Not another inflation article

It is no mystery as to why we have seen rates increase so much over the course of 2022. For many investors this has meant intense focus and scrutiny on monetary policy in order to gauge short term market sentiment. In the long term however, higher rates will mean a fundamental change to the market dynamics investors have been used to for the last decade. The misalignment of long- and short-term perspectives has perhaps never been so stark.

Over the history of equity investing, it has been a fairly good bet that if market indicators were solid, then markets would also be solid and vice versa. Over the last year however, asset prices have been beholden to Central Banks and their policy trajectory. Central Banks have been trying to slow demand in overheating economies through interest rate tightening. Although its function is strictly monetary, a tightening cycle can have some unintended consequences in relation to asset prices. The issue lies in the fact that asset prices tend to factor in economic growth differently to how they factor in inflation. Low unemployment and higher Gross Domestic Product (GDP) are generally good for an economy. They do however contribute to inflation. In times of soaring inflation, this leads to Central Banks tightening more aggressively and potentially pushing an economy towards recession. What is normally associated with recession risk, such as employment falling and weak manufacturing data, paradoxically represents an argument for a looser monetary policy, sending markets higher as the shorter-term focus on looser policy outweighs the fear of a subsequent recession. Markets will have to grapple with the latter reality in due course.

This dynamic has changed the way analysts view certain results. While the above mentioned are changes in macro-outlooks, short term company analysis can also be deceiving. For example, the most recent round of Q3 earnings proved to be somewhat of a positive surprise, with many US companies preserving profit margins in the face of higher input costs. While this sounds good for investors, it can mean that higher prices are not being absorbed by firms and are being passed onto consumers. Consumers as price takers at this point in the cycle would suggest a base of savings that has still not been exhausted. At face value, the robust position of consumers is a positive, but it may mean there is more to run for inflation if they can continue to stomach higher prices.

The role of Central Banks

It is important investors take into account a different change in market dynamics in the long-term. One important point is that markets may have to accept that central banks may not be unequivocal in their support during times of market stress (or at least not to the same extent). It is worth remembering that the Federal Reserve has only two mandates: price stability and maximum employment. The European Central Bank’s (ECB) mandate is narrower still, focusing only on price stability. Central Banks hold no explicit responsibility towards investment markets despite often carrying the burden. During the Covid-19 pandemic, fiscal stimulus was instituted by governments and already loose monetary policy was accentuated by central banks in the form of policies such as the ECB’s Pandemic Emergency Purchase Programme. At the time, credit supply and financial market stability were the guiding factors of such policies, as inflation in the Eurozone had been below target levels for several years.

In the decade ahead, it is likely that inflation will be markedly higher than it has been throughout the 2010s. This will alter the perspective of central banks charged with the mandate of price stability. With climate change and the impending energy transition, energy prices (a key input into inflation calculations) may become much more volatile. Changes in the reactions to central bank priorities are to be expected in the future. Central Banks may be less involved in carrying the burden of recovery which firms have often relied upon. Several instances over the past decade have seen markets spooked over a potential Fed tightening that has then failed to materialise. In 2018 the Federal Reserve rolled back its quantitative tightening programme earlier than expected. In the lead up to this reversal, asset prices had been reacting badly and market participants, not to mention a sitting US President, had fervently voiced their concern. This type of occurrence is unlikely to be repeated in a post Quantitative Easing world.

A tangible consequence for investors is that financial institutions and investors are likely to undertake more due diligence and care with investment decisions in a positive interest rate environment. This is already evidenced in the decrease in Initial Public Offerings (IPOs) and Merger & Acquisition activity. Deal Count was down by over a third globally in the year to October 2022. Along with this, companies’ ability to service debt will be a far greater factor in security selection, with strong balance sheets and fundamentals perhaps returning to some extent. This will also be beneficial for the active approach as price discovery and liquidity become more important. A period of tighter lending conditions will always result in more explicit defaults as well downgrades in terms of debt. However higher rates will mean highly indebted companies, which may still survive, may in hindsight be proven to have been a less attractive investment opportunity.

Changing markets

A paradigm shift could be underway in capital markets in relation to investor perceptions. It is often forgotten that markets are driven by investor behaviour and are not wholly rational. Whilst it’s important to note the flaws in attempting to forecast markets, the following are some potential points of development from market commentators in the coming year.

If US Dollar strength is anything to go by, many investors felt there were few places to hide for the majority of 2022 as safe-haven appeal took precedence in the face of incessantly rising rates. When rates do begin to peak however, the current period could provide a beneficial entry point for many investors.

For the past number of years, risk averse investors have often been pushed far out on the risk spectrum in order to make tangible returns. If these investors have liquidity needs, short duration bonds or cash like securities may finally offer them a real yield. The anguish experienced in bonds of late will also have created an environment for real returns as asset prices are lower.

Greater allocations to fixed income are to be expected, but there is some concern that private assets and private credit may face problems. Liquidity has become a bigger issue in the current environment and publicly listed investments which are marked to market offer greater liquidity and price transparency.

Investors should be aware of these risks but should also not be lulled into the false sense of security that higher deposit rates may bring. Many indicators point to a higher base level of inflation being here to stay, and this will eat away at deposits, as real returns remain depressed. Shorter duration bonds have been the champion of late but as yields reach an inflection point this could change.

As for valuation versus growth stocks, the same argument can be made. Value stocks are essentially short duration as dividends represent near term capital and thus are less sensitive to changes in rates.

An active flexible approach to investing which is not dogmatic in its strategy will be the sensible path in the coming years. Whilst financial conditions change and certain strategies go in and out of fashion, core investing principles do not. Top-down investment which is adaptable will provide this balance as we enter a new era of investing.

For more information speak to your Zurich Broker Consultant.