We believe we are in the process of transition towards a new economic and financial market regime, where resurgent inflation is a key aspect. Inflation, GDP levels, M (the monetary mass), its velocity (V) and debt are all interconnected variables and will be key in assessing the shift towards this new regime.
In this new regime, governments will take over the control of money while maintaining widespread and double-digit monetary growth for several years, as part of a broader transition from free market forces, independent central banks and rule-based policies to a command-orientated economy.
Huge fiscal accommodation will be needed to finance the post-Covid-19 recovery, which has already driven debt to historical highs. Additional money creation, for example to finance the energy transition, will likely be required down the road, as humanity faces the great challenge of fighting climate change. This additional fiscal expansion will need to come under a continuation of the financial repression environment, with central banks continuing to stay behind the curve to allow a further debt expansion at sustainable costs.
This could build the conditions for the simultaneous financing and expansion of both the financial and real spheres and should lead to an increase in asset prices and in the prices of goods and services for some time at least.
This scenario might see another lag before rising inflation translates into higher interest rates (as rates could be capped for some time) before authorities lose control of yield curves, thus leading to a new monetary order (another feature of the new regime). This will only happen when psychological forces start to focus on the most recent readings and start to question the credibility of central banks.
As of now, this is not yet happening. Communication is a key driver behind the psychological dimension of inflation and, in this respect, the Fed has done a great job. Yet, we recognise that the Fed is behind the curve as never before and therefore any further price pressure and/or delay in the hiking cycle could be the trigger for questioning its credibility. So far, talk has been enough to fuel market trust, but markets will assess whether the Fed is really walking the talk as we move ahead.
Investors need to rethink their strategic asset allocation in order to adapt to a world of heightened uncertainty regarding inflation and central banks’ reactions. Traditional benchmarks face challenges: on the bond front, it will be centred on the duration challenge (global indices with high duration and low yield); on the equity front, it relates to concentration risk (particularly in the US) around ten high growth names with high valuations and high sensitivity to rate hikes.
In 2022, the environment may still be supportive for risk taking. With central banks perceived as credible, real interest rates remain low and nominal rates are capped, leading to a continuation of the “buy the dips” attitude. However, the time to focus on the inflation resilience of portfolios is now, as an inflation surprise may materialise.
In fixed income, investors should move to unconstrained and short duration and consider adding an allocation to inflation assets, higher yielding assets with lower duration risks (for example in the emerging market bond space, high yield or subordinated). Divergences in central banks’ actions and inflation dynamics may provide relative value opportunities (i.e. yield curve, FX), which were limited in world of synchronised central banks.
Equity markets remain favoured versus bonds. In this space, investors should look at companies with higher pricing power being aware of the current high market valuations and high margins that will start to reverse towards normality.
At a portfolio construction level, correlation dynamics will also become more unstable, with possible positive equity/bond correlation during periods of inflation risk. This calls for adding additional sources of diversification in the form of lowly correlated strategies, liquid alternatives and real assets, especially the ones that can benefit from periods of higher inflation (real estate, infrastructure).
Longer term, the psychological dimension of inflation could lead to an increase in the velocity of money in the real sphere, as consumers disinvest in anticipation of future consumption, worrying about inflation. When this happens, inflation in the real economy will further rise, expectations will become de-anchored and central bank credibility is lost. This will be the time when the regime shift is complete, leading to a quick re-adjustment of risk premia.
1. See also Discussion paper n.52 - December 2021 by Pascal Blanqué, “Money and its velocity matter: the great comeback of the quantity equation of money in an era of regime shift”.