Inflation – Higher Rates for Longer. What to do about it?

Blain’s Morning Porridge Feb 15th: Inflation – Higher Rates for Longer. What to do about it?

“There are times when you just have to leave something broken on the shelf… and come back to it later..”

This morning: Inflation across the West looks to be more entrenched than markets believed – Higher for Longer. Maybe it’s time to accept it’s going to take time to fix, and look elsewhere for returns.

We are at an interesting point of the year. UK Inflation still above 10%. Ouch.

I took my little dog DeeJay for a wander early this morning. Spring is springing on the banks of the River Hamble. I watched ducks. He chased them. I told him to stay out the mud. He jumped in. I watched a hawk, magpies, curlews, waders and lots of fat pigeons.. and then wandered back home to write the Porridge. Something caught my eye on the ground – a perfect half shell from which a little bird had just hatched. Spring is sprung!

I concluded Markets are also at a similar inflexion point – time to move forward.

Whatever we think we know about markets… we are usually guessing, spicing up our thoughts with received logic on market moves, impetus, momentum, and direction. Yesterday’s Jan US CPI (Consumer Price Inflation) number is out the way, so we can get on to worrying about the next set due in March. We can just keep watching the inflation number and make predictable calls:

Strong number: Stocks fall. Bond yields rise.

Weak number: Stocks rise. Bond yields drop.

Simples… but it’s not. Chuck in energy costs and a host of unknowables and it gets awfully complex.

Yesterday was a bit of a damp squib. As many feared and expected, the CPI number came in a tad higher than expected. This magnifies market concerns the booming US labour market and sticky inflation means the US Federal Reserve will do exactly what it has being saying it will do: keep interest rates higher for longer to avoid an overheating economy.

Central Banks have a critical secondary objective also – to normalise interest rates and hence restore the basic functionality of the capitalist system, but that’s a story for another day. A third objective is to create a soft landing – meaning rates are just like Baby Bear’s porridge: neither too hot or too cold to keep the economy buzzing and avoid a government borrowing crisis when higher rates might just reveal just how unsustainable debt loads are.

The market moves yesterday following the CPI were predictable: stock markets sunk and then recovered.

• 1000 US economic analysts scanned the inflation data with nit-combs to extract further insights and direction from the numbers, and have concluded about 1500 different things about where inflation is going.
• Treasury markets widened – but probably not as much as expected as it looks like there is still plenty of liquidity in the market (much of it coming from Japan where QE is very much alive.)
• The market is back to expecting a couple more Fed Hikes, than, Bingo! Back to bing time:
  • Rates will fall.. BUY, BUY, BUY! Or if they don’t.. SELL, SELL, SELL…

Yawn… Inflation will moderate. Inflation will remain sticky. Get used to it. Interest rates will remain higher for longer. The market will adjust its expectations. The constant swing between which side of a soft-landing the economy is going to land on is getting dull.

We still seem to be in an adjustment phase. The market believing growth stocks still have substantial value (even though they may be profitless today, and higher for longer rates mean they will struggle going forward.) Value stocks – paying real dividends off good earnings – are now priced properly. What’s the upside? Limited.

I rather expect the 2023 market is going to be anything but a reversal of 2022’s dismal trends, but a flatline experience as the market adjusts to the new normal reality of higher rates, stick inflation, relative returns.

Why?

Its not just about the market trying to second guess Central Banks and reimagine what they are saying. Its not just about markets looking for reasons to keep buy stocks in the expectation central banks will ease rates to support them. Its about the last 12 years of monetary experimentation, where artificially low interest rates pushed up the relative value of financial assets – especially stocks. At least half the current market knows nothing else, having spent their entire careers experiencing taper tantrums whenever rates rose, causing central banks to swifty ease.

We saw years of lacklustre economic growth, but surging market valuations and wild speculation as a result of overly low rates. That is all changing. A new reality comes.

As I said above the market is obsessed with inflation, energy prices and what Western Central Banks are thinking. Large swathes of the market are paying zero attention to the “stuff” going on elsewhere – and that’s a big mistake because investment is the art of choosing between the relative values of all financial and, increasingly, alternative assets.

Simply put… if you are spending your day fixated on what Assumed US Home Rental Values mean for the future inflation reports, then you probably missed the “most crowded trade” buying the China reopening, or just how over-priced the Indian market currently looks. (Even after Adani!)

More than a few of my clients got the point of my Brexit comment yesterday: Britain is currently trapped in a political impasse of its own making, unable to resolve the UK’s future with Europe. Were that to look likely to change – as will likely happen following a UK election sometime in the next 18 months – the UK could look seriously good value. The time to be looking at UK assets is probably now.. because change is coming (even if Ford did scupper the UK Auto industry yesterday.)

Or how about South-East Asia. Its nearly 26 years since the Asian Crisis triggered as the rapidly emerging nations of the region found themselves mired in dollar debt, devaluations and subsequent political ructions. Today, the politics may not be perfect, but these are no longer emerging nations, they are maturing economies with expanding middle classes, high growth, strong sectors from tourism, tech to manufacturing. We were recording this week’s Shard Capital Lightbite Podcast yesterday on SE Asia yesterday – and it stuck me.. I’m seriously personally underinvested in these markets. (Something I shall put right..)

Meanwhile, I’m in the process of putting together a new aviation linked deal that should pay double digit returns – and we will be putting it together in a private credit format. THe risk profile won’t be for everyone, but it will diversify returns away from the uncertain landing of the Western Economies. (See what I did there..)

The point is… when the financial seasons are turning, look all around for signs of spring!

Five Things To Read Today

FT                    Investors should not expect much relief from volatility

BBerg              China Stock Slide Puts Hedge Funds’ Crowded Trade at Risk

WSJ                 Berkshire Hathaway Boosts Stake in Apple, Paramount Global in Quiet Quarter

Guardian         UK Inflation falls, but remains in double digits at 10.1%

Businessweek Aiming to be next Emirates, Air India Makes Record Jet Buy

Out of time and back to the day job..

Bill Blain

Strategist – Shard Capital