Back in the early years post global financial crisis (GFC) we used to refer to the market patterns as a ‘rock in the pond effect’. The GFC and the subsequent introduction of Quantitative Easing (QE) had a huge impact. They gave rise to reverberations that repeated with reducing amplitude over the subsequent years. That original crisis was followed by a series of mini crises and further bouts of QE. These ultimately faded, as arguably did the impact of the QE. The waves gradually reduced over time.
The covid lockdowns and the massive monetary and fiscal stimulus that went with them are likely have an even larger impact. This time the effect was not just on the financial markets but to a much greater degree on the real economy. Supply chains around the world were disrupted and demand patterns distorted. An initial massive contraction of output and demand, combined with massive easing was followed by a similarly large rebound in demand and the attempt to tighten rates. In every way this was a much greater shock.
Having seen the first wave of contraction and rebound, we are now entering a period where the economy may again be contracting as the rebound bump fades. Inflation may soon peak as companies find they have overstocked into the rebound period. Commodity prices are falling in most areas, reflecting contracting demand. Policy may move from tightening to easing sooner than expected. We could quickly switch from a period where the story is all about inflation and tightening to one where it is about shrinking economies, disinflation and easing.
We take the view that for various reasons discussed before, there will be an extended period of structurally higher inflation, but it doesn’t mean that there won’t be cycles of increasing and reducing inflation and growth throughout. We are now potentially at the end of the first phase. Economic growth indicators are suggesting a slowdown if not outright contraction already, so soon after the recovery. This feels something like the boom bust cycles of the 70’s.
The chart below shows US quarter on quarter annualised GDP growth, which had been pretty stable around 2-3% for some time since the GFC, we think it will oscillate for some time going forward.
US quarter on quarter annualised GDP growth
Source: Bloomberg 30.09.2007 – 31.03.2022
As demand contracts, reported inflation will likely again decline, although perhaps not to the levels seen in the pre-Covid era. The rapidity of the current cycle and the amplitude of the swings makes portfolio positioning much harder. We are likely to swing back and forth in this way for some years to come. Arguably, a rise in the equity risk premium is merited as a consequence. Equity valuations are typically lower during periods of higher inflation. While positioning in the longer term suggest a bias to real assets for inflation protection, protection against equity down markets and economic contraction is also needed at times.
We believe that very active management will be required in this era, static portfolios may get whipsawed, something which clients do not like. Alongside a structural bias to real assets, value equities, gold, other commodities and property will be the correct structure over the long term. However, this may be vulnerable in the periods of falling growth and inflation. As the economic outlook has deteriorated we have significantly rebalanced away from commodity cyclicals in favour of utilities and staples and reduced our Exchange traded commodity (ETC) exposure.
The greater challenge is what to do with bond portfolios in this environment. While we take the view that fixed income in general will be a poor investment during a longer-term period of higher inflation, there may well be periods where government bonds experience significant rallies in their downtrends. Hence, we have recently increased government bond exposure on the view that interest rates may already be close to their peak in this cycle.