“So far, price rises were focused on a small part of the economy, namely energy and used car prices (as manufacturers struggle to deliver new vehicles due to microchip shortages). Gasoline and heating prices went up for some consumers (many are still on fixed or capped heating bill rates), but overall prices in the supermarkets remained under control. This has begun to change. Food inflation in the US is now 5.6% per annum. In the UK it remains controllable, 1.3% and so in the EU, 2.3%. But it has been on the rise.
“This puts the onus on central banks to demonstrate that they can control inflation and that their sole job is not to prop up asset prices. Likely, central bankers aren’t blind to the limits of their powers. Still, they are responding to inflation with more hawkishness to reassure both the public and their political superiors that they are in control.
“It’s not just the US. Or the UK, where the newly installed Bank of England leadership has shown indecision regarding interest rates. Some countries, like Germany, are more sensitive to inflation than others. German CPI at 6% is now at the 95% percentile (top 5%) since the country’s post-reconstruction in the 1950s. German consumers are already disgruntled over negative bank rates for over five years and ignoring inflation is politically prohibitive, especially for a fragile and diverse new coalition government. So while the German government and central bank transitions have allowed ECB’s Christine Lagarde to maintain a very dovish stance, it stands to reason that they will quickly challenge her, if the country’s mainstream media are any indicator.
What it means for portfolios
“Central banks remain independent. That independence, which is politically granted, will undoubtedly come under scrutiny if inflation runs unchecked, for whatever reason. If we assume that recent, out-of-character movements from central banks are the product of political pressures, then independence has, de facto, already been somewhat compromised. With it, recent patterns for asset returns could change.
“As for inflation? If interest rates aren’t the way to control it, we may have to learn to live with it, perhaps for a few years. Central banks will have to decide whether they are willing to let the mid and long-end yield of the curve adjust (which means 3-5 year rates over 3-4%) or face a permanent reality where the sole purpose of bonds as an asset class is capital appreciation because of institutional demand.
“Our base-case scenario remains that a sharp market downturn should reaffirm the ‘Fed put’, the promise that the world’s de facto central bank will unequivocally add to asset purchases whenever risk levels rise beyond comfort.
“However, we now find that the probability of a cyclical or even secular hawkish shift of central bankers is not infinitesimal anymore. It is an observable and quantifiable scenario. As investors, we should at the very least be prepared and positioned for more market volatility and different patterns for assert returns as we are entering what is promising to be another exciting year.”
