Communication, Communication, Communication
After the bond-market rout of the first quarter, market participants spent the lion’s share of the second quarter grappling with what the US Federal Reserve’s (Fed) newly adopted ‘flexible average’ inflation targeting (FAIT) policy actually meant.
It serves to remind ourselves that the touch paper to the bond-market rout was lit when the Democrats won the Georgia US Senate run-off election in January, handing them a ‘clean sweep’ of the White House, the Senate and the House of Representatives.
Prior to the Georgia run-off, upward pressure on government bond yields was already building, particularly in the US, as the economic recovery gathered momentum. That pressure intensified with a Democratic clean sweep as it paved the way for the Biden administration to implement the large-scale fiscal policies upon which it had campaigned. The prospect of more expansive fiscal policy exacerbated the bond-market sell-off in the first quarter as market participants reassessed the outlook for nominal growth and debt issuance by the US Treasury. As pessimism gave way to optimism, markets brought forward the date at which they implied the Fed would begin tightening monetary policy.
The Fed then spent the months of April and May reassuring the market that the FAIT framework meant that a tightening of policy was still many years into the future. It was keen to impress that it would not repeat the mistakes of the post financial-crisis period, namely tightening policy prematurely and choking off the economic recovery just as it was getting going. Any spike in inflation was seen to be transitory – a function of base effects and supply-chain disruption – so was not a reason to tighten monetary policy. In this context, the labor market was the priority of the Fed: employment was far below pre-Covid-19 levels, and thus accommodative monetary policy remained appropriate for the foreseeable future.
The Fed’s message seemed to assuage those harboring concerns that a tightening of policy would bring the party to an end, and in particular that higher interest rates would undermine the equity market. It also served to give market participants greater confidence that economic policy in the US was, whether publicly admitted or not, gravitating towards modern monetary theory (MMT) – the monetary financing of fiscal deficits. This fueled bullish bets on assets judged to be the beneficiaries of such a policy, often simplistically distilled to those assets that would benefit from inflation.
A potential break from the monetary and fiscal policy orthodoxy of recent decades rightly holds the attention of investors. Should it come to pass, it would have profound consequences for investment returns. But not only is there ambiguity around whether such a break will take place. If it were to occur, there is also uncertainty around what might replace the current orthodoxy. As such, investors have become particularly focused on commentary from prominent policymakers and, in turn, markets have become especially sensitive to any perceived shifts in approach. At its June Federal Open Market Committee (FOMC) meeting, the Fed served up just such an apparent change of tack.
With investors expecting a non-event after April and May’s reassurances that FAIT meant monetary policy would remain dovish for the foreseeable future, markets were surprised to discover that the Fed had brought forward the timing of the first rate hike to 2023, as indicated by the ‘dot plots’, and that now was the time to talk about tapering.
It is noteworthy that the Fed is not planning to raise rates for another 18 months at the very earliest, and that it is still purchasing bonds at a rate of US$120bn a month; monetary policy therefore remains very accommodative. Nevertheless, the Fed appears to have made a very deliberate hawkish shift at the June FOMC, which has left investors wondering just how far it will deviate from the old orthodoxy under its FAIT framework. Are a few months of inflation above the Fed’s 2% target sufficient to make up for the near decade of inflation undershooting the Fed’s target? In the wake of the FOMC meeting, there was a clear repricing of financial markets. Naturally, participants have brought forward the timing of the Fed’s first interest-rate hike, while they have also pared back wagers on inflation.
The reality is that the Fed has a poor track record of forecasting growth and inflation (as do most of its global counterparts, so this is not a criticism aimed at the Fed specifically). To Fed Chair Jay Powell’s credit, he recognized the central bank’s inability to forecast the outlook and noted that the Fed’s expectations for monetary policy should be taken with a liberal pinch of salt. There are likely to be a few twists and turns in the 18 months between now and the scheduled lift-off for rates some time in 2023. Indeed, the first of these twists may have already begun to play out.
From ‘Peak Inflation’ to Second-Half Slowdown
The US economy has been on a tear, expanding at an annualized rate of 6.4% in the first quarter of 2021.1 This should rise to 7.8% in the second quarter, according to the Federal Reserve Bank of Atlanta model that uses high-frequency data.2 Indeed, the strength of the economic recovery was cited as the reason the Fed decided to bring forward the timing of monetary-policy tightening at the June FOMC meeting. However, it is probable that economic momentum is close to peaking.
The US economy began to accelerate as the rollout of vaccinations accelerated. Vaccination cycles typically follow an ‘S’ curve, with the US now in the flattening top part of the curve. The implication is that further increases in the US’s overall level of Covid-19 immunity will be incrementally much smaller. Indeed, most US states are now largely open, so the gains to economic activity to be achieved from reopening have mostly occurred already. Some industries are still subject to restrictions, but the marginal gains from further reopening are likely to moderate rapidly over the remainder of the year and into 2022. This all means that US economic growth is likely to slow at some point in the second half of the year.
To be clear, US economic growth is set to go from great to good. There remains a degree of pent-up demand to be released, more benefits to accrue from further reopening, and some slack to put back to work. Manufacturing activity is likely to remain robust owing to a continuing inventory rebuilding cycle, while the outlook for business investment is encouraging.
In tandem with US economic momentum reaching its climax, inflationary pressures are also likely to peak. Consumer price index (CPI) measures of inflation will be set to slow mechanically over the coming months as the much-discussed base effects go into reverse and supply-chain disruption is resolved.
A similar dynamic is playing out across the world, albeit at different rates. As vaccination programs continue to advance and restrictions are lifted, economic growth accelerates but the scope for further marginal gains declines. Furthermore, the tailwind from fiscal stimulus is set to fade and become a year-on-year headwind as further fiscal packages are highly unlikely to equal those of 2020. China has been in the vanguard, and tighter policy there is already beginning to weigh on assets sensitive to China’s policy cycle. The US has been second, while Europe is a distant third, along with a tail of smaller developed and emerging markets.
In combination, this means that global economic growth is likely to peak in the coming quarters and consumer price inflation will begin to cool. We are likely to see the fears of economic overheating that accompanied the bond-market rout of the first quarter replaced by concerns about an economic slowdown, and some will inevitably argue that recession lies just around the corner.
Strong economic data is already falling short of consensus forecasts. Expectations have caught up with reality, and as we head into the second half of 2021, the risk of disappointment is rising. The recent shift in equity-market leadership is perhaps an indication of how the narrative is set to change. Cyclical parts of the market – those with the greatest sensitivity to nominal growth – have begun to underperform, while the relative performance of secular-growth companies has begun to improve. A global slowdown will inevitably see some commentators argue that we remain stuck in the ‘new normal’ of stubbornly low growth and inflation. A Fed that has turned orthodox, if that is indeed the case, would certainly support this view.
Investing in a Grey World
Any predictions of a return to the new normal of low growth and low inflation will cite the immovable objects of disinflation: ageing demographics, too much debt, and technological disruption. But it is premature to rule out a regime change on the basis of the coming global slowdown and an apparently hawkish shift from the Fed. As we have outlined before, a reading of financial and economic history shows that the necessary condition for a sustained acceleration of inflation is the monetary financing of fiscal deficits. Despite a seemingly hawkish shift from the Fed at the June FOMC meeting, the broader debate regarding the role of monetary and fiscal policy remains very much in play, not just in the US but across the developed world. There is a clear and growing demand among electorates for the state to play a greater role in managing economies. The wars on inequality, climate change and Covid-19, which form the basis for active fiscal policy, are set firm.
There are, of course, those who resist and continue to support the established orthodoxy; those seeking to deviate cannot brazenly chart a new path: the concerns of prominent public figures and officials must be listened to, particularly in democracies. The Federal Reserve is subject to the same pressures, and is torn between those demanding that the status quo is maintained, and those demanding bold action to tackle the challenges of the day. The reality is that the trajectory of monetary policy remains far more uncertain than it has been for decades, not just in the US but globally.
Identifying inflection points in real time is far from straightforward. We must assess new information as it comes to light and try to assess what it means in terms of possible outcomes. What can be said with certainty is that inflection points are colored by more vociferous debate across societies. The tension between supporters of the status quo and those who see a new way often manifests itself in the upheaval of established political landscapes, and this has clearly been the case in the West in recent years. While it is tempting to point to the Covid-19 crisis as the catalyst, in reality it is better thought of as the latest chapter in the continuing Western debate about what the way forward should be.
Financial markets are not immune from the elevated uncertainty, and we should expect them to be whipsawed between the status quo and a future unknown. Navigating this environment will prove challenging for investors, as much of the received wisdom distilled from the disinflationary decades that began in the early 1980s will prove incorrect. But it is also not simply a case of dusting off the playbook from the inflationary 1970s.
As ever, the debate has been simplistically reduced to a binary choice – inflation or deflation – as battle lines have been drawn over the last 12 months. But in reality, the world is not so black and white. It is grey and, arguably, a lot more grey around possible inflection points. More often than not, the status quo persists. Regime changes are far rarer, but they can occur, and when they do, the implications are huge for investment returns. We believe it is therefore important to keep an open mind, and to keep dogma in check.
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