MUNIX WEEKLY
STARTING THE YEAR WITH A BANG
Investors in financial markets are constantly trying to price in today what tomorrow might look like. On some occasions they are considerably surprised, leading to rather sharp changes in asset prices. On other occasions the lack of volatility might come as a surprise. The news that headline inflation in the USA reached 7% year-on-year in December, its highest for 40 years, certainly caught the attention of the media. However the US bond market hardly shivered; it had been well prepared for such a figure via economists’ models and a stream of warnings from Federal Reserve officials. Undoubtedly core inflation, that is excluding the ever-volatile food and energy prices, reaching 5.5% a year indicates the considerable pressures facing many sectors within the US economy. Expert analysis concentrated on problems facing second-hand car prices or a variety of retail, manufacturing and services sectors affected by the pandemic.
Nearly 60% of US CEOs expect elevated inflation to continue until at least mid-2023, according to a survey by the Conference Board. Nevertheless most economists agree that headline inflation is in the process of peaking. Despite a variety of complicated demand and supply factors affecting energy prices, these are range trading. Companies are reporting fewer supply chain constraints. Clearly adverse news from the Ukraine, sanctions on Russia and a collapse in gas supplies to Western Europe would be unfortunately timed. The consensus view remains that headline inflation should decelerate at a moderate pace into the autumn and eventually return to the official target in late 2023. How employers and employee react to a tight labour market is the next key issue for economists and policymakers to consider and address in the spring. Labour shortages in 2022 are the top concern for Conference Board CEOs.
US bond yields, and indeed the yields in most other major markets such as in Germany, have either only sold off modestly since the start of the year or range traded, as in the UK. It remains noteworthy that market expectations of future interest rate increases are generally steady against the backdrop of growth and inflation forecasts currently circulating.
Of course as new news comes in, so market expectations shift a little. February’s Bank of England meeting is looking more like 50:50 for a rate rise than it did a few weeks ago. There is more evidence that the damage from Omicron on the nation’s health and finances will neither be huge nor long-lasting. GDP rose more than expected in November, whilst high street retailers generally reported that consumer spending held up rather well in December. The UK ten-year gilt yield has tried several times to break through 1.2%, and if it does so this will be a sign that investors are expecting earlier and more aggressive actions by the Bank of England. The peak in inflation in the UK will not be until April.
Central bank governors are walking a fine line between emphasizing their determination to get inflation down, enabling the economic recovery to continue, and not allowing long term inflation pressures to become entrenched. So far, they have convinced bond investors that they will succeed. The terminal or peak level of interest rates at the end of this tightening cycle is only expected to be about 1 ½ to 2 ½% across the USA, Europe and the UK. This is very low by historical standard; investors are, in effect saying that interest rates will only be neutral after adjusting for inflation. Such a view requires considerable emphasis on tight fiscal policy and the adverse effects on economic activity from the pandemic. It may well be correct but if it is wrong it is very wrong indeed.
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making