Monetary policy is more art than science. We all agree that higher rates undermine growth and that helps bring inflation down. But the precise mechanisms and timing are unclear still. In the US, the Fed will have raised rates in a year more than at almost any time since the early 1980s. It is probably enough. This leads to a positive view on fixed income, where yields are the highest for 15 years. Investors can get higher yields for less risk than was the case in recent years. Returns in bond markets are very unlikely to be negative for a third consecutive year. Despite all the concerns about market liquidity, central bank balance sheet reduction and potential defaults and downgrades, I think 2023 will be the year of the bond.
Rates and inflation
It is very difficult to calibrate the size of any increase in interest rates necessary to bring inflation down. Inflation is complex and economists are not usually very adept at forecasting it, especially when it is either rising quickly or falling quickly. This week, St Louis Federal Reserve Governor, James Bullard, suggested that rates might need to go as high as 7% and that he saw a minimum for the Fed Funds rate of at least 5% up to 5.25%. The market currently has a 5.0% peak priced in but that is subject to change if inflation does not continue to come down. Higher than that, however, would be disastrous for growth and markets.
Some very basic analysis of changes in the Fed Funds rate and the rate of core Consumer Price Index (CPI) inflation in the US over the last fifty years highlights the problem. The statistical relationship between changes in the Fed Funds rate over one, two, and three years and the change in the core inflation rate over one, two, and three years is weak. Indeed, the simple correlation is positive in some periods. On the occasions that the Fed Funds has increased by 400-425 basis points (bps) over one year, the subsequent one year change in the core CPI has fallen three times and risen three times. Markets are hoping that this time around we get a similar reaction from core CPI that we got in 1982 when the core CPI rate fell by 2.0% after the Fed had increased the Fed Funds rate by 400bps in 1981. There have been plenty of times when more tightening has been needed to bring inflation down. One needs to go back to the 1970s to see examples of where the Fed Funds Rate increased over a two-year period that would be consistent with Bullard’s worst case scenario. Even then, the subsequent two-year changes in core CPI were mostly positive. Such an outcome would bring inflation down a lot but with a huge cost to growth.
The point is that aggressive monetary tightening does not necessarily bring inflation down. It depends on the type of inflation and whether it is endemic or not. It was in the 1970s and early 1980s, and has been less so since. Back then rates needed to be higher and tightening cycles more aggressive to break the wage-prices spiral that kept inflation high. This year’s monetary tightening in the US is the biggest (in terms of change of 12 months) in the period since 1990 because it has been driven by the biggest increase in the core CPI. Bringing inflation down will depend on much more than increases in interest rates which, as many have pointed out, are rather a blunt instrument. The biggest contributor to a decline in inflation would be energy prices and the knock-on effect that would have on general price inflation over the next one to two years. My hunch is that the Fed will soon collectively take the view that enough is enough, even if the models aren’t particularly well calibrated.
Extending the simple analysis to the correlation between interest rate moves and growth momentum implies a much greater effect than on inflation. Over two-to-three-year periods of rising rates, industrial production growth momentum has typically been negative – meaning the year-on-year growth rate falls. US industrial production year-on-year growth in October was 3.3% compared to 4.7% a year before. Monetary policy slows real growth before it slows inflation. That makes sense as growth needs to slow before it impacts pricing and wage behaviour. When the Fed Funds has risen by more than 400bps in a year, historically, industrial production has moved very negative.
Correlation is not causation and the lags between monetary policy decisions and the impact on both growth and inflation is long and variable. Importantly, it is uncertain except for the fact that the signalling is clear. When central banks tell us that they are raising rates to bring inflation down it means that they want households and companies to change behaviour and that they are prepared to let growth slow and unemployment rise until that happens. Today’s global economy is so different to that of the 1970s and 1980s, so the uncertainties are even greater. Markets will take the bet that there is little chance of central banks risking taking even more aggressive rate hikes when such uncertainty exists
I doubt the Fed will raise interest rates much more before halting. Next year will not see a 400bps increase in the policy rate. The same is likely to be true for the Bank of England – especially with fiscal tightening – and the European Central Bank. Indeed, the combination of falling energy prices and weaker growth might provoke earlier rate cuts than is currently priced in. That is not the central case, but it is something that markets are already starting to flirt with. The US Treasury yield curve is very negatively sloped (-70bps between two-year and 10-year bonds) and five-year bond yields are lower in the forwards market than their spot yield in USD, Euro and Sterling.
Bonds look good
All of this makes me bullish on fixed income. Rates are close to peaking in the US and the increases we have seen in bond yields in many markets means – going forward – the risk-return trade-off is much better for bonds. At the index level yields are higher per unit of duration and credit risk than they have been for years. Higher yields mean lower bond prices and even if yields don’t fall, bond holders will benefit from a strong “pull-to-par” as prices converge on 100 over the remainder of their maturity. But investors shouldn’t rely on capital gains in the bond market. In contrast to years of quantitative easing pushing yields down and prices up, returns are going to come more from income going forward. That’s important to keep in mind when building portfolios – bonds can contribute more effectively to managed income type strategies in combination with solid dividend paying equities.
The current quarter has seen very strong returns from both fixed income and equities. The drivers are clear – expectations of a peak in inflation and interest rates in 2023, the US economy not yet collapsing into recession, and the mid-term elections marginalising Trumpian populism. In the UK, the government of Rishi Sunak delivered an infinitely more sensible fiscal statement this week than the one that shook the gilt market in late September. Even on the geo-political side there have been glimpses of how a negotiated settlement in Ukraine might come about. That remains a long-shot and not worth trading on yet. But if it were to emerge that Russian was giving up on Ukrainian territorial ambitions, one would expect a significant (positive) rebound in energy and global equity markets.
But there will be recession related concerns for equities in 2023
It might be another bear market rally. Most strategists think that equity markets should get a lot cheaper. Business models are being challenged by revenues and profit margin pressures. It is not clear what level of future earnings should be used to value stocks today, especially those that have registered steady growth in recent years because of increased spending on technology and communication services. Consumer technology, both hardware and software, might struggle for a while as households trim spending. Corporate investment spending is likely to be weaker too. The big increases in capex should be driven by energy transition needs and further automation and digitalisation – but the recession will hold that back.
Energy key to the long-term outlook
I keep saying energy is key. The COP27 doesn’t appear to have done much to accelerate the energy transition, but the focus on energy security is real in national government plans. Chancellor Jeremy Hunt reiterated that energy security is one of the key pillars of the UK’s long-term growth plans. The fact that he also announced a tax on renewable electricity producers suggests short term political expediency around making the fiscal numbers look good still trumps long-term economic efficiency and environmental concerns. However, generally, taxes and subsidies continue to encourage carbon reduction and energy efficiency. The problem is the pay-back is not immediate and equity markets tend to be quite short-term focused. Capital needs to flow to energy transition businesses, but it may need energy prices to remain higher for these investments to get the required rate of return (either through participating in the economic rent or providing a more economically competitive alternative that can grow revenues quickly). At least the collapse of a lot of the crypto architecture might have a positive impact on energy use and related emissions!
The World Cup begins on Sunday. You know, I have not even heard a rendition of “World in Motion” yet. The excitement is just not there compared to the traditional (northern hemisphere) summer competitions. One benefit for sports clothing manufacturers might be that it gives parents an easy decision for holiday presents this year – football kits from around the world! Seriously though, there should be some great matches. Brazil are the favourites followed by Argentina and France. But there are so many top teams and maybe as the tournament evolves, December holiday parties will morph into World Cup parties. Hopefully the Q4 rally in markets can continue alongside.