Fireside Primer: The Central Banks’ Illusion of Temporary Inflation
The world today looks very different from the world we knew at the start of the year. Our focus back then was on the end of the pandemic and what this meant for the global economy. We identified some of the other problems, including the growing tensions between Russia and the Ukraine, there is still no end or peaceful resolution in sight. And now we find ourselves in the throes of runaway inflation, dissipating the illusion central bankers had all along of how long it would last.
This week, in preparation for our last Fireside Conversation in this latest series, we share an excerpt from BFI Infinity’s quarterly InSights. This is literally “fresh off of the press” from Daniel Zurbrügg. The inflationary issues that were only deemed as temporary by central bankers is now running rampant and it would be a big mistake now to simply assume that things will their way out to pre-pandemic levels.
Daniel will be joining Marc Seidel from BFI Consulting/AltAlpha Digital, and our BFI Capital Group’s Frank R. Suess, to sit on the panel that will be there to answer your questions on May 25th, 5pm Swiss/Central European Time, during our Conversation, “Potpourri of Participant Questions – How to Invest in the New Era".
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Very quickly after the launch of the Russian offensive, countries around the world, especially in the West, turned against Russia and announced economic sanctions the likes of which we have never seen before against any other country. It seems that this conflict has brought western countries together much more swiftly than we could have imagined. Not too long ago, it looked like Europe and the U.S. would drift further apart, however, the Ukraine war changed everything. And with it, Ukraine has been moving even closer to the West, and especially the European Union, much quicker than we expected. It is clear that Russia and Ukraine will not have much of a future together and it may well be that Russia has created an outcome that is very different from what it originally wanted.
Of course, the war did and continues to create volatility across financial markets. Initially, global equity markets sold off by around 15-20% but have recovered recently and currently major markets are only slightly negative for the year. The biggest impact has been felt in energy and commodity markets with oil prices shooting above USD 100 per barrel. But it’s not only energy prices that are on the rise. In fact, most commodities are seeing rising prices. And it is not only due to the war, but probably more linked to the continued problems in the global supply chains.
This situation might normalize over time on a higher level, but it will probably still take 6-12 months until prices start to stabilize and only then will we see a dampening effect on inflation.
Figure 1: Sentix Overall Economic Sentiment
Source: Sentix, Fortune
Consumer prices have risen by more than 5% in Europe over the last twelve months and more than 7% in the U.S., levels that we have not seen in more than 30 years. The pressure on producer prices has been even higher, but as expected, producers are not able to pass all cost increases on to the consumer. This is now creating a completely new macro environment with inflation being much higher and interest rates rising with it as well. US 10-year treasury yields have risen rather dramatically in recent weeks to hit levels of almost 3%, so yields have pretty much doubled since the start of the year. This is already being felt in many ordinary households, with mortgage rates, for example, having jumped very significantly.
This might not yet cause a dramatic change in the U.S. housing market, since over the last few years, with record low financing rates, most buyers have financed their property purchases with fixed long-term mortgages at much lower rates. However, going forward, this will certainly cause a slowdown on the housing market with cheap financing options no longer available, at least for now.
With almost 70% of US households living paycheck to paycheck, rising prices will eat into disposable income very quickly. In fact, many households have been seeing their spending budgets come under considerable pressure already in recent weeks.
Figure 2: US Home price growth at a record high
Source: CoreLogic, Bloomberg
With this, it should be clear that growth rates will continue to be under pressure, as they have been for months already. The U.S. economy was entering 2022 with a growth rate of around 3% or even slightly higher. According to the Atlanta Federal Reserve, growth has been declining to a pace of around 0.5% in early April, showing a very clear trend. Slowing growth is not only a U.S. problem, as the same is true for Europe and other parts of the world. The IMF and other organizations have therefore started to lower global growth expectations and the current projection of 3.6% global GDP growth for 2022 still might look too high.
Despite the fact that central banks around the world have been providing monetary stimulus for many years, now the situation seems to be changing rather rapidly. With inflation rising quickly, central banks have no other choice than to normalize monetary policy and hike interest rates. Rates are still way too low: if a 10-year treasury yield is around 3% and inflation is around 7%, there is a clear mismatch, so it is no surprise that the market is expecting a series of rate hikes in the coming months. This needs to be done during a time when growth is already slowing, and the big question is how long will central banks continue to hike rates before they will need to change tack to stimulate the economy again. We foresee a situation when eventually central banks will become more reluctant to hike rates further and such a monetary “U-turn” looks likely to happen in the coming 12 months and its effects will probably be rather strong in financial markets. It would almost certainly cause stock prices and commodity prices to jump and maybe even more importantly, cause the U.S. Dollar to start falling, potentially rather dramatically.
Figure 3: Commodity price boom
Source: Refinitiv, FT
It is crucial to understand that the current macroeconomic environment with inflation being on the rise is not a demand driven situation but rather a supply side driven inflation. Actually, demand globally has been good and stable, but the supply side has not been able to keep up with that. It seems to be almost normal today to experience delays in delivery and shipping of many consumer products, usually because certain parts are not available. This is in sharp contrast to the past decade, when the supply of products was always stable and never a reason for concern. The pandemic has changed it all and we are seeing that the repair of global supply chains is taking time. Also, it is not only a matter of rebuilding supply chains, but there is also a clear trend away from globalization, as we’re switching from global trade to more regional trade. Geopolitical considerations are reinforcing this trend, and this, for example, becomes very visible in the global microchip market, where we see record amounts of new investments to build chip factories in Europe and the U.S. in order to become less dependent on China and Taiwan.
Also, it would be a big mistake to simply assume that things will work themselves out and that inflation will gradually move back to pre-pandemic levels. Investors need to understand that we have entered a new phase, a new era so to speak and as outlined in our Special Report in 2020, things are about to change more permanently. This is particularly true for inflation, where we are now starting to witness a series of self-enforcing dynamics that will make inflation more sticky than previously thought. For example, workers around the world will demand rather steep wage increases to compensate for the lower purchasing power. This will increase costs and create a cascade of price increases. That is why inflation is really problematic if it becomes a longer- term issue. Bringing this under control normally requires painful measures and adjustments and we believe those are yet to be seen.
The world is changing at a rather rapid pace and while globalization is not coming to an end, it is obvious that the world is about to split up into different economic blocks with Europe and the U.S. moving closer together again. The current situation in Ukraine is driving Russia closer to China, at least for now, and for as long as the current political leadership is in control. So we’re now facing a more difficult geopolitical situation, more challenging macroeconomics and very likely more volatility in financial markets. This combination creates a very interesting situation for financial markets going forward. Because of these developments a more active investment approach is required, the times when it was enough to buy and hold and let cheap money drive markets higher, are probably over and might not return for a long time.
So, active investment management with an active approach to risk management is now required. This means, as a first step, that investors are required to better diversify their portfolios and that they have to go beyond the traditional bond/stock mix, that is still the case for most private investors. We have for years explained and highlighted the importance of a more sophisticated approach to portfolio construction that not only involves a broader geographical diversification, but also a better diversification among asset classes including alternative investments. That means commodities, precious metals and other alternative investments should be an integral part of a well-constructed portfolio. Also, in view of a potential decline in the U.S. Dollar and the Euro, currency diversification is also a primary consideration going forward.
While we feel that the overall market outlook is more challenging, we continue to see opportunities in selected areas, we just feel that the market environment requires a more focused approach. For example, the recent developments in Europe are offering significant opportunities, as Europe is strongly moving forward to become less energy dependent from Russia (and fossil fuels in general). Also, it is obvious that due to the changing geopolitical situation, European countries are starting to invest in security and defense like they have not been doing for at least 50 years. These two factors alone are going to create an investment boom and we are only at the start of this cycle. There will be big winners from these changes and finding and including these investments in the portfolio is what we are doing for our clients, that is where our passion is.
A final word about gold, since we always get a lot of questions about that: Gold has been moving close to the USD 2’000 mark, in fact it even briefly traded above that a few weeks ago. Readers who have been following our updates in the recent past will remember that we have always had a rather positive outlook for precious metals. This outlook has not changed, in fact it has gotten even more positive. We don’t make any precise predictions; we simply feel that the current environment creates a situation where the risk/return outlook for precious metals is heavily skewed to the upside. That is why we stay strongly committed to our investments in this asset class.
Finally, we would like to encourage you to sign up for our current series of webinars called “Fireside Conversations”, where we discuss different topics related to investing and economics.
We would like to thank you for your interest in our work and we look forward to receiving your questions and feedback. Please reach out to us if you have any questions, as we are always happy to hear from you and help you in the best way we can. We wish you all a wonderful springtime and send you our best regards from Zurich, Switzerland.