John Leiper – Chief Investment Officer – 1st September 2020
In a speech for the history books, last week Fed chairman Jerome Powell announced a significant change to the way it conducts monetary policy by formally announcing ‘average inflation targeting’. This means the Fed will now allow inflation to overshoot its official 2% target to compensate for prior years where inflation failed to reach that level.
This feels like a key moment, a bookend to the Paul Volcker years which were characterised by the Fed’s commitment, in the early 1980s, to beat inflation at any cost, even if that meant causing a recession and lower employment in the process. In contrast, Jerome Powell has the opposite problem in that he needs to stimulate demand and increase inflation whilst credibly promising not to raise interest rates in the process.
Having established that the Fed will now ‘allow’ inflation to run above 2%, the question is how it plans to do so. Since the sub-prime crisis, and a decade of unprecedented and unconventional monetary policy, the Fed has demonstrated its ability to drive asset prices higher across financial markets, but inflation in the real economy has remained stubbornly subdued. This is demonstrated in the chart below which shows the Fed’s preferred measure of inflation.
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We believe ‘this time it’s different’ because prior attempts to stimulate the economy, via successive rounds of quantitative easing, have typically been accompanied by government austerity. This meant QE was more of an asset swap between central banks and the market which never found its way into the real economy. However, due to the COVID-19 shock this is no longer the case. Politically, governments are now far more willing to resort to aggressive fiscal policy and this means QE, in 2020 and beyond, could prove far more inflationary than historic precedent suggests purely by its interaction with this new fiscal landscape.
As a result, Powell’s speech can be seen as the klaxon for a potential new phase in the macroeconomic cycle, one that mirrors the Volcker pivot of the early 1980s. If we do see a return to inflation (the jury is out) this should benefit real assets, such as equities and commodities, over nominal fixed income securities such as government bonds. The funds are currently positioned for this outcome.
Within fixed income, we remain overweight inflation-protected securities which rose slightly following Powell’s speech. This position has performed extremely well, in part due to the strongest monthly inflows into TIPS ETFs since 2016, as investors seek cost effective ways to hedge against potential future inflation. However, with elevated positioning and market-implied inflation expectations rising towards the pre-pandemic high of 2%, further gains will increasingly depend on signs of progress in the real economy.
Given the importance of a strong underlying economy, it is interesting to note that financial conditions are actually tighter now than before the start of the crisis (see Room To Run). This means more stimulus is required to bring about a stronger economy and the higher required inflation. This might ordinarily be achieved via short term interest rates but with yields already close to zero there isn’t much room to fall without going negative, which is something the Fed has ruled out. Easing financial conditions via lower longer-term rates is also somewhat problematic as this would undermine banks and their ability to provide credit to the economy. Given the sheer volume of pending Treasury issuance, to pay for the coronavirus rescue packages, we believe long-term rates will actually drift higher over time.
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We have seen evidence of this recently in term premiums, which is the compensation investors require for holding long term bonds. Typically, term premiums move in line with inflation expectations, but this relationship broke down over the last few months with premiums moving in closer lockstep with the number of coronavirus infections. However, premiums now appear to be closing the gap, like they did in late 2019, which points to rising yields. We believe this move will be gradual and remain positioned for a further steepening of the curve. However, if yields back-up too far too fast, tightening financial conditions in the process, then we expect the Fed to step in with some form of yield curve control, despite recent comments to the contrary.
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With little room for manoeuvre in rates, and credit spreads relatively tight, we think the best mechanism through which the Fed can ease financial conditions is the US dollar. The direction of the dollar is important for asset allocation decisions and if we are truly at the beginning of a new weakening cycle then this implies the record outperformance of US equities relative to the rest of the word could be coming to an end. The funds are positioned for this outcome, which is not yet reflected in market prices, via an underweight allocation to US equities. Within the US we retain exposure to the technology sector and in equities generally we like quality companies with resilient pricing power.
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Thus far the dollar weakness story has been about other developed market currencies, notably the euro which has risen towards 1.20 and sterling which recently reached a 2-year high above 1.33. Meanwhile, emerging market currencies have lagged their developed market currency peers, by about -14% versus the US dollar. We think there is considerable scope to catch-up, particularly if the coronavirus starts to fade in those countries that have been hardest hit, and as such we retain our overweight allocation to unhedged emerging market equities.
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Finally, we continue to like commodities which should also do well in an environment of higher inflation and US dollar weakness. I’ve written extensively on this in the past so instead of covering in any great detail here I thought I’d just make passing reference to Warren Buffett’s recent decision to buy gold miner Barrick Gold as well as five of Japan’s leading trading companies which provides broad exposure to global commodity prices. Our commodity carve-out has performed very well over the last few months and is currently comprised of gold, silver, copper and coffee.
To summarise, following announcement of the Fed’s new approach to monetary policy, interest rates are likely to stay low for longer and we expect to see higher inflation over time. We will likely see additional fiscal and monetary stimulus with easing financial conditions primarily achieved via a weaker US dollar. This sets the scene for a new stage in the macroeconomic cycle which should benefit equities and real assets over fixed income securities. The key risks to this outlook include a resurgence in the virus, competitive currency devaluations or failure to generate a meaningful economic recovery that causes investors to question whether the considerable faith they have put in governments and central banks to see us through the crisis was truly warranted.
This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.
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