Bedrock’s Newsletter for Friday 22nd April, 2022




“A crisis is an opportunity riding a dangerous wind.” 

Chinese Proverb

Friday 22nd April, 2022

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The global economy is set to slow sharply this year, while inflation continues to soar. That is the central forecast in the most recent IMF World Economic Outlook report, released on Tuesday this week. It accords with our macroeconomic views, highlighted in these pages several times in recent months; and it also presents a conundrum to central banks as they begin to raise interest rates for the first time since the pandemic struck in 2020. Having dragged their feet for so long, policymakers need to hike rates to re-establish the credibility of their inflation targets and prevent high inflation (and inflation expectations) from becoming entrenched. But with economic growth already slowing, there is a limit to how far they can go without triggering a recession. Moreover, the level to which rates can rise safely may not be high enough to bring inflation back to target anytime soon…
 

In a ‘normal’ tightening cycle, the inflation that central bankers want to avoid is the potential by-product of a rapid demand-led recovery brought on by accommodative monetary (and fiscal) policies introduced as the economy enters recession. When the economic environment deteriorates, central banks ease policy via rate cuts and asset purchases in order to reassure investors that there will be ample market liquidity regardless of short-term fundamental developments and to allow households and firms to have access to equity and debt financing on favourable terms at a moment of stress. By reducing the cost of capital, loosening policy can blunt the impact of the recession, hasten the reabsorption of any economic slack created by the downturn, and boost the subsequent recovery. However, the rapid pace of growth stimulated by easy monetary (and fiscal) policies is unsustainable once the recession-driven slack has been re-absorbed. At this point, such policies cause so-called ‘excess demand’ in the economy (i.e., more than can be met by supply at a given level of prices) and inflation begins to gather pace. Reducing and eventually eliminating excess demand by raising rates to the level of the so-called ‘neutral rate’ restores the economy to a more sustainable long-term growth trajectory with inflation under control (i.e., close to the pre-agreed target). If supply factors remain unchanged by the recession, the sustainable growth rate after a crisis should be approximately where it was before the crisis. Policymakers just need to get the economy back there; and, hey presto, job done.


However, the task facing central banks today is hugely more complicated than the simple model outlined above because the supply-side of the economy has been so severely disrupted by the pandemic – and disrupted in ways that were and are hard to predict (or even measure, initially). To make matters worse, officials only realised very recently just how persistent the supply dislocations are likely to prove… and inflation is running hot as hell already (+8.5% YoY in the US in March to be precise). Prices of food, energy, and other commodities are rising fastest, moves that have now been exacerbated by the war between Russia and Ukraine given that both are major commodity producers. However, manufactured goods have hardly been spared as cost pressures caused by tangled global supply chains are passed through to increasingly unhappy customers. And this inflation is already having a real impact on global economic growth. In particular, rising energy and food prices are causing a cost-of-living crisis in many countries and the resulting ‘fuel and food poverty’ is sure to hit spending by low-income households on other goods during this year at least. Since such households spend the lion’s share of their income in the current period (i.e., save the least for a rainy day – or for a war in Ukraine for that matter), the economy is likely to suffer disproportionately from this type of inflation near-term. Moreover, and more worryingly from a humanitarian perspective, there are incipient food crises now underway in a number of developing countries which could trigger famine or political instability in the coming months. Fragile states in the Middle East and North Africa, like Egypt, Syria, and Yemen, look particularly vulnerable, given how dependent they are on grain imports from Russia and Ukraine (c.70% of total grain consumed in Egypt comes from these two countries, for example). Put simply, this is not the backdrop that you want when you start hiking rates; and it is not clear what sustainable rate of growth is achievable today in light of the supply-side obstacles. Knowing when to stop is tricky when it comes to tightening policy; and there is a clear risk of ‘stagflation’ (i.e., persistently weak growth and high inflation) taking hold in the coming months if not enough is done.


Therefore, policymakers face a major dilemma. Should they prioritise beating inflation by implementing restrictive monetary policy as soon as possible or err on the side of caution and boost flagging economic growth? How many rate hikes can pandemic-impacted companies and governments take following a crisis that pushed their debts up to record levels? Having ridden to the rescue of ailing businesses in 2020, can central banks really watch the very same firms go to the wall this year and next, if necessary, to get back to their 2% inflation target?

There is a lot of uncertainty about the Fed’s reaction function to inflation data given the increasingly negative global growth outlook discussed above. However, Powell has signalled that we can expect a 50bps hike when the Federal Open Market Committee (FOMC) meets to discuss monetary policy in two weeks’ time. And markets for their part are now pricing in 9 hikes in the US before year-end. We think that the Fed would struggle to implement so many hikes in quick succession, but we would certainly not bet the farm (or your money) on it. Therefore, we continue to favour low duration in fixed income. In addition, you end up with considerable interest rate duration in equities when you own growth stocks, and we see opportunities here after the huge price falls of recent weeks (Netflix aside). Commodities and commodity equities are also among our preferred themes in the current environment since both benefit from supply shortages and the still-limited CAPEX plans that have been made following the pandemic. But, overall, we suggest balance in portfolios today. This is a complex environment in which to invest. Good risk management demands humility.