Active Thinking

At GAM Investments’ latest active thinking forum, both David Dowsett and Adrian Owens discuss the knock-on effects of persistent inflation on markets and where investors might seek respite.

27 May 2022

David Dowsett – Global Head of Investments

Markets are now moving into historic territory, with the Dow Jones experiencing its longest losing run since the mid-1930s. From an equity perspective, the news is not getting any better, with results from Target and Walmart dominating headlines of late. This goes to the core of the bigger problem – higher inflation, which is now meaningfully impacting consumer spending habits, particularly among those with lower disposable incomes. This also lies at the heart of the problem for investors – prices are rising and activity is slowing simultaneously so there is no real comfort anywhere for those trying to express a risk view.

Having said that, we have seen a decline in core yields. This is significant because before any asset class can perform, we need to see a stabilisation in core yields. We must acknowledge the possibility that the decline we saw was a result of the negative risk environment, but nonetheless, this is the first sign we are looking for in terms of market stabilisation.

We also believe it is important to watch out for any potential policy initiatives from governments. We saw China move rates earlier this month, which did not have much impact on markets, but there is some evidence that it will restimulate in the second half of the year. We should also pay attention to rhetoric in relation to tariff reductions from the US with regard to China. It is very difficult to know if this would pass through Congress, but it is serves as evidence that, from a policymaking perspective, the US government is beginning to consider actions to counter the slowing growth, higher inflationary environment that we face. Given how far markets have sold off, anything that changes the existing rhetoric is worthy of attention, in our view.

Adrian Owens – Global Rates

Investors have priced in a higher inflation profile over the past couple of years but we believe that inflation will be slow to come down and remain more elevated than widely appreciated. As a result, it is important investors retain some form of inflation protection in their portfolios, in our view.

The major developed market central bankers pumped liquidity into the system for a number of years and, in our opinion, became complacent when inflation did not immediately pick up. In short, they underestimated those long and variable lags in the system. Today there is plenty of evidence that there remains a huge overhang of liquidity and that real interest rates remain too low for the stage of the economic cycle. Indeed, the real federal funds rate is around levels last seen in the 1940s.

We believe investors should keep a very close eye on the US labour market. When the Federal Reserve (Fed) started to raise rates in 2004 and 2016, it did so when the quits rate, which refers to number of people quitting their jobs, was significantly lower. A higher quits rate, as seen today, means that lots of people feel secure that there are other jobs for them to go to and as a result, workers are able to demand higher wages. The quits rate is an excellent indicator of the strength of the labour market and wage growth. We think unless we see this figure come down more meaningfully, strong wage growth will continue to stoke core inflation. This tightness in the labour market is also highlighted by the fact that for every unemployed person there are almost two job vacancies. Furthermore, we believe that if the Fed does not go beyond what is currently being priced in, the consumer will be in a position to continue spending. Consumers are sitting on a cash amount of roughly USD 2.3 trillion, or about 10% of GDP, following the Covid pandemic. However, for the consumer, the key factor influencing their spending is their employment income and until we see more of a deterioration in the labour market, spending will likely remain robust, even against a backdrop of a soft equity market.

A second area of concern is the rents market. US rents, which account for about a third of core PCE inflation, are at 4.8% year-on-year and the leading indicators suggest that they could continue to increase. Combined with labour market pressures, underlying inflation is unlikely to get back close to target until we see more tightening from the Fed, in our view.

It would not surprise us if the Fed and some of the other central banks begin to talk more openly about accepting higher levels of inflation going forward. A couple of years ago, the Fed changed its mandate to accept inflation above 2% for a while. History suggests that high levels of debt act as an impediment to growth. We believe the only way forward for the Fed, European Central Bank and Bank of England in particular is to accept above target inflation for a period of time, effectively targeting nominal growth. We believe that for them the costs, in terms of growth, will prove too high to bring inflation back to target over the next two to three years.

As a result of these factors, we believe inflation protection or a bias to be short front-end rates is important in this environment.

We see opportunities particularly in the UK where the market is pricing in interest rates to peak after another 140 bps rise which would bring the terminal rate to just above 2%. With inflation running at approximately 9%, that is a negative real interest rate of -7%. We find it hard to believe that the rise in interest rates currently priced in will be enough to get inflation back on track and the central bank may have to do more. Currently, the Bank of England is proving reluctant, citing concerns about growth but there is a risk that investors take it out on sterling. If the UK is likely to suffer weak growth and only modest rate hikes, sterling may weaken adding to inflation pressure. The central bank will then have its hand forced by the market. There are also some interesting curve dynamics. Markets are currently pricing higher rates in the UK followed by fairly rapid cuts. We think that it may not play out like that and so we see this as an investment opportunity.

There are also some interesting relative value trades. Some of the emerging markets are beginning to look compelling, in our view. The one that stands out to us is Brazil. Brazil has hiked interest rates more than 10% in just over a year, which is almost unprecedented. The last time Brazil hiked rates, it took three years to hike 700 bps. Now, it has taken rates up to close to 13%. Compared to the US, which is at the beginning of its tightening cycle, Brazil has already done the bulk of its tightening so taking a long position in Brazil versus short positions in the US makes a lot of sense to us. It is beginning to look similar in Mexico where rates are at 7% but they probably still have further to go.

Over the last 18 months as central banks have become more active to varying degrees, real relative interest rates have once again become important drivers of currency, creating more opportunities to generate returns in currency markets.

GAM is an independent, global provider of asset management services operating in three principal fields: investment management, wealth management and third-party fund management services. Across all areas of our business we are committed to the pursuit of highly differentiated strategies, having long recognised that results beyond the ordinary are best achieved by thinking beyond the obvious.