Combatting inflationary pressures in the post-pandemic recovery
16 June 2022
A challenging start to the year
Since the start of the year and in particular since the end of March, equities have suffered from the removal of monetary stimulus and forward guidance regarding rate rises to combat inflationary pressures in the post-pandemic recovery. Combining the monetary policy tightening with the war in Ukraine and the effect from China’s COVID-zero policies has seen equities selling off alongside bonds.
June has seen a further sell-off across equity markets. The release of U.S. May inflation figures on 10 June has been the primary catalyst for this sell-off. This was accompanied by a surge of professional investors getting out of the way of the Federal Reserve’s expected tightening. Many fund managers (hedge funds, quant-driven strategies, momentum driven strategies, etc) have reduced their equity exposures to the bare minimums. Data from Deutsche Bank AG shows equity exposures at two standard deviations below average levels.
Monetary policy updates (15.06.2022)
The week ending 10 June culminated in one of the worst weeks for U.S. inflation since COVID, with the headline CPI print in May setting a new 40-year high of 8.6% YOY. Added to this was a 0.3% increase in the long-term inflation expectations in the University of Michigan survey, which now stands at 3.3%, the highest level since mid-2008. The survey also noted an increase in the short-term (1-year) expectations, which now stands at 5.4%.
At the 15 June meeting, the U.S. Federal Reserve delivered a 75-bps increase in interest rates. Noting the above, Federal Reserve Chairman, Jerome Powel, said, “one of the factors in our deciding to move ahead with 75 basis points today was what we saw in the inflation expectations”. As per the forecasts from US policy makers, rates in the United States are expected to rise to 3.4% by December 2022.
In Europe, the European Central bank (ECB) has also taken a hawkish stance in the face of stubbornly high inflation, signalling a ~25-bps rate hike for their July meeting. According to ECB’s forward guidance, the current rate of -0.50% could be back above zero by September 2022.
At home, the Reserve Bank of Australia (RBA) began tightening with a 50-bps rate increase at their June meeting, raising our cash rate to 85-bps. Governor Lowe noted the rise in inflation and the resilience of the domestic economy, not least the labour market, as reasons why the pandemic era emergency monetary policy is no longer required.
The Australian markets are pricing in aggressive rate hikes leading to a terminal rate of 3.15% by December 2022. However, the RBA policy statement following the meeting struck a less aggressive tone, referring to uncertainties around the future path of consumer spending and the expected fading of inflationary impulses from high global commodity prices. We acknowledge that RBA’s stance could change over the coming months as we have witnessed over the last six months.
What is driving inflation
Current inflation dynamics appear to be different from those observed over the previous 30 years. Inflation typically results from an excess of demand over a limited amount of supply. In most cases since the early 1990’s, excessive demand has driven inflation. In contrast, in the current cycle, we are not seeing abnormally high demand, but rather supply that is uncharacteristically low and disrupted.
Change in US PCE* and euro inflation, 2022 v 2015-19 average
*PCE - the personal consumption expenditure price index (PCEPI) is one measure of U.S. inflation, tracking the change in prices of goods and services purchased by consumers throughout the economy. This is the preferred measure of inflation for the Federal Reserve.
We have seen significant supply constraints, such as a tight labour market and supply chain snarls, that will take time to resolve as the economy works its way through several major shocks (i.e., the pandemic, inflation, China’s COVID policies and the war in Ukraine).
When inflation is caused by supply factors, central banks face a very difficult choice of either slowing growth with higher rates or learning to live with more persistent inflation. Striking a balance between the two is ideal. The biggest risk is that the Federal Reserve, ECB, and other central banks fail to navigate the above trade-off and raise interest rates to levels that destroy growth and jobs, ending in a hard landing resulting in recession.
We expect continued increases in interest rates (refer expected rates in the monetary policy update section) in the short-term as central banks work to bring inflation under control and within acceptable ranges.
At the same time, the drivers of inflation (supply side factors) that we are experiencing may persist for some time, as a number of factors, including the tragic war in Ukraine, China’s COVID policies, clogged supply chains, and a tight labour market, make a quick resolution more difficult to obtain. As central banks work to bring inflation under control, we expect continued volatility across markets and asset classes. This will bring both risks and opportunities, which the Findex investment team and investment committee will continue to monitor and address.
Given this backdrop, it is important to remember that we are long-term investors with a disciplined and rigorous approach to portfolio management. This includes our Strategic Asset Allocation (SAA) framework supported by State Street.
New SAAs were approved in the February 2022 Investment Committee Meeting in light of significant changes in the macro environment including higher inflation and central bank tightening.
New SAAs also acknowledge the current low return environment across the asset classes.
We have been moving towards these allocations since February 2022.
Additionally, our MDA portfolios employ a Tactical Asset Allocation (TAA) framework.
The TAA review is a quarterly investment process which seeks to identify tactical market risks and opportunities. State Street consults on both the TAA and SAA components and brings significant expertise, resources and tools to bear.
The Findex investment team, Findex investment committee and our consultants stand ready to adjust portfolios as required.
While all reasonable care is taken in the preparation of the material in this document, to the extent allowed by legislation, Findex accepts no liability whatsoever for reliance on it. All opinions, conclusions, forecasts or recommendations are reasonably held at the time of compilation but are subject to change without notice. Findex assumes no obligation to update this material after it has been issued. You should seek professional advice before acting on any material.