Given our experience with inflation over the past two years, we are all now primed – psychologically and behaviourally – to anticipate it. So the inflationary tinder will catch alight much more easily next time conditions are conducive.
This inflationary dynamic will be unique in one important respect. It will be like the 1960s-1970s inflationary dynamic but in reverse: this big initial inflation wave will be followed by waves which are successively smaller but on a rising trend.
We are also likely to see more currency crises. As the UK’s experience shows, currencies will be punished hard when policies are out of synch with US policy and domestic inflation trends.
So the dollar is key to policymaking. If you are a true sovereign – ie control your own printing presses – and the dollar is in a weakening trend, fiscal policy will be an effective means of stimulating the economy with less risk of stress on your currency and bonds. Unfortunately, the Truss government failed to recognise this timing aspect of its growth policy.
In summary, liquidity dynamics are the key driver of the next leg of our inflation volatility thesis. But it is the lens of inflation volatility which should shape portfolio management strategy. So the autopilot stays off. Investors will have to remain active in their asset allocation, imaginative in the tools they use and mindful of a new regime which is corrosive to passively held wealth.
“For investors, it means another year when portfolios, like Tesla cars, can’t be fully self-driving.”
WE STARTED SINGING BYE-BYE, MISS AMERICAN PIE
Last year, capital preservation became a much higher hurdle.
The inflation punch was hard, forcing the Fed to abandon its transitory framework and consider a new regime where supply shocks are a recurrent feature of the landscape.
So rising interest rates did the damage in 2022. The music died for the 60:40 investment paradigm, built on a system dynamic which was biased towards disinflation but is shifting to one biased towards inflation.
A lot of other hope in markets died too, as a western financial system wired for zero interest rates confronted US rates at 4.5%-5%. In a face-off between inflation and the wiring of hyper-financialisation, the latter will prevail. Falling inflation in 2023 will be the product. Whether this is supportive for markets will depend on the interplay of liquidity and fundamentals. The $2 trillion in the Fed’s RRP facility means ample liquidity is available to the system, but it can easily get trapped in that facility.
We are in a transition from peak interest rate volatility – as the market gets confident about the upper limit on US interest rates – to uncertainty over how long peak restrictiveness lasts.
The first phase of this is bullish for risky assets: declining volatility drives money back into markets, improving price trends, which triggers repositioning buying by trend following investors. In this phase, the market can dream about a Goldilocks narrative for 2023: not too hot on the inflation front for the Fed; not too cold for the nominal economy and corporate earnings; just right for risky assets.
Once this repositioning has happened, though, the dynamics of liquidity – proxied by commercial banks’ reserves at the Fed – are likely to reflect ongoing QT and the need for markets to price in interest rates remaining at peak restrictiveness for longer than currently expected. In short, liquidity headwinds are likely to reassert themselves.
For equities and credit, a positive outlook relies on a Fed pivot, not a Fed pause. Only continued disinflationary surprises could bend the Fed towards the market’s expectations of rate cuts in the second half of 2023. In hyper-financialised markets, cheap money matters more than profits; but profits still matter. Expecting Goldilocks seems a triumph of hope over realism.
More generally, equities and other risky assets face an asset allocation headwind. For investors seeking a nominal return, bonds now offer a risk-free alternative. This should result in a lower allocation to risky assets.
For bonds, tightening liquidity could provoke stresses in the treasury market as risky assets sell off. This would probably result in policy intervention. Conversely, if the data is surprisingly disinflationary, bonds will continue to rally. So, while there might be more volatility ahead, 2023 should ultimately be a good year for bonds.
For investors, it means another year when portfolios, like Tesla cars, can’t be fully self-driving. The terrain ahead will change with the interplay between liquidity and fundamentals, and impactful global developments could dash into the road at any time. Not a journey to be undertaken with passive vehicles.
In the end, wealth is getting reallocated as asset markets reorientate to the new regime.6
Bye-bye, Miss American Pie. ●
6 This article was drafted in late 2022
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