022 as early signs are indicating this is already underway.
Climate change, or the world’s stop-start efforts to combat global warming, is the other major catalyst that is happening at the same time. The topic is far too large to cover in this note, but the simple equation is developed nations around the world – in various guises and at different paces – are imposing a price on carbon to incentivise a reduction in carbon emissions. In effect, we are trying to switch from a cheap and efficient energy source (fossil fuels) to a less cheap and less efficient energy source (wind/solar). Therefore the cost of energy is going up – just ask any European about their energy bills this winter. These policies are aimed at constraining global warming over the next several decades – this is not transitory.
The two drivers of inflation though have combined into an over-heated inflation rate in 2021. This is broadening out into most sectors of the economy, and into inflation expectations. With labour mobility still constrained and most people facing rapid cost-of-living increases, we expect wage inflation to step up. In effect, the inflation baton will pass from supply chain bottlenecks to more familiar sources like tight labour markets, rising wages and higher housing and energy costs.
We think central bankers will continue tightening monetary policy into the first half of 2022 and then (if we are right) evidence of a slower rate of inflation should become clear mid year. We also think the market has already priced in the likely extent of central bank tightening – at least in NZ. To be clear, we do not believe inflation is going back down, we just think it won’t go up as fast as it did in 2021 (and by inference, we believe the market is pricing in a faster clip of inflation in 2022 than we think will happen).
Global markets are starting 2022 with a bit of a wobble – inflation is high, labour markets are tightening, Omicron is raising questions over economic growth, fiscal stimulus is receding, and monetary policy is tightening. Our central case is that the rate of inflation recedes back inside central bankers’ ranges mid-year, and the monetary tightening phase will top out at much lower levels than historically (and lower levels than currently priced) – but that is six months away.
What does this mean for our funds?
Well, for a start, Cash is not a great place to be in this environment. It may work as a place to hide for a few weeks but not for any length of time. Real interest rates (the nominal interest rate minus the rate of inflation) remain negative and are likely to remain so despite rising nominal rates currently – traditionally, one of the easiest policy ways of dealing with an over-geared fiscal balance sheet is to inflate the problem away. So, we think real interest rates will remain negative and the buying power of Cash, therefore, is reducing – i.e. Cash has a negative relative return expectation. None of our funds have a large Cash weight.
The diversified funds owned very little bonds (relative to their strategic asset allocation - SAA) at the start of 2021. By the end of the year, both funds had increased their bond holdings (at the expense of cash), taking advantage of the sell-off in NZ bonds in October. Bonds remain under the SAA as, while they are cheaper than they were and we think NZ rates particularly have gone too far too soon, bonds are still not at attractive enough levels over the medium term. We think other assets will out-perform bonds, so the diversified funds remain well invested in domestic and global equities and property.
Within equities, a rising interest rate and high inflationary environment tends to favour cyclical stocks (I.e. the economy must be good if there is inflation… in theory) and tends not to favour yield stocks (rising rates means competition for investment dollars that might otherwise go into yield stocks) and, crucially, is negative for long-dated growth stocks (the value of a dollar now is greater than the value of a promised dollar later). Hence, cyclical stocks have been more in favour lately than growth stocks. We think that continues for the next couple of months and then, if we are right in our central case that inflation dissipates mid-year, there will be a reversion first to higher quality / stronger balance sheet stocks and then to growth stocks, when interest rates top out at still historically low levels.
Our trans-Tasman funds have had relatively low exposure to yield sensitives sectors; and a greater than normal exposure to cyclicals. We have been adding to our REITs and reducing our materials exposures a little. One of the old truisms of a relatively high inflation environment is the value of cash goes down relative to the value of ‘real’ assets. Hence, now that interest rates have re-priced higher, REITs may well be a good place to be.
Disclaimer: Anthony Halls is Head of Investments at Mint Asset Management Limited. The above article is intended to provide information and does not purport to give investment advice.
Mint Asset Management is the issuer of the Mint Asset Management Funds. Download a copy of the product disclosure statement.
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