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Between a Fed and a hard place

UK: Suitable for professional clients only.

Date: 24 September 2021

Paul Craig

Portfolio Manager

Bond investors probably heaved a huge sigh of relief following the recent US inflation report for August, which came in lower than expected. A happy miss in this instance, as core US inflation in August is still twice what it was a decade ago.

However, before we start raising the bunting, it’s worth noting that outside covid-sensitive sectors, the gain in consumer prices (CPI) was still quite fierce. So even if you’re somehow able to live as a relative hermit, the cost of living is still rising noticeably. This is already beginning to impact on consumer expectations and could upset the apple cart for consumer confidence and spending.

The big question, of course, is whether inflationary pressures are as transitory as the US Federal Reserve (Fed) has stated. In some cases, the Fed has clearly been quite correct; the epic leaps that we saw in the prices of used cars, airfares, hotel rooms and car rentals have (naturally) abated.

However, there is mounting evidence that inflation may be deeper rooted than can be explained by ‘merely’ a pandemic lockdown and the global supply-chain failures they’ve spawned or, in the case of the UK, by the after-effects of Brexit.

While it would be nice if ‘ordinary’ investors, like you and me, didn’t have to worry about inflation, unfortunately, as the chart below highlights, we do.

Between-a-Fed-and-a-hard-place-chart-1.jpg

History lessons

With the exception of a couple of brief pockets in the last decade, the last year or so has been the first time that (US) core inflation has risen above the yield on 10-year Treasuries since the early 1980s.

Clearly, bond yields below core inflation levels is something that’s very rare and which markets don’t generally tolerate for long. The relationship between the two feels especially rarefied at today’s level.

As the second chart shows, the current position is certainly abnormal which, ultimately, means something needs to give.

Between-a-Fed-and-a-hard-place-chart-2.png 

The likely outcomes are binary: either inflation really is transitory and swiftly recedes to a level comparable with investors’ longer-term expectations; or bond yields rise, meaning their prices fall, probably by an uncomfortable amount.

Having said that, any sensible investor must also acknowledge that the recent state of the world has led to this self-imposed state of ‘financial repression’ (namely where savers earn less than inflation which allow banks to provide cheap loans and governments to inflate away their local currency debt).

In the meantime, investors will be left to guess how long ‘transitory’ might be (ice ages are transitory, after all) and, more pertinently, how long the Fed can continue to convince the world that today’s rampant inflation is only fleeting.

While it would be nice if ‘ordinary’ investors, like you and me, didn’t have to worry about inflation, unfortunately we do.

Boots on deck

Ultimately, we don’t have any greater insight into the outlook for inflation than does the Fed – although I can assume it has a few more analysts and economists at its disposal than we do.

That said, we (meaning Quilter Investors) haven’t ‘printed’ trillions of dollars for a public handout, so are under less duress to convince markets of our preferred outcome.

It is plausible to have a foot in both camps, specifically inflationary pressures for certain sectors may well prove transitory, but inflation may remain higher than pre-lockdown due to the disruption caused by tackling the pandemic.

With all this in mind, we find little value or diversification benefits in owning government bonds at this point in the journey. Corporate bonds may offer better value than ‘govies’, but if yields for the latter rise, then so will corporate bond yields. We remain very selective for this reason.

Consequently, we find better value within equities, but are cognisant that equity markets have come a long way since the sharp sell-off in March 2020. This means that diversification and quality, across both growth and value factors, is crucial.

Essentially, we want to be exposed to a broad selection of good-quality businesses that are well-placed to operate amid a backdrop of rising prices, supply-chain constraints and changing consumer behaviours, but that aren’t yet priced for perfection.

The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. Because of this, an investor is not certain to make a profit on an investment and may lose money. Exchange rates may cause the value of overseas investments to rise or fall.

This communication is issued by Quilter Investors Limited (“Quilter Investors”), Senator House, 85 Queen Victoria Street, London, England, EC4V 4AB. Quilter Investors is registered in England and Wales (number: 04227837) and is authorised and regulated by the Financial Conduct Authority (FRN: 208543) but is not licenced or regulated by the Monetary Authority of Singapore (“MAS”).

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