Why have investors stuck to the belief that inflation would fall to 2% and stay there? Anthony Rayner argues that it is being driven by emotional dynamics and that in fact the structural data environment suggests a very different inflation profile.
We’ve had a non-consensus view on inflation for some time, as we believe the consensus view has been driven by an overly optimistic bias. Consensus was initially led by the Fed’s “transitory” view but even when the Fed rowed back from that position, the consensus has, for the most part, assumed that inflation would fall to approximately 2% and then obediently stay there.
We think this is driven more by emotion than data. Recency bias would lead many to assume inflation will retain the disinflationary profile of the last 20 to 30 years, even though the previous 100 years has been characterised by higher levels of inflation. This is understandable as the vast majority of investors will never have experienced higher inflation in their career. There is also a degree of wishfulness too, many investors did very well out of the disinflationary period, with low rates pushing most financial markets materially higher.
Of course, the consensus bias for lower inflation isn’t going to be wrong just because it’s driven by emotional dynamics. However, we think the structural data environment suggests a very different inflation profile.
Specifically, we believe inflation will not be easily subdued and will reaccelerate to levels central banks will be uncomfortable with. We have focused on three structural areas that drove the disinflationary period but which have reversed over the last few years; deglobalisation, resource supply constraints and loose fiscal policy. Two of these are increasingly under the spotlight, in large part due to the overwhelming support for Donald Trump in the recent election.
Deglobalisation will no doubt accelerate, with the inflationary (and arguably recessionary) impact of US tariffs (Chinese hawks and nationalists dominate key roles), compounded by trade ‘partners’ retaliating. Meanwhile, fiscal policy was already very loose, with lockdown having severed the psychological link to the relative fiscal discipline of the previous 30 years. Expectations are that fiscal policy will be even looser under Trump. More generally, history shows that populists tend to favour growth today at the expense of inflation tomorrow.
Importantly, as a result of stronger economic data, and rising inflation expectations, both compounded by the US election, market expectations for interest rates have adjusted materially higher of late. A few months ago, at the end of September, markets were pricing in US rates of just under 3.4% by March 2025. They are now pricing in rates of over 4.2%. This is a significant move higher in a short period of time.
Where markets think US rates will be by March 2025: expectations are higher for longer
Source: Bloomberg 09.08.2024 to 18.11.2024
Our higher for longer base case has a number of implications for how we position portfolios. From a portfolio risk perspective, for most multi asset portfolios, the main risk to diversify is equity risk. History shows that commodities are much better than bonds at diversifying equity risk in periods of inflation (and bonds are better during periods of disinflation). As a result, we have short duration bonds, which help to dilute equity volatility, even if they don’t diversify it, as well as providing a decent income. We also have a material exposure to gold as a diversifier and within equity we are diversifying concentration risk to big US tech, with material exposure to non-US, non-tech and non-large cap.