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After a year of rapidly rising inflation and rate hikes, current market consensus appears to assume that central banks are close to having engineered a safe landing that would allow a return to a Goldilocks scenario of low inflation and healthy growth. However, several of the lead signals our macro strategists monitor point to an alternative narrative in which global growth and inflation may be bottoming out and central banks could be forced to undertake more tightening than markets anticipate. This growing risk of a false landing fits into a wider picture of greater uncertainty and volatility. Research by our macro strategists suggests that we have entered a very different economic era, with structurally higher inflation, frequent cycles and more pronounced country and idiosyncratic risk. We brought together two seasoned practitioners, lead Macro Strategist John Butler and senior macro investor Mark Sullivan to discuss the new regime and its key investment implications.
John: The last 20 to 25 years have been highly unusual as factors such as the globalisation of labour and supply chains as well as the free movement of capital created an environment where correlations between assets were broadly constant and inflation was low and stable. Now, some of these forces have stalled or even reversed, meaning we are likely to witness a return to more pronounced and complete cycles.
Mark: From an investment perspective, this greater uncertainty and differentiation between countries and assets translates into sizeable new risks, with a much wider distribution of potential outcomes but also a larger macro opportunity set to take advantage of.
John: In effect, we are moving away from a regime where a muted inflation response gave central banks the comfort that their stimulative actions would not overheat the economy. Now, we are going back to a pattern of high growth leading to high inflation, which in turn necessitates significant demand destruction to bring inflation back down to target.
We think that the current tightening may be insufficient to get inflation down sustainably and that the cycle may be more resilient than expected. We are already starting to see a bottoming out of growth and inflation, meaning central banks will have to tighten more than they may have anticipated or are ultimately willing to do. While markets have started to show some signs of acknowledging the potential for further rate hikes, market consensus still appears to be banking on a rapid end of the tightening cycle, meaning we could see renewed cyclical volatility as data starts to contradict that narrative.
John: While the growth in headline inflation is currently abating, our research suggests that the structural underpinnings of higher inflation run deep. This ranges from the need for many governments to spend more in areas such as defence, energy transition and income inequality as well as a willingness to use public balance sheets to dampen the impact of shocks.
Labour markets are another critical factor to watch. There is some evidence to suggest that labour markets and wages may have become less responsive to downturns. If true, inflation may well come down, as we are observing now, but it may trough at higher levels and become more volatile.
More volatile inflation (and cycles) also means more volatile interest rates because central banks will have less visibility on turning points in the cycle and exaggerate downturns and upturns.
John: Growth data, and particularly the leads provided by purchasing managers’ indices, are crucial to watch during the coming months as several macro paths could combine to lift global growth again. In the US, the consumer slowdown to date has been gradual, with the combination of improved incomes and remaining savings providing residual support. We also think that the positive demand shock of China’s reopening will be larger than many forecasters currently assume. Japan is also likely to enjoy strong nominal growth as monetary policy remains ultra-loose despite mounting evidence of wage pressures. European growth could also surprise on the upside as energy pressures have moderated and monetary and fiscal policy remain largely accommodative. At a more fundamental level, our non-consensus view is that a shift in Germany’s attitude towards fiscal policy and greater EU coordination create the conditions for Europe to have a self-sustained cycle and generate inflation.
Mark: One of the things we talk a lot about in our team is whether we see alignment between how central banks and markets are positioned structurally and the cycle, as we often see the most significant moves in asset prices when they disconnect. We saw this lack of alignment in play early last year and while most central banks have now reorientated their policies, it is interesting that at the first sign of inflation peaking, the US Federal Reserve and other central banks appeared ready to take their foot off the accelerator. In parallel, investors are still looking to replicate the old model of “buy on the last rate hike”. In our daily Wellington meetings and investor discussions, John and colleagues have been highlighting the risks for asset prices associated with this behavioural anchoring, so we are very alert to those dynamics.
John: Ultimately, we think central banks — many of which have accumulated multiple alternative objectives — will shy away from the demand destruction needed to bring inflation below target. Moreover, we believe that the new regime may introduce a greater risk of financial instability, and a central bank will always prioritise financial stability over inflation targets.
Mark: I think the implications are profound. The old regime, where investors were rewarded for being long in nearly any given any asset class, is now over. As an investor, I want to deliver return streams to clients that do not entail taking a systematic bias or factor bias and ideally provide exposure that diversifies risk within a portfolio. To do that successfully in the new regime involves, in my view, a much higher degree of dimensionality and diversification and, in our portfolio, we really focus on assessing dimensionality/diversification potential. This is now even more important but also much harder to achieve.
John: Our work suggests that the trend towards lower term premia was closely linked to exceptionally high levels of central bank liquidity combined with the free movement of capital and big excess savings globally. Now, we think all these factors are going into reverse. Over time this is likely to cause potentially sizeable upward moves in term premia.
Mark: Concentration risk is a key concern that keeps me up at night in this environment. More broadly, doing good research has certainly become more valuable, but it’s also harder to forecast and keep your research up to date. This is also true for central banks and fiscal authorities. Therefore, they won’t always get it right. As more liquidity gets removed, we will also see new vulnerabilities emerge. I also worry about the large number of potential geopolitical surprises. We think it is important to try to map these, as we do with the help of our geopolitical strategists. From my perspective, these are all further reasons for having a high degree of dimensionality and diversification in your portfolio and being active rather than reactive.
John: I think a key risk is that the market still largely operates on the assumption that we will eventually go back to a world of low and stable rates. As we saw in the UK last year, when these assumptions get tested, it can have severe consequences. Japan is probably the market where those assumptions are the most deeply embedded and therefore the most vulnerable to such a shock. The way the Bank of Japan manages its exit from its yield curve control regime is therefore a critical area to watch, particularly given Japan’s global role as a provider of liquidity and capital. We are also closely monitoring the more vulnerable sovereigns, which include some of the smaller open economies with highly levered housing markets.
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