Stagflation risks are rising

It's been said that ‘history is just one thing after another’, but sometimes those things can seem like a collision of random, even extreme events, nicely expressed by the term ‘polycrisis’, with many things going wrong at the same time.

As 2022 began, the world’s central banks had a plan: normalise policy, head off inflation and allow the growth recovery to continue. Then came the dual shock of war in Ukraine and soaring food and energy prices. How can the central banks keep ahead of events now, controlling rising inflation, while maintaining growth?

Can you recap the difficult market backdrop so far this year?

Yes, 2022 has been a very bad start to the year for markets. It’s the fourth worst start that we’ve seen in the last two decades. A combination of a hawkish shift from the US Federal Reserve to combat inflation, and that's been ubiquitous across global central banks. Inflation itself being a concern for consumer spending power, arguably rich equity valuations and the Russian invasion of Ukraine, have caused significant volatility across most asset classes.

Global equity markets, as measured by the MSCI Global Index, are down about 7.2% for the year. The technology sector, in particular, has been the worst affected with growth stocks, which are very technology heavy, down 9%, so underperforming the broader market.

Looking at the Nasdaq, which is essentially a technology index or an adequate proxy for such, this is down close to 13%, so we have seen widespread wealth destruction in equity markets.

What have been the shining lights in this equity drawdown? Well, value and dividend paying stocks have done very well and are actually positive for the year. Value stocks really like inflation and higher interest rates because they’re composed of sectors like financials and energy. And higher interest rates can make ‘financials’ more profitable. Also, ‘energy’ has performed strongly due to soaring oil prices, which has been a key driver in the inflation dynamics we are seeing.

Over to fixed income, there really hasn't been a place to hide either as the move higher in interest rates has caused bond prices to fall. Also, these higher interest rates are causing stress in credit markets, with corporate spreads widening too. When you look across the fixed income spectrum, there really has been no fixed interest security that has produced positive returns. The Global Aggregate Index, which is composed of government and corporate bonds, is down about 6.7% rebased to euro terms. Unfortunately for bond investors, there has been really nowhere to hide, apart from allocations to inflation swaps, instruments that track the return of inflation, and we in Architas have had allocations to these across a number of our bond portfolios. Asset allocation has been critical and looking at other elements of the investment universe has been important to build resilient portfolios, with gold, for example, up 8% acting as an adequate inflation hedge.

As far as macroeconomic forecasts are concerned, inflation and growth are heading in opposite directions.

That's right, as we know inflation has, for a long time been on an upward journey, originally driven higher by the pandemic with workforces being locked down, factories being shut and delivery routes off limits, the supply side was struck back with significant delays, raising prices for those items that were available. This problem was exacerbated during the recovery, as demand skyrocketed when economies reopened. That disruption to trade and supply chains was dealt a hammer blow by Russia's invasion of Ukraine. Although not a big part of the global economy or trade, they have a significantly outsized effect on the delivery of commodities, particularly rare earth metals, food items such as wheat, and of course oil and gas.

We've seen lots of ever-increasing prices and inflation numbers beating market expectations in almost every region around the globe, with no sign of peaking. In order to combat inflation, expectations of interest rate rises have increased significantly over the last six weeks. This acts as a cooling force to the hot economy. These two items together are causing the slowing of growth expectations, which until now have been moderate but not severe. The obvious worry is that these issues run out of control and there is a significant downside in the economy and markets.

Is stagflation a real prospect for this year?

Just to recap, stagflation is that dreaded combination of slowing economic growth, high unemployment, and rising prices.

And if we look at the current environment around the world, we have had good growth because of the recovery from Covid. However, rising price risk is significant and trade bottlenecks are likely to have a big impact on slowing that growth.

High unemployment: luckily, in many parts of the world we are at record low unemployment. There are caveats to this, such as in Europe. But in the US, to contrast, they've recently hit historical lows. If the hit to growth tips into recession though, which many believe it will do, then higher unemployment is sure to follow.

And on inflation, we already have it and it's difficult to see how, at this point, it doesn't get worse from here. Importantly, it can begin to filter through into significantly higher wage growth, which has that self-fulfilling negative effect in this environment. And that low unemployment we spoke of causes structural inflation, as wage inflation has to occur to attract applicants from an ever-dwindling pool.

The reason this is such a dreaded combination is that it puts governments and central banks in the impossible position of trying to support growth, which inherently has the byproduct of further pressuring prices.

In recent weeks we've had tell-tale indicators from the US Treasury market that we might in fact be facing a recession in the US economy.

Yes, so the inverted yield curve in the US, the apparent harbinger of doom, has shown its head briefly. So front-end interest rates, that's 1 to 2 years, were higher than 10 year and longer dated issues, and this has historically been a relatively good predictor of recession. And it is not to say that this time is different, because Fed policy to combat inflation could very well lead to a recession, but I think there are a couple of important dynamics, in our view, to consider. One- an inverted yield curve does not provide an indication and an exact timing of recession.

For example, the yield curve inverted in 2006 but the recession didn't come until 2008. But this time as well, longer-dated issues have been well supported by liability driven investors like pension schemes and insurance companies who are price agnostic in that they will always buy these issues. And importantly, the Fed's bond buying programme and the Fed’s balance sheet, which has bought and held a large number of these longer-dated securities. So as the Fed begins the balance sheet reduction, which has been announced, we believe that will put upward pressure on yields in the longer end and steepen the yield curve. And indeed, we've already begun to see this emerge. It’s worth reminding listeners that rising pressure on yields means bond prices falling.

And yet the US Fed has started an interest rate raising cycle last month and seems determined to stick to their tightening plan. Is it fair to judge the Fed's actions as ‘tighten until something breaks’?

The Fed has a dual mandate and that's: number one - employment and then number two - controlling inflation, or stability of prices. The labour market has been very tight. Unemployment is down to 3.4% and wage inflation has been creeping up across the US. The Atlanta Fed produces a wage growth tracking index, looking at wage inflation, and that has been rising quite significantly.

Inflation now is a global phenomenon, not only in the US. This combination of supply chain disruptions and an arguably over-stimulated economy and soaring commodity prices means that inflation in the near term is not dissipating, so the Fed really has to tackle this by using its monetary policy, hiking interest rates to try and take some consumer demand out of the economy.

Over at the European Central Bank, which is so much closer to the action in Ukraine, is the policy stance similar?

As yet, we haven't seen the action that we have in other regions. However, the expectations of those rises have increased meaningfully over the last month. Remember that we are at negative levels in Europe, so any shift has an outsized effect, both physically and, more importantly, psychologically. It certainly changes the tone and rhetoric.

What we've had is a significant hardening and increase in hawkishness. There's a preference to be more constraining on the economy, through monetary policy, than to be more supportive.

And finally, China is struggling now with its zero-Covid policy, but economic growth seems to be a very clear priority in the world’s second largest economy.

It does, but what's happening in China has the potential to be extremely important. It could be the equivalent of pouring petrol on the fire. Let's not forget that through many worrying periods for global economies, we have relied on China to support their GDP growth, with its suspiciously precise targets. With the severe lockdowns in major cities and regions, there has to be an effect on trade and demand. Those bottlenecks in trade could worsen meaningfully, and again that pressure on prices filters through.

We would need to see both an extremely accommodative approach by the government and the central bank, which historically there has been. But the market is in something of a’ wait and see’ mode at the moment, and we likely need to see a big shift in Covid spread through the country, which there are meaningful roadblocks still to work out. Quite a contrast in policy to the Western world.

There has been talk over this first quarter, when bond and equity markets have both suffered drawdowns, of an ‘illusion of diversification’. How are we dealing with this at Architas?

We've had the combination of both equities and bonds selling off. Typically, in asset allocation, the bond portfolio is your defensive ballast. So when equities sell off, bonds rise, due to a flight to quality or safe haven asset, and this hasn't been the case because of the hawkish shift by the Fed to combat inflation.

In Architas we've been quite negative on bonds for over a year now, and we've been recommending higher allocations to cash and reducing interest rate sensitivity in portfolios and an allocation to alternatives such as gold.

Lastly, in response to the Russian invasion of Ukraine and the knock-on implications that it could potentially have with inflation dynamics and GDP growth in the eurozone, we've tilted to moderate underweight in our equity portfolios by reducing European equity market exposure.