As Central Banks Tackle Inflation, How Should Multi-Asset Investors Adapt?

Inflationary pressures from the COVID-19 crisis have been compounded by the surge in commodities prices sparked by the Russia-Ukraine war. In the US, the Consumer Price Index hit 9.1% year over year in June—its highest since 1982. In fact, most major economies are dealing with inflation highs not seen in decades.

Policymakers Respond in Force

As global central banks intensify their inflation battle, rate hikes and increasingly hawkish forward guidance have taken a toll on risk assets. With inflation data continuing to beat expectations, markets have been anticipating an increasingly steep rate hike path. Between April and June 2022, markets priced in an additional 100 basis points of rate increases by the end of the year, based on Eurodollar futures (Display), which measure expectations of short-term interbank borrowing rates.

Financial conditions tightened rapidly as a result, accelerating the slowdown already underway. Market expectations of peak policy rates have declined since June, likely reflecting the significant slowdown in activity as well as recent commodity price declines. We also note that markets increasingly see the Fed reversing its stance in early 2023, suggesting heightened expectations of meaningful deterioration in economic growth over the next six months.

Despite high uncertainty, consumer and corporate sectors appear resilient and we see a relatively shallow slowdown as our base case. Meanwhile, supply and demand imbalances are improving as fiscal and monetary support policy are withdrawn and economies reopen. If these trends continue, we expect inflation to gradually normalize and allow central banks to follow less restrictive policy in response to slower growth.

Supply and Demand Imbalances Are Improving in the Goods Sector

With the rise in commodities, US headline inflation surged (9.1%) well above core (ex food and energy), which peaked at 6.4% in March and currently stands at 5.9% year over year. However, due to slowing activity and demand destruction, the Bloomberg Commodity Index has since dropped 15% below its June high. Central banks have looked past commodity price volatility historically. Given concerns about inflation expectations, however, the Fed now sees headline inflation as meaningful in the current cycle. This decline in commodities, if it persists, could provide relief for headline inflation as well as for goods categories exposed to commodities, such as consumer staples.

The initial post-pandemic inflationary impulse was driven by US goods consumption surpassing pre-crisis levels by nearly 20%, while supply was constrained by factory shutdowns, component shortages and logistics capacity. Now we’re seeing gradual adjustments on both the demand and supply sides. Goods consumption, now closer to 13% over pre-pandemic levels, is reverting to trend. Meanwhile, manufacturing capacity utilization and supplier delivery times have been improving.

Logistics costs and delays are also easing. The New York Fed’s Global Supply Chain Pressure Index seems to have peaked in December 2021, except for a blip in May due to more China lockdowns. China’s zero-COVID policy remains a risk, but we don’t expect severe broad-based lockdowns to return. China-to-US shipping rates are down 40% to 60% from late 2021 peaks. At the same time, order backlogs are starting to clear, and inventory-to-sales ratios are returning to pre-pandemic levels. Although manufacturing activity may be losing its tailwind, these improvements should bring pricing behavior closer to “normal.”

Prices Easing for Durable Goods, But Nondurables Reflect Commodities Pressures

Durable goods, the dominant driver behind early post-pandemic price pressures, appear to be reverting to pre-pandemic disinflationary trends. Post-pandemic, durable goods inflation averaged 5% on an annualized basis, compared to its pre-pandemic average of –1.9% in 2014–19 (Display). The run rate over the last three months was just 1% on an annualized basis. We see more room to improve since auto manufacturing has yet to fully emerge from its supply-chain challenges.

Nondurable goods inflation surged past durable goods in recent months, partly due to direct and indirect impacts of rising commodity prices. As such, the recent decline in commodity prices may offer some relief. Nondurables that are less exposed to commodities, such as clothing, have started to see improvement in pricing trends as retailer inventories recover from understocked levels.

Housing and Pent-Up Demand for Travel Driving Services Inflation

Services inflation, which is closely watched by market participants, has been subdued compared to goods, but it has ticked up above pre-pandemic levels. Within services, the biggest recent increases have been in categories most exposed to pent-up demand, such as hotels, transportation and food service. We expect this to gradually normalize as pent-up demand and service capacity adjust, like we’re seeing with durables.

Housing has been another large contributor to the rise in services inflation, as accommodative monetary policy fuelled strong demand in an already-tight market. Given the spike in mortgage rates, and the large stock of new construction, we expect to see pricing adjustment, although this is likely to be gradual.

Price pressures from housing and travel have been somewhat offset by continued disinflationary dynamics in communications, financial services, education and healthcare, partly due to the impact of technology on these industries.

Wages are a key area of focus to assess longer-term pressures, given tight labor markets and the potential for price-wage spiral. While growth in average hourly earnings has risen above pre-pandemic levels, so far it has not accelerated in lockstep with inflation. As activity slows, the job market, while still strong, is showing signs of cooling. Labor force participation has recovered in major economies but remains below pre-pandemic levels in the US. Whether those workers return to work could be pivotal to how wage growth evolves.

Slowing economic activity and central banks’ commitment to lowering inflation have resulted in rapid downward adjustment in inflation expectations, which speaks strongly of continued central bank credibility (Display).

An Unsettled Market Requires Investor Adaptability

Tightening financial conditions as well as deteriorating consumer and corporate confidence have accelerated the post-pandemic activity slowdown already underway. Following the broad sell-off, valuations across stocks and bonds have improved, while investor positioning is extremely defensive compared to history, with the exception of longs in select commodity futures.

Given the lack of excess in corporate investment and employment, we expect activity slowdown to be relatively shallow. Despite the robust recovery in investment, global capital spending-to-depreciation remains well below its historical trend. Meanwhile, US employment has only just recovered to pre-pandemic levels. We believe inflation remains responsive to supply and demand dynamics, which we expect will continue to heal from the multiple global supply and demand shocks over the past couple of years.

As a result, we think a roughly neutral duration allocation makes sense, as well as gradually reducing equity underweight exposure, focusing on relative opportunities in the US, European Union and emerging markets. In the US, a major headwind has been reduced as Treasuries have repriced considerably, while emerging markets are likely to benefit from an improvement in economic activity in China as lockdowns ease and stimulus flows through the economy.

Meanwhile, we think investors should consider reducing commodity exposure based on slowing growth as well as exposure to the US dollar, where we see stretched investor positioning. However, the Canadian dollar seems relatively attractive, with its strong domestic economy and general improvement in the trade balance due to energy as well as the likelihood its rate hike cycle will continue.

The Fed has committed to tightening monetary policy until it sees “compelling evidence” that inflation is decelerating. This dedication will come at the expense of economic growth for now. However, as some of the underlying forces behind rising prices start to wane and as inflation ebbs in more spots, growth downside may be shallower and more temporary than market fears suggest. Investors should be ready to adapt.