Among the key concerns investors are grappling with is the risk of higher inflation, particularly in the US.
The narrative is easily understood. Ultra-loose monetary policy combined with fiscal largesse and a rapid re-opening of economies could result in a lot of newly created money chasing too few goods.
Add in the Federal Reserve’s average inflation targeting policy (which should see rates lower for longer), higher commodity prices and supply chain issues (already appearing in some purchasing managers' index surveys) and inflation seems the plausible outcome of this demand-supply imbalance.
Market measures have already started to price in higher levels of inflation. The US 10-year breakeven rate is currently hovering around 2.40 per cent. Investors would need to go back to 2012 to find a higher level on this measure. Then, like now, the world was in the early to middle stage of economic recovery (in 2012 it followed both the global financial crisis and the European sovereign debt crisis). Similar to today, market participants anticipated that increasing global growth coupled with low interest rates would eventually push inflation rates higher.
As we know, higher inflation rates failed to materialise in 2012. Will that pattern repeat in the post-pandemic recovery?
Certainly shorter-term expectations are moving higher. According to the New York Fed’s Survey of Consumer Expectations, the median one-year and three-year expected inflation rate rose to 3.24 per cent and 3.09 per cent, respectively, the highest since 2014. We would argue that short-term inflation expectations will be driven by base effects, re-opening and temporary supply chain disruptions.
Some longer-term inflation expectations, such as the University of Michigan 5-10 year measure, have been fairly steady and have actually moved a little lower in the past month. Price inputs or PPI have started to rise, but their correlation with core inflation has been weak.
Trends such as aging demographics and the widespread adoption of technology in the Covid-19 crisis (including the seemingly relentless rise of online shopping) are powerful long-term disinflationary forces. As work-from-home becomes more prevalent, new entrants into some sectors of the workforce could reduce the already limited wage bargaining power of existing employees. If rotational and flexible working truly takes hold, it may be that fewer people will need to live in or near London, New York, Paris or Frankfurt in order to work for employers based in those cities.
Our multi-asset portfolios are underweight government bonds, but we think the move to higher yields will likely be driven by the real yield rather than the inflation component. Real yields in the US remain in negative territory. And even if real yields move back to zero, as growth accelerates financial conditions would remain highly accommodative. In short, we see Treasury yields moving higher for the ‘right’ reasons – a higher growth backdrop which should also be a good environment for risk assets.
Finally, we think it unlikely that yields will be pushed up by any imminent Fed tightening. It’s hard to disagree with the Fed’s own assessment that the firstrate hike will not come until the very end of 2023 or the start of 2024, following asset purchase tapering.
Of course, investors may well price in a higher central bank rate earlier than the first Fed hike. The bond market has a well-established history of over-pricing Fed tightening (as any front-end trader who tried to play shorts between 2012 and 2015 will recall).
We remain sanguine on the long-term inflation picture, but we also acknowledge the risk that the market could, in the coming months, over interpret some meaningful year-on-year changes in inflation, which the Fed has warned us to expect.
We are short duration as we think real yields will move higher and of course inflation could rise faster than we expect. However, at this juncture we are not calling for a wholesale regime change in which longer-term inflation and inflation expectations force both an earlier-than-expected Fed move and a reassessment of pricing power within economies.
Gareth Witcomb is a multi-asset portfolio manager at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.