Samarjit Shankar, Managing Director and Markets Strategist, Mariner Investment Group, LLC
EG Fisher, Partner and Co-Chief Investment Officer, Mariner Investment Group, LLC
The outlook for global growth and inflationary pressures has become increasingly uncertain and worrisome as a confluence of factors unfold.
German inflation has risen to its highest level in 40 years while French inflation has beaten expectations to levels not seen since the 1980s. Spanish inflation has surged by almost 10%, the most in nearly four decades. Already elevated price pressures across the Eurozone and heightened risks of recession given the region’s dependence on Russian energy, which may be shut off amid geopolitical posturing, have led to increased volatility in asset markets. Indeed, European Central Bank President Christine Lagarde has warned of the “supply shock” to the Eurozone arising from the Russia-Ukraine conflict, adding that “The longer the war lasts, the greater the costs are likely to be”. Meanwhile, China is grappling with a Covid surge and lockdowns that threaten to impact growth and exacerbate already strained global supply chains.
Not surprisingly, all of these factors have contributed to more policy complexity in the US where a self-admittedly wrong-footed Federal Reserve struggles to play catch-up with a broad-based spike in prices against the backdrop of slowing growth and rising volatility in financial markets.
Economic theory has long taught that the key drivers of inflation can be one or some combination of demand-pull, cost-push or supply-side bottlenecks. As we know now, while the Fed chose to consider the initial spike in US inflation in 2020-21 to be “transitory” given the unprecedented economic circumstances during the Covid pandemic, all three inflation drivers were fueling price increases even as the quantitative easing program continued apace before gradually winding down and ending this year.
As a result, we are now witnessing a belatedly hawkish Federal Reserve being compelled to consider an aggressive rate hike trajectory even as demand wanes and growth tops out. Following the 25 bps rate increase delivered by the FOMC on March 16, market participants are now anticipating possible 50 bps increments as the Fed raises rates by as much as another 250 bps given that headline and core inflation are running at 7.9% and 6.4% respectively as of February.
There are two key areas of concern in the US as market participants fret about how an aggressive Fed rate hike path will impact various asset classes.
One, there is mounting evidence that the primary drivers of inflation are rising costs and worsening supply-side disruptions especially as the Russia-Ukraine conflict and Covid-induced lockdowns in China have further constricted the already inadequate availability of a whole slew of soft and hard commodities, especially oil and wheat. This has not only fed through to markedly higher headline inflation, but the pervasive rise in input costs threatens to keep core inflation elevated and reduce producer profit margins – depending on corporate pricing power, this bodes ill for household disposable incomes and spending as well as corporate earnings going forward. A rapid rise in rates will also directly impact the housing market as higher mortgage rates raise servicing costs and default risks.
Two, not only has the IMF unsurprisingly lowered its global GDP estimates amid geopolitical conflicts and persistent Covid-driven economic disruptions, the rapid flattening and likely inversion of the US yield curve, especially the 2-10 year Treasury spread, has raised the specter of possible recession. A rapid rise in rates threatens to choke off growth and weigh on household and corporate balance sheets.
In addition, we believe the level of the Fed Funds rate in the US vs the “neutral level” is as important as the 2-10 year Treasury spread. With the Fed Funds rate so far below the neutral rate at present, it seems obvious that Fed Chairman Powell will need to be as determined to quell inflation at the expense of growth as he was focused last year on driving up growth at the expense of rising inflation.
In sum, there is a high probability of harmful side-effects as the Fed is compelled to raise rates aggressively when the primary inflation driver is a supply-side commodity shock and growth appears to have topped out. Meanwhile, the Fed is also flipping the switch from bond purchases (quantitative easing) to bond sales (quantitative tightening), with ongoing uncertainty about the pace and mix of the balance sheet contraction as mortgage and Treasury bonds are offloaded in the coming months.
Surely, the odds of all this ending well are low. One thing seems certain, the days of low volatility in the US rates space are well behind us.
These circumstances and developments have increased the opportunity set for seasoned managers in the fixed income relative value space as market dislocations and price/yield overshoots abound amid elevated volatility levels.