Market Thinking

making sense of the narrative

Has Inflation Peaked?

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One of the most important questions facing investors is not inflation per se, but perceptions of inflation. The Fed is focused on inflation expectations in setting wages, while markets are focussed on the Fed’s perceptions of those expectations and the extent to which the Fed is actually looking at the wealth effect not just in terms of the S&P500, but also in terms of the distress already happening in 60:40 and other target date retirement funds, where the drawdown year to date is in double digits.

Amidst all the blood and thunder in markets generally it is interesting to observe that the US 10 year bond is now flat for the month, while the US 2 year has actually rallied a little. Indications of market inflation expectations like the breakeven inflation indices or the OIS Inflation swaps also appear to be recovering, leading us to question whether inflation has peaked? Or perhaps more importantly, have perceptions about inflation (and perceptions of those perceptions) peaked?

There is a circularity between narratives and markets; when a market starts to move it is usually deemed to be on the basis of a ‘fundamental’ based narrative, and the more it moves, the more ‘true’ the narrative is determined to be. Thus as waves of selling started to hit Bond Markets at the start of this year (something we discussed at the time in our series of posts on four problems and a solution (the Real Problem with Bonds) the narrative on inflation was deemed to be not only the cause, but also to be proven by moves in the bond markets. A kind of market logical fallacy; bonds don’t like inflation, bonds have gone down more, therefore there must be more inflation. This is of course only partially true, but to be consistent it does mean that , now certain aspects of the Bond markets are stabilising, as well as the actual evidence from the fundamentals starting to suggest that inflation may not be as runaway as some had claimed, there is a prospect of markets starting to decide that inflation is ‘getting better’.

The chart below, from Goldman Sachs is a good exposition of the likely path of US Core Personal Consumers’ Expenditure inflation and in particular the cause and effect of what they refer to as “Supply Constrained Durable goods” – essentially the effect on supply chains of Zero Covid and Zero Carbon policies (albeit being blamed on Ukraine).

Chart 1. Base effects to bring core PCE inflation down

If there is a perception that inflation has peaked, then it will likely be followed by a perception that the Fed will hold back and not continue to tighten monetary conditions so aggressively. This then will likely trigger a short covering rally in markets and some extension of ‘duration’, both in bonds and equities. The important point is that changing perceptions on inflation could very well be triggered by, for example, value investors putting money into Bonds, rather than any real world information.

Wealth Effects – the problems hitting 60:40

There is another important issue here which concerns the Wealth Effect – something the Fed was believed to be targeting under QE and which now it seems they may be targeting in the other direction – the Fed put being replaced by the Fed selling calls. The most important place to look here is probably pension funds, especially the dominant structures of Target Date funds. These steadily increase exposure to bonds as the investor gets closer to retirement, but the selloff in bond markets means that the value of most funds has been hit very hard this year. The chart shows the total return index for the Morningstar benchmark Moderate Risk Index – essentially a 60:40 fund. A very comfortable annualised equivalent of 6.5% over the last 5 years, even allowing for the 2020 drawdown (and very similar over the last 10 years).

However, as we highlighted in our January articles (Four Problems and a Solution) the poor prospects for bonds were going to make it very difficult for 60:40 funds and as can also be seen from chart 2, year to date the index is down 14%, even greater than the drawdown in 2020. If the Fed takes Pension Fund wealth into account for its wealth effect, then it has already done far more than it needs to.

Chart 2: Balanced accounts struggling

As we noted in May Market Thinking, with short dated bond yields over 2.5%, the argument that There Is No Alternative (TINA) to equities will come under some challenge, especially as balance sheets are being shrunk and long term investors are happy to sit on the sidelines in bonds rather than low or even negative yielding cash – and certainly not Bitcoin!

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