Inflation, Interest, War and Food
PWA's Market Update, April 2022.
“…people who are comfortable with their investments will, on average, achieve better results than those who are motivated by ever-changing headlines, chatter, and promises.” – Warren Buffet – 2021
A volatile start to the year
Global stock and bond markets were already declining as we entered 2022. The decline over the last couple of months was due to several strong headwinds. Data suggested a slowing global economy, Central Banks had signaled an end to easy money (Quantitative Easing), and persistent inflation led to rapidly rising interest rates.
We now have further headwinds with Russia’s tragic invasion of Ukraine. Russia and Ukraine supply a surprisingly large percentage of commodities to the world. Russia’s key exports are crude oil, gas, and coal briquettes. Ukraine was the second-largest exporter of grains to the EU and a large food supplier to Asian and African countries.
This disruption to supply has led to a rapid rise in commodity prices at levels we have not seen in the last 100-years. These rapid rises in commodity prices have pushed peak inflation expectations even higher globally, in turn driving bond yields higher.
CRB Commodity Index – y.o.y % change
Given Europe’s geographic proximity to the conflict and its heavy reliance on Russia for energy, their share markets have declined post the invasion. The STOXX Europe 600 index fell -15.30% from the start of the year before staging a recovery to finish down only -6.31% year to date (as of the 31st March).
The majority of the developed economy share markets are in negative territory year-to-date. Still, more interestingly, bond markets are also tumbling as yields on bonds rise on the back of increasing inflation pressures.
The Barclay Global Aggregate Bond Index (the Agg) is a selection of more than 10,000 government and corporate bonds and mortgage-backed securities. The Agg has declined by c.-7.3% over the last 12-months and has fallen from its previous high by more than -11%. Both of these drops are the largest negative performance numbers in the history of the Agg, and we are only three months into the year!
Barclays Global Aggregate Bond Index (USD) – ending 24t March 2022
Inflation continues to exceed expectations
The Ukraine war’s impact on commodity prices is only part of the inflation pressure we see in 2022. In 2020, as I am sure we all remember, the world was introduced to a pandemic and placed into rolling lockdowns. These lockdowns had a devastating effect on the production and supply of goods. At the same time, governments worldwide provided record-high levels of stimulus to their citizens. These payments led to an equally significant increase in the demand side. This increase in demand has led to suppliers being unable to meet demand.
As shown below, economists worldwide continuously upgrade their peak inflation number for 2022. The continual increase in the forecast can also be seen closer to home, with NZ economists and the RBNZ predicting in February 2021 that inflation would peak at about 2.5%. Fast forward to February 2022, and they are now forecasting inflation to peak at just over 7%.
Latest inflation forecast for 2022 – higher for longer
The forecast peak for inflation has constantly increased, as has the expected duration for which we will be experiencing higher inflation. Still, the one thing that has not changed is an almost universal belief that high inflation will be transitory. It is simply a matter of how long “transitory” is.
As shown in the table below, a significant part of the increase in U.S. inflation has come from energy and food. This pricing pressure is forecast to peak and reduce over 2022, with U.S. inflation forecast to be just under 4% by the end of 2022.
U.S. – CPI Inflation contributions
The more concerning observation from this is that core inflation (excluding food and energy prices) has been climbing and is expected to move higher in 2022. This is more concerning as core inflation is stickier and is more difficult for the U.S. Fed to get under control with their rate rises. We can also note that core inflation is forecast to remain above 2% into 2024.
Interest rate expectations rise rapidly
So what does all this inflation talk mean for the markets? In March, the U.S. Fed commenced raising the U.S. cash rate to a range of 0.25% and 0.50%. This was its first hike since 2018. Since the start of 2022, the expectation around the number and speed of further rate hikes in 2022 has increased dramatically.
As inflation pressures rise, the bond market is pricing in larger and faster increases in the U.S. cash rates. In January, the bond markets were pricing in only a 38% chance of a 0.25% increase in the U.S. cash rate in May and only three rate hikes in total in 2022. The most recent reading shows the market is now pricing in a 72% chance of a 0.50% increase in the U.S. cash rate and almost ten rate hikes. There are not nine more Fed meetings this year, which means that the market has gone from expecting a few 0.25% rate rises to three 0.50% cash rate increases this year.
Market pricing of 0.25% rate rise in the U.S. in May
No. of rate rises expected in the U.S. in 2022
The U.S. bond market is now forecasting this tightening cycle (increasing interest rates) to be one of the most rapid tightening periods in the last 25 years. This aggressive future pricing or rate hikes does leave some room for the Fed to indicate a slower than forecast increasing cycle.
If inflation proves to be transitory and economic growth continues to slow, we can expect the U.S. Fed to consider walking back a few of their forecast rate rises. Given the uncertainty around inflationary pressures, though, we would not want to be taking any high conviction around where the U.S. cash rate will peak this cycle.
Current pricing for rate rises vs previous tightening cycles
Stagflation becomes a larger risk
According to the Oxford Dictionary, Stagflation is defined as “persistent high inflation, combined with high unemployment, and stagnant demand in the country’s economy”. According to Google, the number of users searching “stagflation” has recently spiked to the highest level in Google history (Google started 24 years ago).
Google searches for the word “Stagflation”
We already have one of the requirements mentioned above for Stagflation with persistently high inflation. Concerning the other two measures, unemployment remains at record low levels in the developed world, and according to Fitch’s latest forecasts, global GDP growth will be 3.5% and will slow to 2.8% in 2023.
Probability of U.S. recession in 1-yr & 3-yrs
We may see these other two measures worsen as higher energy and food prices and rising interest rates start to impact disposable income around the world. For example, U.S. job openings remain at near-record highs, with five million more job openings than unemployed people. Still, U.S. small businesses’ hiring plans have recently started to decline from a record level.
Regarding food, the global average food price increase has been +40% since the start of the pandemic. The increasing cost of food and energy, coupled with rising interest rates globally, can drop global consumption. As shown above, the probability of a U.S. recession (negative GDP growth) remains low over the next 12-months, but there is now a 60% chance of a U.S. recession in the next three years.
Summary
It has certainly been an eventful beginning to 2022. Global inflationary pressures remain the primary concern in the medium term. As we get a more precise reading of the transitory (or not) nature of inflation, we will get a better feel for where interest rate rises may end. At present, any forecasts around this come with a sizeable margin of error.
We continue to expect to see heightened volatility in the short term. However, this is not always bad and can present excellent opportunities to purchase quality companies/investments at discounted prices.
Lastly, when the U.S. Federal Reserve started increasing cash rates, this did not mean that it was the end of the share market rally. As shown below, when reviewing fifteen different tightening cycles in the U.S., the global share markets usually moved higher over 12 to 24-months. This is generally because it takes several rate rises before the economy slows and the risk of a recession starts to drag share markets lower.
S&P500 performance 12-mths before & 24-mths after the first rate hike
As discussed at the start, we have come into 2022 with concerns around possible volatility in the global investment markets, which has played out. How financial markets continue to move over the rest of 2022 remains uncertain, with a wide variety of possible outcomes.
At PWA, we monitor these historical events and portfolios closely while remaining conservatively positioned within portfolios and maintaining a disciplined approach.
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