Paul Volcker, chairman of the Federal Reserve from 1979 to 1987, is best known as the central banker who slew the inflation dragon triggered by energy shocks (Arab oil embargo and Iranian revolution) and banking policies excessively pro-growth central government, ignoring supply-side inflation factors. Volcker’s aggressive monetary tightening may have caused a recession, but it sharply reduced inflation in the United States and ushered in a long period of subdued price increases that supported the bullish stock market that began in the early 1990s. 1980s.
Much of the world is currently experiencing another spike in inflation, with supply and demand side drivers that share some similarities with the 1970s but are in many ways also quite unique. A toxic mix of excess demand and insufficient supply has resulted from COVID-19-induced shifts in demand, rigid “just-in-time” supply chains, corporate pessimism at the start of the pandemic, unprecedented levels monetary and fiscal stimulus, and most recently (and most importantly) a global energy shock triggered by Russia’s invasion of Ukraine.
The inevitable result is rising prices. For much of the post-Global Financial Crisis (GFC) period, the main challenge facing global central banks was the opposite: global excess supply and insufficient demand, leading to stubbornly low inflation and sporadic fears. of deflation. This bias likely caused the initial reaction to view the spike as “transient,” which will likely turn into deflation as higher energy prices feed into the base. This view turned out to be very optimistic, despite an apparent spike in supply chain disruptions as the war dragged on and energy prices continued to rise, impacting prices. consumer with a lag as corporate hedges disappear.
We find ourselves in a situation considered almost unthinkable in a pre-pandemic world, as we hear dusty old phrases like “overheating”, “behind the curve” and “wage and price spiral”. Policymakers find themselves in the awkward position of tightening monetary policy only moderately, hoping not to aggravate the negative growth impulse already presented by the existential squeeze on the cost of living, and risk an upheaval in expectations. inflation that ushers in a world of high inflation not seen since the 1970s, or tightening policy aggressively in the hope that quick action will quickly stave off the fear of inflation.
This last course of action has emerged as the preferred option, the lesser of two evils so to speak. Lessons from Volcker and his predecessor support this choice but also teach us that it is a very fine line to walk, with an uncomfortably high probability of “over-tightening” and tipping the economy into recession.
Policymakers may manage to thread the needle between ‘fire’ and ‘ice’, the mythical ‘soft landing’, but for now markets are more concerned about the growing likelihood of extremes of too hot or too cold, both of which have unpleasant implications for asset prices.
Pressing the brakes too hard risks triggering an earnings recession of undetermined magnitude, a risk further complicated by a lofty earnings base reflecting rising revenues and margins in technology, consumer goods and materials that far outpaced the squeeze in pandemic-affected service industries. Equity markets would be under pressure, and potentially bonds too, at least initially, if this episode initially appeared “stagflationary” (high inflation accompanied by weak growth) but in the end it should turn out to be positive. for bonds as the slowdown is driving inflation to a peak.
On the other hand, more persistent above-target inflation will certainly require even higher real interest rates going forward, which will constrain economic activity for a longer period of time and increase the cost of capital for businesses everywhere. domains. Again, history tells us that markets like low (but positive) inflation and that in most other cases, market-implied discount rates tend to rise, capping equity returns when multiples earnings decline, and returns from fixed income securities are hard to come by as inflation reduces the attractiveness of nominal cash flows.
South African capital markets, as usual, present their own nuances to the story. Inflation has also increased, but to date the magnitude has been much more subdued relative to our own history than seen in developed markets. SA CPI increased to around 1.3x the 10-year average while this ratio is 4.1x in the United States. Again, there are multiple causes here. South Africa has a history of relatively high inflation, businesses are actively hedging currency and input costs and, more importantly, levels of monetary and fiscal stimulus during the pandemic were of necessity much more limited, leaving the demand side of the economy further weakened and only supply-side factors to drive inflation.
Investing in an inflationary world
While all of this may sound a bit depressing, the uncertainty and changing probabilities will undoubtedly create opportunities for investors with strong frameworks and calm heads. While many might be tempted to run for the safety of short-term cash, real cash yields remain low despite rate hikes. This is therefore only useful if it is seen as a temporary “dry powder” that offers the possibility of deploying in riskier assets as opportunities arise: either in bonds as the slowdown gains ground and inflation moderates; or in equities at more attractive valuations as their inflation-hedging qualities come to the fore.
Bruce Mommsen, Co-CIO and Head of Equities at Matrix Fund Managers.