We are at a crossroads. With the possibility that the global pandemic’s influence on the markets may be receding, borders reopening and economies continuing to rebound, life as we knew it pre-Covid may finally be resuming. Not so for investors.
Last week’s CPI Report pushes the US Economy well past the 5% annualized inflation mark, effectively shutting the door on the falling rates and low inflation era that investors have worn comfortably for decades. Instead, investors will now have to contend with a confluence of four factors that will complicate the investment marketplace for the foreseeable future: (1) resurgent inflation; (2) the pace of the economic rebound; (3) the tapering of the Fed’s asset purchase program; and (4) an anticipated Fed hike in interest rates and the pace at which those increases continue over the next several quarters.
Here is how I believe these four factors will play out.
Not since the Spanish Flu have investors had to adapt to managing risk during a Global pandemic. What’s changed now versus the past 18 months is that investors are staring into the whites of inflation’s eyes. The results will be telling. We have entered a completely new inflationary world that we haven’t experienced in decades. While we’ve had bear markets before, those periods were all in benign inflationary environments. Now for the first time in many years, the Federal Reserve has truly let inflation go beyond their stated 2% target average.
The economy continues to expand and draw people back into the workforce. While growth in employment slowed in the last 2 months likely due to the Delta Variant, the fundamentals remain fairly strong. The pandemic has led to structural changes to our workforce, which is now decidedly smaller, particularly with women leaving the workplace in large numbers for a variety of factors, and time will tell whether these changes are permanent.
We believe the Federal Reserve has also concluded that the economic backdrop has allowed them to meet their dual mandates of average inflation over multiple periods reaching 2% and employment growth regaining much of the Covid induced job losses. This will lead to the Fed tapering their current asset purchases in treasuries and mortgage-backed securities. We expect the Fed to announce at their November 3rd meeting the beginning of this tapering process, with a first taper in purchasing of mortgages and treasuries potentially starting as early as mid-November. We would expect this process to last through June of 2022.
As for rate hikes, whereas the Fed was initially looking at not hiking rates until 2023, recent economic data, culminating in last week’s CPI report has put potential interest rates hikes on the front burner. Our call is that the Fed will make their first-rate hike in Q4 2022 and begin to bring rates to a more normal level versus expected GDP and inflation throughout 2023. This will likely usher in a structured rate hiking program of 25 bps per Fed meeting for the following several quarters.
What does this all mean for investors?
Whether we ultimately have a growing economy with inflation in excess of what the markets have seen in decades or a less likely stagflation situation, this is a new world for most investors. On top of that, the Fed’s taper and then raising of interest rates will create even more volatility in the fixed income space, resulting in more mispricings in the Treasury rate curve and the mortgage and credit markets.
In my opinion, the net-net is that strategies that have historically worked like a 60 / 40 asset allocation between equities and bonds or risk parity strategies won’t work as well in this new inflationary environment. Investors would do well to consider actively managed strategies like fixed income relative value, to help them navigate this brave new world.