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Investment Institute
Viewpoint CIO

Different ways to 2%

  • 31 May 2024 (5 min read)

Central banks will likely stick with a 2% inflation target in the coming years. However, policy may have to be set to keep inflation from being too much above target, rather than too far below, as was the case in the decade after the global financial crisis. This potentially means a higher equilibrium level of interest rates in the future. More immediately, rate cuts will be limited and a flood of money out of cash into bonds and equities looks unlikely, especially given the lower-risk premiums in credit and shares. But as long as central bankers don’t engineer a recession to meet inflation targets, high yield and equity exposures remain attractive.

Didn’t they do well? 

If there is such a thing as central bank hubris regarding controlling inflation, it comes from the period after the financial crisis. Between 2010 and 2020, the Federal Reserve (Fed), the European Central Bank (ECB) and the Bank of England (BoE) all achieved inflation that was, on average, below 2%. The Fed formally adopted the explicit long-term inflation target of 2% inflation (measured by the personal consumption deflator or PCE) in January 2012. Between then and the eve of the pandemic in March 2020, the core PCE rate was below 2% in 91 out of 99 monthly observations.

2%, easy 

The UK began inflation targeting in 1992 after the pound left the European exchange rate mechanism. However, it became the bedrock of monetary policy when the BoE was granted operational independence following Labour’s victory in the May 1997 general election. Like in the US, much of the decade following the global financial crisis saw inflation undershoot target. In the five consecutive two-year periods between May 2011 and May 2021, the consumer price index level ended up below that implied by a 2% inflation rate three times and only marginally overshot in the May 2017-May 2019 period.

But now? 

The inflation spike of 2021-2022 was a shock. Markets were hit and central banks reacted aggressively. Questions were raised about inflation targeting. The narrative evolved from the pandemic-related supply shock (transitory) to concerns about second round effects and a change in longer-term inflationary dynamics. Today the concerns are about price stickiness in the services sector, wage growth being too high and anecdotal evidence of inflated prices and activity – real estate prices in the Mediterranean, lack of availability of airline seats and hotel rooms, alongside $100 hamburgers at New York restaurants. What is not being openly discussed, certainly by policymakers, is that we might not be able to get back below 2% without a severe recession.

Shifting influences on prices 

Even as inflation has moderated, recent monthly changes in the most widely followed inflation indices have been well above what they averaged during the 2010-2020 period. In the wake of the 2008-2009 crisis, disinflation was driven by globalisation and balance sheet retrenchment, along with the impact of technology on the cost of numerous consumer goods and services. To return to those days we are likely to need a benign combination of lower commodity prices, increased low-cost import penetration, new disruptive business and distribution initiatives in mass consumption markets (remember the supermarket wars?) and probably higher unemployment. Instead, geopolitical risks to commodity supply, protectionist trade policies and profit margin-protection work in the opposite way, especially when demand is holding up. Only if demand was squeezed would suppliers feel the need to cut prices so that aggregate inflation softened.

Higher equilibrium rates 

I’m not saying we are in for a repeat of 2022-2023. But investors should be prepared for monetary policy to be set to keep inflation from being persistently above 2% rather than preventing inflation from falling persistently below 2%. That is very much the situation today with investors less confident about the timing of a first cut, particularly from the Fed.

There are potentially significant implications for the medium-term outlook for interest rates. Real policy interest rates were negative in the 2010-2020 period because central banks were fighting debt-deflation. That is done. Assume inflation tends to be above 2%. In order to stick with a 2% target, real rates are likely to have to stay positive suggesting nominal policy rates in or above a 3%-4% range in the US and UK and 2%-3% the Eurozone. How far above that range rates go depends on the appetite for forcing inflation back down through engineering a recession, an increase in spare capacity and higher unemployment. Living with inflation a little above the target range has greater social utility than the alternative.

Can’t let go of the cash 

Today investors with assets in cash or short-term fixed income strategies are benefitting from interest income. Moving out of cash is not an easy decision. A year or so ago there was an expectation that there could be a surge of flows from money market and bank accounts into bond and equity funds as central banks encouraged the idea of significant rate cuts. That seems less likely now, given the rate outlook and that risk premiums on credit and equities have been squeezed.

The rate outlook is set to look more like it did before 2008 than in the quantitative easing (QE) period. It means a higher hurdle rate for returns from riskier assets than cash. It also means that long-term yields are not likely to move significantly lower. The big move in fixed income will be a readjustment in the shape of yield curves through lower short-term rates, but that is and will continue to happen only slowly. My take on that is to prefer short-duration exposure in fixed income.

The outlook also supports fixed income generically as an asset class that is more attractive than it was before 2022. Yields are higher than inflation. There is more opportunity to use bonds to meet future cash-flow liabilities. Compound interest is a powerful force. Just because rate cuts are not going to be very exciting in the months ahead, does not mean fixed income is not an asset class to hold. Indeed, the return versus risk trade-off is arguably better if rates are not going to move much. Volatility in fixed income has continued to edge lower in recent months. And remember there are loads of bonds trading at a price below 100 (unless they default, they will mature at that price). A snapshot of the ICE Euro Corporate Bond index shows 82% of outstanding bonds with a price below 100, 53% below 95 and 29% below 90. Carry and pull to par are more interesting fixed income strategies than market timing of rate moves.

Old and cynical 

In my more cynical older age I increasingly take the view that no forecasts are stupid (within reason) but the idea of trying to forecast (most) things is stupid. Future outcomes for things we can observe are all on some dynamic probability curve and no-one is giving us the weights. So, the best bet is to think about what the individual feels most comfortable with as an investor. That is cash for lots of people. For me, as a professional in the financial markets, I see themes which I think support certain allocations that could deliver superior returns to cash. The equity-technology theme is one – just look at the capital spending numbers as companies ramp up their artificial intelligence capabilities and what that means for firms supplying data centres, cabling, cooling systems and (renewable) energy. I think high yield credit is another, as the financing risk of more leveraged, cyclical companies is spread more widely these days. An 8% yield in a US high yield strategy is attractive compared to there being no yield pick-up over cash in much of the investment grade market (hence the preference for short duration which has an attractive asymmetric return-risk profile to the likely evolution of rates).

In the QE world investors in high grade debt and cash paid an option premium to keep them out of trouble in a very uncertain world (central banks stood by as buyers). It was binary – little return for assets supported by central banks, potentially big returns for assets that were at risk from the debt-deflation nexus. Today is not like that. Cash provides income, there is little need nor incentive for investors driven by the need to build wealth to take interest rate duration risk. The market has rewarded risk takers in credit and equity and the macro backdrop looks as though that will continue. But there may be a reckoning ahead when the 2% inflation framework of developed market central banks is seen to have no clothes.

Scarlet ribbon 

There are other things on my mind. The UK election is a big one that provides the potential for an upgrade to UK equities – more on that in the next couple of weeks. And of course, I could not let the football season end without a comment on Manchester United’s superb Wembley victory over that other team from the same conglomeration. I prematurely said weeks ago the future of United is based on youth - and that came through with the goal scorers in the Cup Final. I am sure, come August, I will be just as excited as ever about the Reds. More scarlet ribbons in 2024-2025.

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 30 May 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.

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