What if inflation is not transitory?
Those core central banks have been sanguine about inflationary pressures being only temporary. As shown in the chart below this leaves us in limbo for forward rates and inflation outlook. The big fear is “what if inflation is not transitory?”, the fallout from a breakout would be extremely volatile, as developed markets have not had to contend with rising inflation for 30+ years. So many investment models and biases are not calibrated to such an environment. This leaves many participants disconcerted as to the ultimate new normal.
Are we now talking inflation averaging at 2%, 3% or 4+%? And will Central Banks take the necessary steps to prevent inflation from persistently overshooting their target?
USD 5y5y Swap & 5y5y Inflation Swap
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With asset prices elevated due to plentiful liquidity, there is real danger of many classes being simultaneously repriced lower, should the central banks be forced to change their relaxed view of transitory inflation, and raise benchmark rates, along with ending QE. This of course would affect all those markets that have been the beneficiaries of low rates: Real Estate; Bonds; Equities; Crypto; Venture Capital; Private Equity; Credit; Special Purpose Acquisition Company (SPAC) etc.
Such an outcome would literally “blow the doors off”, which is why the next 6 months of data is crucial to long-term investing.
Will manufacturers be able to pass through rising PPI costs to CPI, or absorb those costs at the detriment of profitability? Each policy move on tax, fiscal, trade or wages, suddenly takes on a heightened importance as to its effect on sustained inflation. We think excess labour capacity, and new Cap Ex increasing supply, should dampen those forces, but would not be surprised by a short term spike. So much of the G10 outcome will rely upon the likes of China, whose state policies influence the extent of commodity demand and exported manufactured goods inflation/deflation.
An excellent article from our own EM specialists covers this in detail, alluding to improvements in ESG factors coming at a persistent price.
This theme was recently echoed by BoEs Governor Bailey on the rising cost and risks of greening the economy in a disorderly way.
In a turn of fate, the pressure on EM to clean up their environmental act may well be the catalyst to ultimately end cheap financing that has enhanced so many investment sectors within the developed world.