What happens when an unstoppable force meets an immovable object?
Last week, the most consequential central bank in the world – the US Federal Reserve – announced a shift towards “average inflation targeting” whereby it will allow inflation to overshoot its 2% target to make up for periods when inflation has run too low. This represents a major change in the Fed’s monetary policy strategy and, in our view, means that the Fed Funds rate will stay at its near-zero level for up to the next five years.
The Fed is making a major move for good reason. Inflation in the US, and in most of the developed world, has stayed stubbornly too low in the post-GFC period due to structural forces such as aging demographics and technological disruption which has resulted in an almost indiscernible Phillips curve.
Drawing on lessons from past failed attempts in Japan and Europe, the Fed is seizing an opportunity to lean into the re-opening recovery and decisively gather escape velocity from the low-inflation trap at the zero-bound of rates; i.e., when rates are at zero and inflation levels are too low, central banks run out of space to cut rates to boost economic activity and inflation, and are therefore “trapped”.
Will the Fed succeed where the Bank of Japan (BOJ) and European Central Bank (ECB) have had, at best, very mixed results from their past efforts?
We think what the Fed wants, the Fed usually gets. Case in point: After unleashing an unprecedented amount of stimulus against the Covid-19 crisis this year – the most severe recession we’ve seen since the Great Depression - the Fed has by now engineered a perfect V-shaped market recovery that was only a few months ago believed to be highly unlikely. And this tidal support of financial asset prices and wealth effect have contributed significantly to supporting consumer spending and confidence and the momentum of the ongoing recovery.
Given the Fed’s efforts and the economic recovery underway, we expect to see core PCE inflation (the Fed’s preferred measure of inflation) moderately rising from its current levels just above 1% (the July print was 1.3% YoY) to around 2% levels over 2021 to 2023, albeit unable to sustainably overshoot the Fed’s 2% target over this period as employment levels and savings remain elevated.
Not to forget, Biden continues to lead in the polls for the upcoming US Presidential Election, and prediction markets are at present reflecting a Democratic sweep to be the most likely election outcome. The Democratic party’s agenda to implement significant fiscal spending on healthcare, the environment and, importantly, infrastructure will potentially form another key tailwind for inflation.
Already inflation expectations have rebounded significantly from their lows in March but in our view, the uptrend still has some more to go. Therefore, Treasury Inflation-Protected Securities (TIPs) remain a relevant inflation hedge in portfolios alongside gold (BOS 12-month forecast: USD2150/oz) and long-dated US Treasuries (which we have a neutral view on).
In our view, the bigger investment implication of rising inflation relates to the equity allocation in portfolios.
Granted, growth is likely to be scarce in this new economic cycle ahead, and hence the focus on maintaining long-term core positions in growth sectors exposed to structural trends, such as 5G, ecommerce, the internet of things (IOT) and the cloud, will form an indispensable mainstay of investment returns.
But given the dramatic year-to-date outperformance of growth sectors versus cyclical/value sectors, such as energy, commodities and industrials, which remain attractively priced and are poised to benefit alongside rising inflation and recovery, we believe that it is now appropriate to rebalance from much larger technology and healthcare positions given the sharp year-to-date rally into selective cyclical and value names. This will further diversify portfolio exposure across a wider range of drivers of performance and contribute to buttressing portfolio volatility ahead.
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Version: July 2020