Inflation Still in the Driver’s Seat
Inflation was the biggest surprise of 2021. Although we came into the year expecting inflation to exceed consensus forecasts by a significant amount, we underestimated the size of the surprise. Changes to GDP growth forecasts during the year were relatively small in comparison, though earnings forecasts in the US were revised up meaningfully during the year.
This evolution of inflation relative to expectations will be a key determinant of overall market performance in 2022. In a “soft landing” scenario, the transitory drivers (such as supply constraints mainly caused by the pandemic) pushing inflation up diminish during 2022, vindicating the US Federal Reserve’s (the Fed) view. In this economic outcome inflation recedes, surprising the consensus on the downside, and the Fed proceeds slowly on policy normalization. Market pricing of longer-term rates is not adjusted upwards by much, and real rates remain low. This scenario suggests a “Goldilocks economy,” wherein the relative valuation of equities versus bonds remains largely unaffected and a long portfolio of both would do well.
In an alternative scenario, inflation falls by less than the Fed expects. As a result, the Fed is likely to initially tighten monetary policy by less than what proves to be warranted. This causes investors to question the Fed’s credibility, thus causing inflation expectations to dislodge further. Higher short-term inflation expectations pass through to more long-term ones, which then feed into wage and price growth expectations, leading to a self-reinforcing inflation spiral. In this case, a “hard landing” becomes more likely as it is difficult to precisely calibrate the degree of tightening needed once a central bank is already behind the curve. Such a scenario could see central banks responding to wage and price inflation by tightening more aggressively than current market pricing, leading to tighter financial conditions and potentially risking a recession. One might then expect that equities and shorter-dated bonds would fall together for some time.
Inflation Scenarios with Dynamic Implications
|1. Federal Reserve views are broadly correct and inflation prints out lower than consensus expectations
|Inflation is transient and Fed can gradually raise rates as expected
|2. Central banks belatedly become aggressive
|Inflation overshoots and the Fed (and other central banks) become aggressive and taper faster than expected
For informational purposes only. There can be no assurance that these scenarios and implications will be achieved.
Portfolio Agility Remains Imperative
Given this wide spread of market outcomes, it is going to be especially important to remain agile and responsive to the evolving economic data. If the Fed takes on a hawkish stance because they’ve been behind the curve, based on similarly aggressive rate hiking cycles in the past, returns of both equities and shorter-dated fixed income will suffer. This increases the importance of remaining diversified across asset classes, investment styles, and time frames, and choosing solutions with a low beta to traditional markets over a full market cycle. Agile strategies should deliver low average holding periods across positions and emphasize capital preservation.
Amid such an uncertain backdrop, it is important to note that while commodities have been a good place to be in 2021 (when inflation was high and rising), they may fare less well if the Fed does eventually turn aggressive. Therefore, investors will need to be more dynamic with their investment allocations and ready their portfolios for the inflation scenario most likely to prevail.
Asset Class Direction with Different Inflation Scenarios
|Short-dated Fixed Income