• Eng Guan

Inflation and How It Is Affecting The Markets

Everyone should be acquainted with what inflation is today. Even if you do not invest, you would still feel its effects around you. Just take a look at the prices of all the daily stuff you pay today against maybe a year or two ago. A local stall I frequent used to sell really good whole-cooked chicken for $18. But just last year, the price went up to $26. While I think the price is still reasonable given that they priced it much lower than competitors before this, that, however, is still more than a 40% jump. Of course, not all prices increased by that much. But when inflation outpaces your wage growth, it is enough to make ordinary people feel the pinch.


How Did Inflation Come This Far?


Loose Monetary Policy - Easy Money Since 2008


The central banks worldwide sowed the first seeds as far back as 2008. US Federal Reserve began lowering interest rates and printing money relentlessly to pull the economy out of the Great Financial Crisis. However, this is all in hindsight. Analysts and economists have long talked about inflation as a consequence of easy money policy. But the fact of the thing is, inflation didn't come back in any big way for more than a decade until last year in 2021. For a good amount of time, all this easy money mainly finds its way into pumping up prices of stocks, real estate, cryptos, etc. But it fails to ignite consumer demand or spending and inflation was well under US Federal Reserve's threshold.


Covid 19 Recovery Demand-Supply Imbalance


The emergence of Covid-19 is the next seed. It sent the world into a state of lockdown. Businesses were forced to slow or stop operating. People are asked to stay home. Workers are furloughed or even laid off. Demand falls. That was in 2020.


Then as the world comes to grip with Covid-19 and the vaccination rate increases, demand starts to come back fast and furious. But the people are not returning to the workforce as fast. The pandemic changed behaviors. Some took the chance to retire. Some took their time to come back with all the welfare and benefits. Others reprioritized their lives and decided to do something else. There are many possibilities. Foreign talents who went back to their home countries may also be hesitant to return with Covid-19 and possible lockdowns in the backdrop. The situation is still fluid.


This resulted in a severe labor shortfall across industries be it construction, shipping, logistics, manufacturing, etc. To top it off, surging energy demands caused shortages in natural gas and coal, and their prices spiked. As a result, China, the world's manufacturing house, experienced a serious power crunch with cities facing cuts in electricity supply. And a strict zero covid tolerance policy in China leading to occasional lockdowns in affected cities also hampers the overall recovery.


Russia Ukraine War in February 2022


The third event is not a seed. It is more appropriate to say it is adding fuel to fire. Russian troops marched into Ukraine on 24 February 2022. That led to outcries and countries condemning Russia for their aggression. And unsurprisingly, the US and other countries imposed sanctions on Russia. Then Russia retaliates. While the physical conflict is largely constrained within Ukraine, it does have a wider global impact. Russia is one of the top energy producers in the world. Europe, in particular, relies heavily on Russia for its energy imports such as natural gas, oil, and coal. Ukraine, on the other hand, is among the top producers and exporters of grain products such as wheat and corn. So everyone will ultimately pay some price for this war as this can only mean that prices of these products are going to go higher from here. With already persistent inflation, this spells more uncertainty and troubles ahead.


Where is inflation now?


Based on the latest Consumer Price Index (CPI) reading for February 2022, the YoY inflation stands at 7.9%. This is one of the most-watched gauges on inflation. But what US Federal Reserve used as a reference is the Core Personal Consumption Expenditure (PCE) price index. And based on the core PCE price index, the current inflation hovers at 5.2%. There are some differences between these 2 indices. But the key one is that the core PCE price index strips out volatile food and energy prices. That accounts for the lower reading. But having said that, it is still well above the Federal Reserve's target of about 2% inflation for price stability.


YoY Inflation based on CPI and Core PCE
YoY inflation based on CPI and Core PCE

Prior to the war, economists expected inflation to moderate in the 2H 2022. But with the war still raging on, things are now more uncertain and the forecast looks set to rise.


How has this inflation impacted us and the financial markets?


Let's take a look at how the different asset classes performed in 2021. This is the year that was marked strongly by the post-pandemic recovery. Inflation, while already a concern, did not really flare up until April 2021. As a whole, bullish sentiments governed the year with risky assets such as stocks and REITs, largely discounting the impact of inflation and clocking one of their best years. As for the other asset classes, other than TIPs and high yield bonds, government, investment-grade corporate bonds, and Gold were down for the year.


2021 Asset Class Performance
2021 Asset Class Performance

The sentiment took a turn in 2022. Stocks crashed as inflation finally sinks in. And the Ukraine-Russia war deepens the rout. But they are not the only ones. Almost all asset classes fell. The only exceptions are Gold and Commodities.


2022 YTD Asset Class Performance
2022 YTD Asset Class Performance

Why are markets reacting in such a way to inflation?


Erosion of purchasing power


Inflation has always been there. We are living with it all the time. In fact, we always expect a moderate level of inflation with a growing economy. But what we fear is persistently high inflation that outpaces wage growth. Because that erodes our buying power. Yet excessive wage growth can also in turn fuels inflation because all these added manpower costs are eventually passed on to consumers. Long-lasting inflation can have a serious impact because many of these price increases are going to stay even if the raw material or energy prices come down in the future. Wages and prices of end consumer goods and services tend to be upward sticky. As an example, I don't think I will ever get to buy a whole chicken for $18 ever again.


Stocks valuations get hit


If your future earnings and buying power suffer from inflation. So do businesses. There are only that many costs that businesses can pass on to consumers before people cut down on their purchases or look elsewhere. So with inflation, stock valuations drop as what you expect to earn in the future are now worth less than they used to be. And inflation hits harder on growth stocks. Why? Because these are stocks priced for their potential to grow which are factored into their higher future earnings.


Nominal bonds come under pressure


Basically, anything that is priced with future cashflows is negatively impacted by inflation. Nominal bonds are no exception. These are bonds that pay a fixed coupon rate periodically based on a fixed principal. In fact, they are even more sensitive to inflation. In particular, longer-term bonds with cashflows far out into the future. Because, unlike stocks, nominal bonds have no means to adjust or pass on the effects of inflation elsewhere. As a result, you can expect their prices to head south when inflation rises.


TIPs finally saw some light


Treasury Inflation-Protected Securities (TIPS) finally had their chance to shine. These securities are just like their nominal counterparts. They pay a fixed coupon rate (which is lower than nominal bonds). But their principal adjusts according to inflation (based on CPI). As inflation goes up, the principal goes up. So even though their coupon rate stays the same, TIPS holders get paid more because the coupon is now calculated based on a higher principal. Hence, inflation benefits TIPs. But that said, TIPs, like all bonds, are still negatively impacted by rising interest rates. So while inflation supports TIPs, a rising rate environment dampens it. And when inflation pressures are high, we can expect the rate hike pressures to be high as well.


Commodities will thrive


The cost of the raw basic materials or commodities for the manufacturing of goods we use is often a key source of inflation. These are your energy sources such as natural gas, crude oil, coal. Food such as wheat, corn, cattle, etc. Construction materials such as steel, iron ore, and more. These are driving costs up for businesses and eventually the end products and services that people consume. But of course, a root cause for the surge in all these commodities is the imbalance in demand and supply amidst the Covid-19 recovery. So as a whole, commodities fare better than the rest in this inflationary environment.


Gold has traditionally done well as a hedge against inflation but ...

Gold, a long-time safe haven and hedge against inflation, is expected to do well in an inflationary environment. But that said, its performance in 2021 was kind of disappointing. Not only did it not react to the rising inflation, but it was also actually one of the worst-performing asset classes for that year. It "woke up" only after the Russia-Ukraine war erupted towards the end of February 2022 where it delivered a stellar month. But if we consider a wider perspective, there are other factors aside from inflation that impact the prices of Gold. Bullish sentiment for risky assets in 2021 and an increasingly hawkish Federal Reserve driving higher interest rate expectations weigh down on Gold. That might explain its underperformance.


Central banks are forced to accelerate tapering and rate hikes


Price stability is a key focus for the US Federal Reserve. If inflation swells, we can expect the central bankers to act by raising interest rates to cool the economy down. That will inevitably put more pressure on both stocks and bonds. Higher interest rates mean higher costs of capital for businesses. And it makes existing bonds issued at lower interest rates less appealing to investors.


But even though inflation rose above the Fed's target of 2% since April 2021 and steadily higher thereafter, Fed's reaction was a lot milder than what the market expected. They held on to their view that the current inflation is transitory. They believed it is a result of the demand-supply imbalance due to the economy opening up after the pandemic. They expected the heightened inflation to be temporary and will abate when the supply catches up. While they might still be right, this episode is, however, lasting more than just "transitory". So they change their stance in September 2021 and accelerated their pace of tapering and adjusted their rate hike expectations in the months that followed.


What is the expected outlook for interest rate hikes in 2022?


Based on where the Fed Fund's futures are trading on 14 Mar 2022, we can see what the market participants expect the rate hike path to be like for 2022.


Market Implied Fed Rate Hike Path (as of 14 March 2022)
Market Implied Fed Rate Hike Path (as of 14 March 2022)

The dotted blue line is a hypothetical line representing a 0.25% hike at each of the 7 FOMC meetings for 2022. The solid orange line tells us where the market is expecting the rates to be at each of these meetings. The grey vertical bars indicate to us the probability of a hike of at least 0.25% at each of these meetings.


As you can see, it is not so much of a question of whether the Fed is going to hike interest rates or not. It is more about how much they are going to hike. Right now, the market is pricing in a faster rate hike than 0.25% for earlier meetings. And at the end of 2022, the expected Fed Funds rate is almost 2%. That is almost as good as hiking 0.25% for all the 7 meetings this year.


Does that mean we should be piling into commodities, TIPS, and Gold?


At the current moment, the scenario is definitely far from ideal. But market expectations are changing all the time based on new developments. And no one can see how things are going to unfold. In the worst case, some compare the current state against the stagflation era in the 1970s. That is a period plagued by high inflation and a slowing economy. The worst of both worlds. But that said, there are quite a fair bit of differences and mitigating factors in today's circumstances. That is just my personal view, so I am not going to delve into it here.


As a general principle, I am not an advocate of timing regimes. Because I do not know how things will turn out. For example, how long is this going to last and how bad is it going to get? Your guess is probably as good as mine. Many scenarios are possible. For example, if Fed turns out to be more hawkish and it hikes 0.5% this coming round, we can expect the market expectations to reflect a more aggressive hike expectation going forward. In that event, markets will become even tougher. But if inflation abates and the war tapers off, we may see the rate hike expectations adjusts to a milder path. And in such a scenario, it will lift some pressure off both stocks and bonds. There is also the possibility of war and inflation aggravating and tipping the economy into a recession. Then Fed will have to think twice about hiking rates which can possibly push the economy faster and deeper into a downturn. But if there is anything good, a recession is likely to keep inflation down with falling demand.


So rather than time regimes and making discretionary switches among asset classes, a more viable approach for me is to diversify across a good mix of asset classes and strategies to start off with. While that wouldn't mean my portfolio is perfect and immune to inflation, it does give better protection in tough periods.


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