Anthony Rayner
Premier Miton Macro Thematic Multi Asset Team
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Great expectations?
As we have argued for months, and reiterated in last week’s Perspectives, this inflationary episode is persistent. And this, combined with resilient labour markets and hawkish central banks, has seen market expectations for central bank rates move dramatically higher over recent months.
The chart below illustrates how markets are increasingly accepting the higher for longer inflation environment, showing expectations for what rates will be by the end of the year in the UK, US and EU. The UK has moved particularly higher, reflecting more stubborn underlying inflation, but even expectations in the US and EU are near to where they were before the US regional banking crisis broke.
Source: Bloomberg data from 20.12.2022 to 26.06.2023
To be fair, part of what has driven expectations higher is also the belief that the banking crisis has been contained. Nevertheless, higher rates contribute to financial instability and with rate expectations now back to roughly where they were, or higher, risk of financial instability is elevated again.
Consistently persistent inflation
It is of course now relatively straightforward to observe that inflation is persistent, in large part just because it has evidently not been temporary, but there are lots of moving parts and it doesn’t pay to be too binary or simplistic in this environment.
Inflation doesn’t exist in a vacuum, economic growth, monetary policy (including its lagged effect), fiscal policy (including the politics of the cost of living), the cost of mortgages, the cost of capital generally and what it means for return on capital, are some examples of why this is a complex environment, especially as many of these variables feed off each other.
There are intended consequences of higher rates, such as reduced speculation and recession, but there can be unintended consequences too, such as the banking crisis, which feed through into increasing policy risk.
Definitely not throwing caution to the wind
In terms of recession, last week saw a number of data points that were softer than expectations. The PMI surveys for the US and the EU were both lower than 50 (consistent with contraction) and weaker than expected, then this week the German Ifo survey was worse than expected too. Meanwhile, the US yield curve, a classic leading indicator of recession, has become even more inverted.
It begs the questions, what should investors position for? We think persistent inflation and recession is the most likely scenario. However, even if we’re right, it doesn’t make asset allocation an easy set of choices.
For example, will it be a severe or mild recession? Related to that answer, will a recession see inflation fall sharply or not? The nature of the recession is important in terms of earnings growth impact too but also markets have been driven primarily by Fed liquidity over the last couple of decades, so the outlook for Fed liquidity is crucial. This too is still opaque as it depends on how these varying dynamics interrelate with each other, and not just with other economic variables but financial assets too.
For example, how will what the Fed does compared to other central banks impact the US dollar, a key driver of other assets? Similarly, what will stagflation mean for US Treasuries, an asset at the heart of many portfolios? So, whilst a base case can be clearly sketched out, we don’t think it pays to have too much conviction at the moment at an asset allocation level.
As a result, we keep our bias to large cap liquid developed equity, with a fairly balanced sector exposure. In general, our bonds have limited interest rate and credit risk and we keep our exposure to gold and agricultural commodities to provide some diversification.
All in all, we remain relatively cautious.
