Blain’s Morning Porridge Nov 23rd 2021 – The Central Bank Quandary: Inflation vs Recovery
“The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation”
This morning: Jay Powell keeps his job and faces the inflation quandary – hiking rates too soon risks recovery, but inflation needs addressed. The likelihood is lower rates for longer – which will juice euphoric markets further. What’s the alternative? Stop buying financial assets and buy the real economy!
Jay Powell got to keep his job at the Fed while Lael Brainard gets the number 2 slot. What does it mean? It’s a bit of a Parson’s egg – good in parts. Reappointing Powell to the top job removes some of the uncertainty a new Fed Head could have caused, while Brainard is widely expected to tighten the Fed’s focus on regulation, which will partially satisfy Leftist Democrats demanding change. The market responded strongly – the S&P hitting a new high before Asia shrugged off the news this morning: classic buy the news, then take the profit and move on to the next thing.
The key issues for the Fed, for all central banks, is the inflation quandary. Is inflation real and long-lasting, or not? Listening to the pair of them last night, Powel and Brainard committed to protecting the great American public from inflation and creating new jobs to the replace the 8 million that seem to have simply vanished from the US economy. That’s a pretty clear signal.
The key question is when will rates rise? Don’t hold your breath.
Like many market watchers, I don’t accept inflation is “Transitory”, even though the trigger for the current inflation rise was certainly a series of cascading supply chain shocks as the global economy re-opened. These will be fixed, but they already kicked off consequences – which are now being felt across the global economy.
The supply chain shock catalysed real inflation triggers across the economy. Wage inflation is one aspect. Businesses are being forced to pay up for staff reluctant or unavailable to return to work. That’s been particularly clear in the details; like ageing HGV drivers retiring and no-one testing new drivers, the shortage of Catering Staff after they’ve gone to become delivery workers, and builders, engineers, etc who’ve found staying at home more life-rewarding.
They all want paid more to go back to the past. There expectations have been exacerbated by energy and food price spikes hitting household wallets, further pressuring the long-term push on wage demands, which is further fuelled by headline busting pay settlements – meaning everyone feels more entitled to be paid more. Exactly the same process happens across all aspects of the economy – cost push inflation.
But should Central Banks act on inflation? That could be a major policy mistake.
Policy mistakes by Governments and Central Banks are a massive market risk. Consumer confidence remains weak in the wake of the virus and the cost increases populations are seeing every day. If you hike taxes to pay the pandemic bills, and rein in government spending on infrastructure and social services, at a time when interest rates are being managed up – as the UK Conservative Government plans – that’s unlikely to end well. It’s more likely to create an unvirtuous stagflationary cyclone than boost recovery.
Which may be why central bankers – who aren’t daft – are sticking with the transitory arguments even though they can see real inflation on the rise. They are probably right – rising interest rates won’t speed up supply chain repairs, and will only deepen demands from workers for higher wages to cover their increasing borrowing costs.
It’s a frying pan/fire choice, but expect Central Bankers to err on the side of low rates. They will likely remain lower for longer. Meanwhile, Global Central banks will also remain accommodative. They may tweak QE bond buying programmes, more to remind markets they can. They will likely wait for the post pandemic recovery to stabilise and then act on wage inflation, hoping it won’t have metastasised into something more dangerous.
And if rates remain low… then keep you market buying boots laced up tight, keep buying and keep dancing… As long as rates look artificially low, then the relative attractions of equity to bonds scream… Buy, Buy, Buy!
Oh dear…. That means buying into a market that’s clearly overvalued, driven by a mispriced approach to risk, increasing corporate buybacks (as corporates leverage up on stupidly cheap debt), a declining earnings outlook and about one trillion other reasons to be nervous…
Maybe it’s worth going back to basics to understand how to play markets in this environment?
I recently received an email from a reader asking me to explain how bond markets work, how they’ve been impacted by ultralow interest rates, and what’s the alternative. She’s read a piece warning bond yields are completely out of whack with reality. What should she be doing with her savings – she asked. The regulations mean I can’t give investment advice. I can only advise institutional investors, and only if they pay for – say the rules. Which is why you must never, ever, never regard the Morning Porridge as advice, just commentary. (If I was a 25 year-old Gen-Z ranting on a YouTube video about what a great company Tesla is or how fantastic it is to HODL cryptocurrency, its ok… apparently.)
Anyway, on the basis I am not giving advice, let’s quickly remind ourselves of the basis of Financial Asset markets:
- Equity investors are optimists who live in the perpetual hope of seeing their returns explode exponentially from picking the right winners! They crave excitement, stories, themes, and the “narrative”.
- Debt investors are pessimists who care about getting repaid their principal and interest. Dull, boring and predictable works for them.
The price of equity is determined by just how excited the market voting machine gets. The price of a bond is determined by yield – which is a function of credit (the underlying risks) and interest rates. If rates decline and risk stay the same, then the price of a bond will rise. But if risks are increasing, and rates are increasing, then the price of a bond will fall.
Credit risk is a catch all term encompassing any risk likely to impact the ability of bond issuer to repay that debt. The risk of competition, obsolescence, management failure, financial crisis, inability to service its debt, the risk of default. Sovereign bonds are considered the risk-free rate – issued by nationals with the financial sovereignty to issue their own debt.
The price of every financial asset is determined relative to every other asset. The base line to calculate the relatively of financial assets is that risk-free interest rate. If it is too high, then bonds will look better relative value. If it is too low, it favours equity.
At the moment, real interest rates (that’s the interest rate minus inflation) have never, ever, in market history been so negatively low. Real US interest rates are about -4%, meaning you are kissing goodbye to $4 per annum in spending power on a $100 investment yielding a notional 2%. Of course, it looks better to buy a stock that promises a higher return and upside appreciation.
The problem is by messing around with interest rates, you unbalance the whole financial asset structure. Bonds yield too little, and Equities are overpriced. As I said above, that will continue till interest rates start to normalise, forcing the relative value of equity lower. Which means, have fun in the equity markets today… but we don’t know for how long.
There is an alternative. Avoid financial assets. Think about real assets… Gold, Property, etc… Buy assets linked to the real world.
A number of readers have asked what I’m doing in the Middle East and Egypt… haha.. Good question. Aside from being Shard’s Market Strategist, I’m also head of Alternative Assets – basically anything that’s not traditional stocks and bonds. I’m down here to finance a massive infrastructure project which will offers returns uncorrelated to markets. We will be selling private equity and private debt.
Unfortunately, it’s for professional institutional investors only – but if you’ve got $100mm plus hanging around looking for something correlated to the real economy rather than the ravings of internet memes… then give me a call..
Out of time, back to the day job…. Buddy can you spare $7 bln?
Strategist, Head of Capital Markets and Alternative Assets