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Article | 11 February 2022 | Podcasts
Market volatility has returned, driven by swiftly rising inflation and sharply tighter central bank outlooks. Have we passed the point of no return for a Goldilocks outlook for 2022, with major economies ‘not too hot and not too cold’ by year end?
We take a look at what needs to go right from here. And what are the risks to that scenario.
Presented by Pela Strataki CFA and Alex Burn CFA, Senior Investment Analysts. Hosted by Lorna Denny, Investment Specialist.
The Architas Podcast is now availabe on all popular podcast platforms (Apple, iTunes, Spotify, Android Apps) just search for 'Architas Updates' on your favourite podcast app.
Is a 'Goldilocks outlook' still possible for 2022?
There is an old saying, ‘As January goes, so goes the year.’ And we certainly made a volatile start. The catalysts? Swiftly rising inflation and more hawkish rhetoric from the central banks, suggesting tighter policy. But the fear is that if rates rise too sharply, the recovery could be choked off too early. On the other hand, if the central banks don't act decisively, then inflation could become embedded. It seems rather like a rock and a hard place. Could we have already passed the point of no return for a benign outlook to the year?
What is a Goldilocks outlook?
The term is used to describe an ideal economic scenario whereby growth, and probably also inflation, is ‘not too hot and not too cold’. In a way, this is what central banks are trying to achieve. Goldilocks theoretically is when unemployment is low, asset prices increase, inflation is low, interest rates are low and GDP grows steadily.
Again theoretically, it requires government spending on infrastructure, private and public investment in a variety of different industries and a favourable tax policy. If growth is too hot, demand can spiral upwards and price rises can become embedded. If growth slips into negative territory, or recession, then demand is weak, prices might fall consistently, leading to deflation. And then obviously there are all the environments in between. And there is a further possible outcome where growth is choked back, but prices keep rising. That's what we know as ‘stagflation’, a very uncomfortable position for economies and markets.
Could you give us a little context on the volatile start to 2022 in financial markets?
Government bond yields have been rising throughout January and February. The US 10-year yield currently stands at 1.93%, having finished 2021 at just over 1.5%. That's a big move in the space of six weeks. As bond yields move higher, the total face value of negative yielding debt outstanding has dropped sharply to below $10 trillion.
Even the German 10-year Bund now has a positive yield of 0.24%. Peripheral eurozone bond markets have come under pressure. And there has been a knock-on effect to the equity markets, especially for high growth tech stocks, whose best earnings are at some time in the future. The S&P 500 had its worst January since 2009 and the Nasdaq hit correction territory, falling 10% from its all-time high in November.
These dramatic moves stem from the markets really adjusting their expectations of how fast and when interest rates will rise this year. Could we use the US Federal Reserve's (Fed) plans as an example?
All this stems from expectations of where inflation will be over the next few years and how persistent it will be. To summarise, the journey we've been on so far: since the recovery began in the second half of 2021, the Fed’s, and other central banks’, view has been that inflation will be temporary, or transitory to coin the phrase, meaning because of the sudden return of the economy lots of items would be in short supply, demand would surge, temporarily raising prices.
Gradually over the last six months the market, followed by the Fed, has come to the realisation that inflation is proving to be stickier than expected. One of the central banks’ key tools to combat inflation is interest rates. Therefore, an expectation of higher or longer-term inflation is tackled by higher interest rates.
The market expects around five rate rises this year. Where there continues to be slight deviation between the Fed and the market is in the medium term, where the Fed believes a higher terminal rate is needed versus the market’s slightly lower.
It's not just the Fed though. Even the European Central Bank (ECB), which has been so steadfast in sticking to loose policy, seems now to have changed its tone?
Indeed, at the ECB press conference last week, Christine Lagarde declined to repeat her earlier comment, that an interest rate rise this year would be highly unlikely.
Instead, she reported concern about the elevated levels of inflation in the eurozone, which stands at a record high of 5.1%. One rate rise by year end has become consensus at this point, and market pricing suggests eurozone policy rates could go up as soon as June.
It's worth noting, however, that the picture in the labour market, in the eurozone in particular, is actually quite different from what we see in the US, and indeed in the UK. There are fewer labour shortages in Europe and there is less inflationary pressure coming from wage increases there.
The Bank of England has already embarked on a trajectory of rising rates. Can you explain how the governor is attempting to head off a wage spiral?
That's right, the Bank of England has embarked on some ‘tough love’. A squeeze on real incomes is very much being felt in the UK and, seeking to quell the effects of this getting worse, they've begun raising interest rates. Estimating that inflation will stay above their 2% target for the next three years if interest rates remain where they are. At the same time, they announced they had begun reducing, or tightening, the £895 billion stock of assets they have bought since the Financial Crisis.
Initially stopping reinvestments as they mature, reducing the total by £70 billion over the next two years. The most contentious moment of the day, that the media has latched on to, was the governor's comment around raising wages, saying raising wages would prolong the problem period we are in.
Is it possible then that a change in perception of central bank policy could be enough to choke off rising prices on its own? Or even perhaps, to choke off growth?
The expectation of higher rates can indeed restrain spending plans and limit rising demand in the economy. It hits consumer confidence, and this has a cooling or dampening effect. It could restrain some inflationary pressures coming from increases in consumption, but not necessarily those arising from constraints in supply in certain sectors. Or indeed rising energy or commodity prices. It's by no means a straightforward situation.
Have we already passed the point of no return for decent growth and benign inflation - the Goldilocks scenario - for this year?
On the side of growth, we are looking at moderating numbers versus last year, but still above trend growth rates. Interesting to note that for the first time in 17 years, the growth outlook looks better in Europe than in the US, which should feed through to corporate profits there. And even in China, where we're seeing a policy-driven slowdown, it is being managed and accommodating measures are already being put in place. We don't expect a hard landing there. It's a decent picture for growth per se.
A bigger question mark to my mind is around inflation, how that pans out and how it impacts central bank policy around the world. There is still a chance that inflation might moderate, taking off some of the pressure on central banks to act, but I have to say at Architas we are actually worried that the inflation dynamic may prove more worrisome this year than markets expect.
Is the weight of this solution all in the hands of the central banks?
To a degree. The central banks have a big impact on the economy and the potential for that scenario. They tread a very fine line between controlling inflation expectations and choking off the economy, something we can very much see in real life now. But rather than solely enabling a Goldilocks environment, a central bank’s key primary objective should be to reduce the extremes of inflation.
But all this aside, QE has driven a huge increase in focus on what the central bank does by the entire market. Theoretically, the other potentially more important factors to providing a nurturing environment for a Goldilocks environment are government spending on infrastructure, fairly universal at the moment, but it needs to be sustainable and focus at least five years out.
We need private and public investment in all variety of industries. Capitalist governments always target this, the balance between a supportive nature on markets and business and also balancing that off with living up to their social contract. And then finally a favourable tax policy. There is some divergence within countries at the moment on this.
Some economies are already trying to repay the bill of the pandemic, obviously. Governments are in a very difficult position, I would say, on the last two elements of that especially.
Markets must have confidence that these central banks are up to the job that they are trying to do. How will they achieve this?
Central bank credibility is key here, and central banks are stuck between a rock and a hard place. On the one hand, they have been criticised for being ‘behind the curve’ on inflation. Too little too late could see inflation, and indeed inflationary expectations which are also very important, spiral out of control.
On the other hand, some market participants do worry about a so-called ‘policy error’ on the hawkish side. Tighten too fast and you choke the recovery. Markets don't normally respond well to tightening liquidity conditions. It's a very fine balancing act and it's good communication with the markets that is key here. I would say the central banks are doing a decent job of that at the moment. The Fed has made it clear they want to be flexible and data-led. The ECB has put a formal framework in place already, which helps with predictability and transparency.
What changes have we made to our tactical asset allocation recently?
Firstly, we maintain our overweight in equities. While acknowledging the risks, we feel equity markets are well positioned to deliver in 2022. Macroeconomic data continues to remain strong, labour markets are recovering, unemployment has improved, companies remain in good shape and strong corporate fundamentals should provide the basis for a period of solid earnings. And volatility has made valuations more compelling. As such, we maintain that moderate overweight in equities.
In Europe, we’ve grown confident in the relative performance. Europe tends to do well when cyclicals outperform and, as Omicron passes, we expect cyclicals to enjoy a period of superior performance.
With bond yields rising, we’ve become increasingly cautious in impacted styles, more specifically growth stocks or ‘long duration’ stocks. They are pressurised, as their expected future earnings, which they are priced on, diminish as the rate they are discounted by rises with interest rates. We also have a moderate underweight in duration assets, which we maintain.
Consequently, while bond yields have already risen towards their highest levels since the pandemic began, the likelihood of them moving lower again grows less likely, as we near a rate liftoff in the US in the coming months.
And finally, we've introduced a moderate overweight in cash and alternatives as a means of diversification in portfolios, rather than via fixed income. They can be used to achieve lower duration in portfolios and avoid the negative total return potential, which are embedded within most bond asset classes. A scenario that's ever more likely as central banks globally look to tighten monetary policy.