The three things I would tell my clients this week
Central banks have said they will keep rates high. We can’t afford to ignore them.
The BoE is behind the curve and is facing stagflation. It needs to do more, faster and harder than its peers.
Sticky inflation means sticky rates. And (high) sticky rates mean market volatility as well as financial and policy divergence. In this world, money managers should remain sanguine about risk and neutralise portfolio volatility as much as possible. Where risks are taken, the potential rewards should be worth it.
Last week, central bankers held a conference in Sintra, Portugal. There, they confirmed that inflation remains sticky, and interest rates will thus remain elevated for some time. The central banks keep telling us what they will do. They have been consistent in their fight against inflation. Even when something did break, banks with poor risk management, central banks did help markets, but only through the provision of credit lines. Unfettered money printing or abandonment of interest rate hikes was not an option they would entertain.
Fed’s Jerome Powell said that “If you look at the data over the last quarter, what you see is stronger than expected growth, a tighter than expected labour market and higher than expected inflation”. He said he would not rule out consecutive rate hikes.
Britain’s Andrew Bailey, who’s facing worse growth, a tighter labour market and higher inflation than his peers, added that “I’ve always been interested that markets think that the peak will be short-lived in a world [where] we’re dealing with more persistent inflation”
Our investment committee member, the learned and insightful Anthony Peters (I would suggest subscribing to his email list), has reiterated for years that central banks will continue to tighten until they suffocate the economy.
Yet, markets seem to ignore what central banks and experience tell them is going to happen.
One of the professional quirks in the asset management industry is the “cathedral-sized ego”. A fund manager needs to make money. If markets are efficient, then everything that’s in the public sphere is well priced-in. To make ‘alpha’, outperform the market by betting somewhat differently, then they would need to think outside the box. See what others don’t. They do this many times a day throughout their long careers. Adding up for twenty or thirty years, the thought “what can I see others don’t” easily mutates to “I can see what others can’t”. That’s how one ends up thinking they are cleverer than the central bank. “The central banker says x, but I know they are trying to trick me”.
If one’s career mostly consists of the last fourteen years, when central banks went out of their way to curb volatility, then it’s natural to think that central bankers communicate a hawkish stance simply to lower inflation expectations and exert some control over wages, but at heart, they are market doves. They want low rates and money to flow easily.
In reality, central bankers have long lamented their inability to escape the Zero Interest Rate trap. Very low rates tend to cause pension deficits, an anathema in an ageing society. And they tend to be the source of asset misallocation. If a client is getting 10% returns on a balanced portfolio, why risk their money and waste their time starting their own business for merely double the rate of return?
At this point, while headline inflation is falling (in most places except the UK), services inflation remains sticky. It has moved beyond supply-side disruptions and acquired an internal dynamic. The fact that commodity prices remain low, only adds to the anxiety, as geopolitical disruptions may only push them up again.
Whether the Fed hikes once or twice from here is, by and large, immaterial. Rates are high enough to cause problems, and tightening will continue for some time. The BoE is behind the curve and is facing stagflation. It needs to do more, faster and harder than its peers.
We doubt that central banks are eager to cut rates soon and return to a an ultra low interest rate regime. They would be happy to avert a systemic crisis through credit lines (the literal job of a lender of the last resort), even pause rate hikes when necessary. But if the market thinks that central bankers are itching to lower rates before they see clear evidence that they are suffocating the economy, they could find themselves surprised, and their ego-cathedrals in ruins.
Sticky inflation means sticky rates. And (high) sticky rates mean market volatility as well as financial and policy divergence. In this world, money managers should remain sanguine about risk and recognise that their best friends in the past decade, central bankers, are not there anymore to bail them out at the first sign of trouble. They should neutralise portfolio volatility as much as possible. Where risks are taken, the potential rewards should be worth it. And we would do well to remember that fighting the central bank is folly, not because there are always right, but because they are powerful enough even to remain wrong.