Investment Insights | Kevin Boscher
05 Jul 22
Boscher's Big Picture - Recession or inflation – which poses the biggest threat?
As we approach the half-year point, markets have become increasingly agitated as sentiment has swung wildly between the prospect of inflation staying higher for much longer versus the threat of a significant global economic slowdown or even a recession. Kevin Boscher, chief investment officer at Ravenscroft, reflects on the last six months and what the future may hold.
This has been a tough few months for investors with both bonds and equities falling significantly, due largely to “sticky” and rising inflation forcing central banks, and the US Federal Reserve in particular, to tighten monetary policy through the combination of higher interest rates and an end to money printing (Quantitative Easing). Clearly, the uncertainty and volatility created by the tragic war in Ukraine has added to investor concerns, mainly due to spiking energy and food costs, which have added to the inflationary impulse. In addition, China’s extraordinary policy of zero Covid tolerance and lockdown has negatively impacted both the potential supply of traded goods, thus adding to inflation woes, and global demand, thereby threatening economic activity. Unusually, practically all financial assets have struggled over the past two quarters and even the hitherto strong performance from energy and commodity related plays is coming under pressure as the threat of stagflation and recession grows.
A mixed picture
The global economy is deeply out of sync; the US economy is weakening but still growing and inflation has surged. China, on the other hand, ground to a halt due to its stringent Covid containment policies and property crackdown and desperately needs both a re-opening plan and much easier monetary and fiscal policies. European and UK growth is also under pressure whilst headline inflation has soared, mostly due to higher energy and food prices. The global energy shock has imparted a stronger stagflationary impulse to Europe whilst inflationary pressure in the US has become more broad-based with excess domestic demand putting upward pressure on wages, rents and a range of consumer goods and services. In the meantime, Japan remains mired in deflation with the bank of Japan the only central bank still pursuing a very expansionary policy. The outlook for emerging markets (EM) is mixed with commodity-based economies enjoying a growth boost as global demand has surged. Commodity importers, on the other hand, face greater inflationary pressures and the prospect of slowing activity, especially those more dependent on China for growth. Inflationary pressures in EM are also diverging and some policy makers are further ahead in the global tightening cycle. The global economy is likely to remain out of sync for some time and policy making is also diverging significantly, which has material implications for both the economic and market environment ahead.
The impact of the consumer
There is little doubt that economic growth is slowing, and the risk of recession is growing, especially in Europe, the UK and US. The US consumer is key since they account for approximately 70% of the economy, with similar trends in the UK and Europe. Consumers are being hit hard by the combination of rising food and energy costs, persistent goods and services inflation, higher financing costs and falling real disposable incomes. Even in sectors where wages are rising, they are doing so at a rate which is less than inflation and with a lag. So far, the US consumer has been resilient thanks to the excessive savings built up during the pandemic, a tight labour market and buoyant house prices. However, consumer spending could downshift quickly as savings decline, the impact of Fed tightening really kicks in and when unemployment starts rising, which is inevitable given the current Fed hawkish stance. With the Fed draining liquidity from the system, which is resulting in a significant slowdown in US dollar money supply domestically as well as outside of the US, a shrinking US fiscal deficit (as the extreme pandemic-related spending slows) and a more cautious consumer, it is almost inevitable that the US will enter a recession within the next 12 months. Indeed, the Fed expects this and is adamant that the economy needs to “cool” materially if longer-term inflation expectations are to be brought under control. As already mentioned above, with China struggling and the recession risks in Europe and the UK also elevated, the threat of a global slowdown is material.
Bringing inflation under control
A contributory factor to the gloomier growth and market outlook has been an increase in investors’ expectations for where interest rates are likely to peak in this cycle. This is largely due to inflation appearing to be even more entrenched than previously thought and the subsequent shift in central bank policy towards a more hawkish stance. Central banks, led by the Fed, seem determined to bring inflation under control through a quicker and steeper rise in rates, even if this results in a recession and higher unemployment. The Fed, in particular, has changed its view of late due to the broadening of inflation indicators and rising longer-term inflation expectations. Whilst the Fed is acutely aware that it can do little to address rising food and energy costs, it believes that demand across the economy is exceeding potential supply across a range of sectors, which if left unchecked could result in more persistent wage and price increases and a change in the psychology and behaviours of both consumers and companies. If we, as consumers, believe that prices are going to keep on rising, we will likely bring forward our spending, draw down on savings, borrow more and demand higher wages. Companies, on the other hand, will hold more inventory and keep raising prices in the knowledge that demand and costs will both increase. The market and the Fed now expect rates to rise to around 3-3.5% early next year, which is significantly higher than anticipated a few weeks ago.
The longer-term outlook for inflation continues to be the single most important factor for the global economy and financial markets. Opinion remains divided as to whether the current spike in inflation will gradually ease and return to its pre-pandemic disinflationary trend or instead become more entrenched and result in a longer-term higher range, more like the 1970s. The main argument in favour of the cyclical view is that the powerful forces that have been putting downward pressure on both growth potential and inflation remain intact. These include an ageing demographic, which results in increased savings and lower spending, technological disruption (which boosts productivity and lowers company costs) and the benefits of globalisation, whereby the price of consumer goods and services fall thanks to outsourcing and lower production costs. In addition, high global debt levels tend to dampen growth and increase savings. Those who believe that higher inflation will prevail for much longer point to the fact that the huge monetary and fiscal stimulus injected during the pandemic has led to unusually high demand, at the same time as supply has been constrained due to Covid-related shutdowns, logistical bottlenecks, and a shortage of labour. These factors have put upward pressure on inflation, which is becoming more persistent as the shrinking workforce in many developed nations (plus China) leads to higher wages and the shift in psychology explained above. They also argue that globalisation has peaked and is going into reverse as the US and China battle for supremacy and due to elevated geo-political tensions. High energy prices present an additional complicating factor and are largely the result of the supply side disruption, war, and a major under-investment in fossil fuels over recent years. High energy costs add to inflationary pressures in the short-term but tend to be disinflationary longer-term since they act like a form of “tax” on consumers and weaken the growth outlook.
At a crossroads
Having been firmly in the disinflation camp for the past 20 years or so, based mainly on my experience in this industry of falling inflation, bond yields and interest rates since the early 1980s, I am much less certain now as to which direction we are headed. Indeed, I can make a strong case either way and the truth is that nobody knows and this includes central banks, governments and economic forecasters. The world has never been through a pandemic followed by war and then a complete China shutdown. Nor do we know what impact Quantitative Tightening (QT) will have on economic activity and markets. Also, it is rare for the global economy to be facing the threat of inflation whilst equally worried about the risk of a recession. There is simply no economic model that can predict what comes next and it was both fascinating and humbling to hear the Fed chair Powell recently tell us that the Fed has little confidence in both its growth or inflation forecasts over the next year or so but will react to the data as it materialises. Against such a background, it makes sense from an investment strategy viewpoint to keep an open mind, have a plan for all the potential outcomes (including a wide range of possible scenarios between the extremes), stay flexible and adapt if required. This is largely why Ravenscroft has had “navigation” portfolios in place for some time and will likely continue to do so for the foreseeable future.
In my view, the most likely scenario over the next year or so is that inflationary pressures gradually ease as global economic activity falls, commodity prices subsequently decline, the goods shortages and supply problems diminish, and labour market pressures subside. The Fed, and other central banks, seem very determined to tighten policy and prevent longer-term inflation expectations becoming entrenched. This includes the most aggressive rate hikes since the 1980s and, if implemented, will weigh on activity and ultimately, inflation. However, much will depend on whether central banks will follow through with their intentions and remove the excess demand in the system or if, instead, they pivot at the first signs of economic or financial stress. Also, the key upside risk is that tight labour markets and high inflation expectations will trigger persistently high wage growth and a subsequent shift in consumer and corporate behaviour. It’s also true that energy and commodity prices could be in the early stages of a structural move higher due largely to supply and demand imbalance and a significant underinvestment in new production over successive years. However, as explained above, this would be expected to weaken demand and dampen growth over time, which would help offset some of the more inflationary impact.
Thinking ahead to the next year or so, I am of the view that central banks will find it difficult to materially tighten policy and raise rates to the intended levels given the threat that weaker growth, rising unemployment and a potential market or financial crisis presents. The global economy and markets are also likely to be sensitive to higher rates given the record high debt levels. In addition, with governments intent on addressing numerous challenges, including income and wealth inequality, an underinvestment in healthcare against the background of an ageing demographic, climate change and now energy, food and defence security, this will likely necessitate more spending and bigger fiscal deficits longer-term. Central banks will need to enforce financial repression to keep financing costs low and print money to finance this government spending. Such a policy would almost certainly sow the seeds for a much bigger inflation problem further out or, at the very least, lead to higher volatility around both growth and inflation and a more uncertain macro environment.
Central banks face a difficult dilemma as they attempt to soften demand sufficiently to ease inflationary concerns whilst seeking to avoid a serious recession or a financial crisis. This is an extremely tough ask and history suggests that a “soft” landing will be nearly impossible to achieve. This will not stop the Fed, ECB and Bank of England from trying and they definitely seem to favour a mild recession if that is what it takes to bring inflation under control. They are also keen to raise rates sufficiently to provide them with more monetary ammunition to deal with the next economic or financial crisis. There are a number of potential scenarios that could cause them to pivot and temper their hawkishness. In particular, they will be closely monitoring the impact of rising unemployment on consumer spending, financial and market stress, oil prices and clear evidence that inflation expectations are easing. At this current juncture, the Bank of England appears to be more concerned about the gloomy growth outlook whist the ECB is focused on the impact of higher sovereign spreads and yields on the periphery economies (such as Italy, Spain, and Portugal) as they seek to avoid a repeat of the 2010/11 Euro crisis. In the meantime, the Bank of Japan seems intent on continuing to print money in order to break away from deflation, even if this has already pushed the Yen to an all-time low and it ends up owning all of the government bond market. China, on the other hand, will need to ease monetary policy at some point very soon if the economy will have any hope of meeting the government’s growth targets. Diverging policy is an increasing theme for markets to digest.
What does this mean for financial markets?
For now, the tough Fed stance and stubborn inflation could extend the rare combination of falling stock prices and rising bond yields a while longer. However, as growth slows, the risk of recession and/or financial stress increases and the profits outlook worsens, I expect government bonds to rally well in advance of stocks. Also, yields on US Treasuries across all maturities, and UK Gilts to a lesser extent, are looking much more attractive after the recent sell-off, which has seen the worst drawdown for Treasuries in over 40 years. At the same time, sovereign bonds are unloved, under-owned and massively oversold from a technical perspective. Another inflationary shock, such as higher energy prices or an escalation in the war, could see sovereign bond yields rise further. However, in the absence of this, it is more likely that yields will fall from these levels over the next few months delivering solid returns for investors at the same time as providing an attractive hedge against slowing global growth or an unforecastable financial accident. Even if inflation stays high and the Fed follows through with its planned tightening, longer duration yields have likely peaked, and the maturity curve would be expected to flatten in the expectation that inflation would eventually be crushed.
Credit markets have also had a tough time over recent months with significant losses for both Investment Grade and High Yield bonds. The combination of slowing growth, a weaker profits outlook, hawkish central banks, higher rates and the threat of rising default rates is bearish for the sector, especially High Yield. Hence, the bear market in credit will likely last a while longer and any further widening of spreads (over equivalent sovereign bonds) or weakness in prices will largely depend on the extent and duration of the growth and profits decline. Having said that, a lot of bad news has already been discounted in both equity and credit markets. In addition, assuming that the Fed will turn more dovish at the first sign of economic or financial stress, then any slowdown/recession could prove quite mild and falling sovereign yields would be supportive for risk assets generally. Finally, many companies are in a relatively strong financial position at present, having been through a tough test in 2020 and thanks to the subsequent and extremely generous monetary and fiscal support, which has enabled a very strong economic and profits rebound. Given the hugely uncertain and challenging macro background, it makes sense to keep duration (interest rate risk) short in credit markets and stick to active managers with a proven track record through both good and tough markets. Like equities, there will be an opportunity to add to attractive credit issues offering significantly higher yields than a year ago, and with an improving fundamental outlook, but patience is required and the risks remain skewed to the downside for now. In a similar way, emerging market debt also looks interesting at the current time.
The bear market in equities is advanced but the conditions are not yet in place for a durable trough and recovery. I have previously argued that equities need three strong “pillars” to do well; reasonable growth (both economic and earnings), plentiful liquidity (to drive economic activity and financial markets) and attractive valuations. Over recent months, equities have been in a sour spot with the Fed and other central banks tightening policy materially in the face of higher inflation and draining liquidity out of the system. Valuations have fallen significantly, especially for growth stocks, which are negatively impacted by higher interest/discount rates and were previously trading on very expensive multiples. The sell-off has been both swift and severe and whilst the major indices are lower by somewhere between 15-30% (with a few notable exceptions including the FTSE100), many individual stocks have fallen much more, in some cases more than 50%.
Equities continue to face several headwinds and are likely to stay volatile for the next few months, with further downside possible. Central banks are likely to continue hiking rates and tightening policy in an effort to bring inflation under control. At the same time, their policies will result in falling growth and an increasing risk of recession. Earnings will almost certainly come under pressure as growth stalls and costs continue to rise, especially as analyst estimates are still elevated and too optimistic. Whilst valuations have moved lower, they remain expensive in some areas and will probably correct further as interest rates continue to rise and earnings contract. The duration and depth of this bear market will almost certainly be determined by the path of inflation and central bank policy. If the Fed changes tack and becomes less hawkish, either because inflation is easing or in the event of an economic or financial crisis, then equities will rally hard as interest rates and bond yields fall. Also, a significant change in Chinese policy towards either the Covid zero tolerance or an aggressive monetary/fiscal stimulus would boost global growth prospects and support equities. Any fall in energy costs, especially if accompanied by a resolution in Ukraine, would also be very helpful, since this would imply an improvement in both growth and inflation.
In the meantime, we will likely see occasional equity rallies, but these will fade in the absence of an improved liquidity, interest rate, growth or valuation environment. Given this background, it makes sense to stick with a diversified and defensive equity strategy, which combines quality growth companies with value and favours large cap over smaller companies and more defensive stocks over cyclicals. We continue to like commodity and energy related stocks on a long-term view but these sectors may struggle for a while if growth slows as expected. As highlighted above, at some point, hopefully in the not-too-distant future, it will make sense to become more optimistic on equites and increase weightings. Assuming that the Fed eventually pivots towards a more accommodative policy, then we may see a rotation into growth stocks, such as tech, and early cyclicals, such as housing related equities. These sectors are more sensitive to interest rates than to economic prospects. However, given that growth stocks are still expensive versus value stocks, the longevity of any such rotation will depend critically on the future path of inflation and interest rates. In the meantime, some very attractive investment opportunities are starting to appear in areas such as emerging markets, where valuations look cheap, and biotech, which started its bear market much earlier than the broader market and where M&A activity could act as a catalyst for a recovery.
A strong US dollar
The strength of the US dollar is largely due to four key factors; a hawkish Fed and a big shift higher in US interest rate expectations; higher yields available on dollar bonds; a significant decline in US money supply as the Fed has tightened policy; and a stronger US economy relative to Europe, Japan and even China. Many of these factors remain supportive for the dollar and I expect further appreciation over the next few months, but this could change if the Fed is forced to change its stance and interest rate expectations move lower. Having said that it is very difficult to make a strong case for most other currencies given the concerning outlook for the UK economy, the challenging issues in Europe, the continued focus on QE in Japan and problems in China.
Slower growth and a recession in the US economy will likely cause a cyclical pullback in commodities, and indeed we are already seeing lower prices in many sectors, but the secular trend will probably stay bullish. The post-pandemic surge in commodities seems to be predominately driven by supply factors, capacity constraints due to underinvestment over many years and more recently, the Russia-Ukraine war. In addition, the ESG movement has jacked up capital costs for the fossil fuel industry, limiting investment to expand capacity. The world has little spare capacity to boost oil output, despite high prices and the war has really highlighted this problem. Commodity demand will weaken as global growth slows but probably not by very much in a deeply unsynchronised world, especially if China eventually climbs out of its slump. In the meantime, gold remains in a long-term bull market given the extremely challenging and uncertain macro environment.
These are unprecedented times for the global economy, financial markets, and geo-politics. Although it is feasible to plan for a few potential outcomes, it is almost impossible to have much conviction about how things will evolve. Much will depend on whether the current inflation spike proves to be the start of a longer-term trend, and how policy makers respond. A more defensive stance remains appropriate for now as we seek to protect capital for our clients and as we navigate our way through the uncertainty. However, markets have already discounted a lot of bad news and opportunities are starting to emerge across a range of assets, most notably equities. It is also reassuring to remind ourselves that even if we are returning to an environment more akin to the inflationary 1970s, some assets did very well in this period, including some specific equity sectors.
At Ravenscroft, we will stay cautious and patient for now and will be monitoring the direction of growth, inflation, and central bank policy over the next few months. We remain optimistic that better times lie ahead but have a contingency plan in case things take a turn for the worse.