At the latest Crestone Investment Forum, held on 22 February 2022, we asked panelists to share their views on the likely path of markets and the global economy in 2022. Key issues focused on the likely persistence of inflation, whether central banks could manage inflation lower without damaging the economic recovery, and when fixed income assets would become attractive. Since the beginning of the year, risks have been intensifying. Inflation has been persistent, leading the market to accelerate pricing for interest rate hikes. And in the days following our forum, Russia invaded Ukraine, causing wild swings in equity markets in the immediate aftermath. Our panellists viewed the immediate few months as challenging and questioned the extent equity markets would be able to trend higher in the face of near-term headwinds. However, while the outlook was not without risk, centred around inflation, they were broadly constructive for the year ahead. As the world enters H2 2022, our panellists see a more supportive environment for risk assets, helped by strong, above-trend global growth and an expectation inflation would moderate. Four key themes emerged from the forum
How concerned should we be about persistent inflation?
In recent months, inflation has proved stickier than expected, and renewed upward pressure on inflation has added to the risk that central banks may accelerate tightening policy—or indeed, actively slow growth to contain price pressures. Understanding the panellists’ views with regards to inflation was key to framing the discussion. We asked how concerned they are about persistent inflation, at what level they see it normalising, and how they think central banks will balance rising inflation risk against the increased impact of rising interest rates on household leverage.
Scott Haslem, Chief Investment Officer at Crestone Wealth Management, opened the conversation, explaining that the global economy looks primed for ongoing, strong above-trend growth this year, even if it is a bit slower than last year’s recovery. Key drivers include the fading impact of the Omicron variant of COVID-19, consumers flush with cash, and production needing to respond to low inventories. Despite the likelihood of rising rates, he explained that monetary policy should remain accommodative, but this is not without risks.
“Some risks are geo-political in nature, but the other key risk is that central banks will need to do more than is currently priced into markets to lower inflation.”
Catherine LeGraw, asset allocation strategist at GMO, feels the persistence of inflation has been concerning. At GMO, they are most concerned about wages. She explained that, with rising wages, consumers would have more power to bid up prices, which can then drive wages even higher. This constant wage price spiral is the real risk for persistent ongoing inflation.
“If we see a wage price spiral then that could indicate we are in a more persistent episode of inflation.”
Bill Callanan, Chief Executive Officer at Syzygy Investment Advisory, believes inflation will persist and the US Federal Reserve (Fed) is significantly behind the curve. Agreeing with LeGraw’s view on wages, he feels we are clearly in a high-pressure economy where we have “gone from slack to all types of elements of constraints that are self-evident in the different pricing metrics”.
Callanan explained that the Fed initially held the view that inflation would be transitory, largely as the transition from goods to services continued and supply chains began to normalise. With US wage growth now rising at 10% nominally, he explained the pie is large enough to get very decent goods and services spending. The Fed also expected consumer goods spending to slow, but what it sees in its survey work is that capital goods can pick up a significant portion of that due to an increase in capital expenditure. He believes households and corporates have enough firepower to withstand tightening—together they hold over 85% of US GDP equivalent in cash, so there is a significant amount of ammunition to offset some of these inflationary pressures.
At what level will inflation normalise?
Keeping in mind the Fed’s long-term inflation target is 2% and we are currently seeing 5-7% prints, panellists were asked if 3% is what high long-term inflation looks like. LeGraw feels that inflation of 3% is a high figure when we have been close to zero for a decade. For GMO, the issue of inflation is a real concern and its portfolios are running with extremely low inflation risk. Callanan feels inflation will be higher than the Fed’s median forecast (approximately 2.5%) and will be a source of pressure. He feels there are limited ways this issue can be rectified—incremental supply substitution or demand destruction (but this will take time in a strong economy and would actually push inflation up).
Steven Watson, Portfolio Manager at Capital Group, is more relaxed on inflation. “Just a year or so ago we were never going to see inflation again. A number of people could not even imagine the US 10-year [bond yield] rising above 150 basis points. Now, the end of the pandemic is in sight and the global economy is restarting in a staggered manner.”
Watson explained that this has resulted in labour market disruptions and supply-chain difficulties. He feels current inflation has a strong transitory element to it, and there is significant disparity in rate hike expectations in the market. He suggested market participants may have become too relaxed last year and are perhaps now a little over-excited. Two things give Watson comfort: “Firstly, oil is nature’s interest rate and high prices could result in some slowing. Secondly, the yield curve is telling us we don’t have much to worry about.”
Ben Powell, BlackRock Investment Institute Chief APAC Strategist, sees supply as the main culprit. “If supply is the issue, you can raise rates as much as you like but that’s not going to immediately solve for ports congestion, for example. The two things are unrelated. You can destroy demand to achieve lower inflation, but that will cause consequences—some of which are less desirable and socially disharmonious.”
While there is regional disparity, Powell explained that the US has appeared notably fragile due to multiple decades of underinvestment in infrastructure and a tight labour market. Asia has not suffered from the same very high levels of inflation we are currently seeing in developed markets. The US has shown itself to be particularly vulnerable, given it is the world’s hyper-power.
How will central banks balance rising inflation with increased household leverage?
Callanan suggests there is now a different interest rate buffer and possibly less convexity to Fed rate hikes compared with any other time since the GFC—this is whether you look at it from the perspective of corporates or households. With record margins and very flush balance sheets, corporates are likely to be much less affected by rising rates over the next decade. In the US, 90% of household mortgages are fixed rate, which presents a different type of stock and flow issue for the mortgage and housing market. Household balance sheets are now in much better shape with a better starting point in terms of debt servicing costs. Interest costs as a percentage of debt servicing costs are low and wages are growing rapidly. Whether one adjusts debt servicing costs by CPI (consumer price index) or by wages, mortgage rates are now negative, which means the risks in terms of leverage are much less than in the post-GFC period.
Callanan explained that when you have real yields in the US at their lowest level since the 1970s, and an implied Fed funds forecast of 1.70% or 1.80%, market pricing is not that aggressive, given the persistence we are likely to see with inflation.
“Even if inflation is 2.5-3%, it would still leave the Fed with a negative real Fed funds rate, which wouldn’t be commensurate with neutral policy.”
While Powell agrees with Callanan’s comments, he sees two potential scenarios playing out—and with each scenario, there are those who would be negatively impacted. The first scenario concerns the effects of unemployment among minorities. He explained that, in the current socio-political climate, the Fed is extremely aware of the negative consequences of being excessively hawkish and how this could impact employment among minorities. In the second scenario, with the average maturity of Treasury debt being seven years, if rates were to rise to even 2.25%, interest expense would become the biggest line item for the US Government, and through the pandemic the Government has taken on a lot more debt. Powell feels that if the Fed were to hike rates aggressively, this would create a political issue with every government department ranking junior to interest expense (the latter being more relevant in a fiscal conversation).
The Crestone view: We believe that inflation globally will moderate into mid-year as supply-chain rigidities begin to ease. This should see interest rates continue to normalise at a moderate pace, supporting an above-trend growth outlook in 2022.
