21 Jun 2021
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The Fed has two mandates: maximise employment and keep prices stable, with inflation at around 2%. The Fed’s policy response when the pandemic began was to cut interest rates and buy up bonds which meant that the economy kept moving as scientists developed vaccines and the population figured out how to live in a Covid-19 world.
And now? Inflation is running well above the Fed’s target rate and unemployment figures are still high. The Fed could raise rates to calm inflation, but this would slow economic growth and damage the job market. By keeping rates steady, though, there’s a risk of greater inflation. What came out of the Federal Reserve Open Markets Committee (FOMC) meeting this month and what changes are afoot?
There are 18 members of the FOMC and they each submit their expectations anonymously. Once collated, the results are presented to the market. At the last meeting in March, 11 out of the 18 members said they didn’t expect interest rates to rise until 2024 but at the meeting in June, only 5 members were still thinking along those lines. Inflation and economic growth are also expected to gain momentum.
It’s no surprise that the Fed started considering longer-term interest rates and inflation but the shift in numbers over a short period of time is more of a shock. What are the reasons behind the shift? Despite there still being 7.6 million fewer jobs held by citizens in the US compared to February 2020, the Fed is expecting a relatively low level of unemployment going forward. Economic growth for this year is now forecast to be 7%, up from 6.5% in March, and the inflation forecast is now 3%, up from 2.2%, although inflation is expected to fall back to 2.1% in 2022.
Have markets been spooked? With higher interest rates earlier on in the cycle, the yield curve has steepened at the longer end and we’ve seen a rise in longer-term bond yields. The dollar has been relatively weak recently but has started to rise against the basket of other currencies. Stock markets fell slightly but have flattened out indicating no significant overreaction to the inflation news, which is likely to be linked to the positive economic growth forecast.
In theory, higher interest rates and inflation are better for value companies as they typically provide a higher level of income, bringing forward your return. In the US, not surprisingly, the value part of the market is performing well. Fixed income markets have suffered though with yields across the globe rising including: US Treasuries, German bunds and UK gilts.
Q1 GDP for the US economy was 6.4% and inflation was 5% in May. The UK’s inflation figure for May was slightly above target at 2.1%. In the US and the UK inflation is rising but interest rates aren’t moving meaning negative real interest rates; bad news for savers as the higher rate of inflation and static interest rates erode the value of money. Is the great British public saving or spending right now?
Retail sales show a fall of 1.4% in May relative to April but over April and May combined, average total retail sales were 7.7% higher than March 2021and 9.1% higher than February 2020. A breakdown of retail figures shows that supermarket food sales dropped by 5.7% in May; people have been treating themselves to a meal out and panic buying and stocking up may finally be abating.
What’s the story for investors? The first point to consider is whether inflation is persistent or short-term transitory. If you believe it’s going to be short-term, you may accept some temporary inflation with a view to your assets naturally providing a return as it tapers off in the future. If you’re in the persistent camp, you’ll be concerned about the effect it’s likely to have on asset prices, with the worst-case scenario affecting bonds and equities if inflation is persistent and high.
You may be asking yourself which assets will be protected against inflation? Longer duration assets, including many conventional government bonds, have more sensitivity to fluctuations in longer-term interest rates and/or inflation, so shorter dated fixed income assets could be more attractive. Inflation-linked bonds would seem an obvious option, but you’re also subject to their longer-duration characteristics, so even though you’re buying inflation-protection in theory, you’re buying a lot of interest rate risk at the same time.
Value exposure as a hedge against the worst-case scenario could be an astute move; substantial growth that leads to high inflation is a good scenario for value investors. Inflation-specific protecting assets like property or infrastructure could also be worth considering. The argument for growth investing is strong right now, but you may have to be more specific about the type of company you invest in. And going global could give you an edge across assets; the wider the opportunity set hedging against a potentially negative scenario, the better. Can you afford to just keep on playing it safe in the current investment climate or will you have to speculate to accumulate?
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