Different ways to 2%

Central banks will likely stick with a 2% inflation target in the coming years. However, policy may have to be set to keep inflation from being too much above target, rather than too far below, as was the case in the decade after the global financial crisis. This potentially means a higher equilibrium level of interest rates in the future. More immediately, rate cuts will be limited and a flood of money out of cash into bonds and equities looks unlikely, especially given the lower-risk premiums in credit and shares. But as long as central bankers don’t engineer a recession to meet inflation targets, high yield and equity exposures remain attractive.

Shifting influences on prices

Even as inflation has moderated, recent monthly changes in the most widely followed inflation indices have been well above what they averaged during the 2010-2020 period. In the wake of the 2008-2009 crisis, disinflation was driven by globalisation and balance sheet retrenchment, along with the impact of technology on the cost of numerous consumer goods and services. To return to those days we are likely to need a benign combination of lower commodity prices, increased low-cost import penetration, new disruptive business and distribution initiatives in mass consumption markets and probably higher unemployment. Instead, geopolitical risks to commodity supply, protectionist trade policies and profit margin-protection work in the opposite way, especially when demand is holding up. Only if demand was squeezed would suppliers feel the need to cut prices so that aggregate inflation softened.

Higher equilibrium rates

I’m not saying we are in for a repeat of 2022-2023. But investors should be prepared for monetary policy to be set to keep inflation from being persistently above 2% rather than preventing inflation from falling persistently below 2%. That is very much the situation today with investors less confident about the timing of a first cut, particularly from the Fed.

There are potentially significant implications for the medium-term outlook for interest rates. In order to stick with a 2% target, real rates are likely to have to stay positive suggesting nominal policy rates in or above a 3%-4% range in the US and UK and 2%-3% the Eurozone. How far above that range rates go depends on the appetite for forcing inflation back down through engineering a recession, an increase in spare capacity and higher unemployment. Living with inflation a little above the target range has greater social utility than the alternative.

Can’t let go of the cash

Today investors with assets in cash or short-term fixed income strategies are benefitting from interest income. Moving out of cash is not an easy decision. A year or so ago there was an expectation that there could be a surge of flows from money market and bank accounts into bond and equity funds as central banks encouraged the idea of significant rate cuts. That seems less likely now, given the rate outlook and that risk premiums on credit and equities have been squeezed.

The rate outlook is set to look more like it did before 2008 than in the quantitative easing (QE) period. It means a higher hurdle rate for returns from riskier assets than cash. It also means that long-term yields are not likely to move significantly lower. The big move in fixed income will be a readjustment in the shape of yield curves through lower short-term rates, but that is and will continue to happen only slowly. My take on that is to prefer short-duration exposure in fixed income.

Old and cynical

In my more cynical older age I increasingly take the view that no forecasts are stupid (within reason) but the idea of trying to forecast (most) things is stupid. Future outcomes for things we can observe are all on some dynamic probability curve and no-one is giving us the weights. So, the best bet is to think about what the individual feels most comfortable with as an investor. That is cash for lots of people. For me, as a professional in the financial markets, I see themes which I think support certain allocations that could deliver superior returns to cash. The equity-technology theme is one – just look at the capital spending numbers as companies ramp up their artificial intelligence capabilities and what that means for firms supplying data centres, cabling, cooling systems and (renewable) energy. I think high yield credit is another, as the financing risk of more leveraged, cyclical companies is spread more widely these days. An 8% yield in a US high yield strategy is attractive compared to there being no yield pick-up over cash in much of the investment grade market (hence the preference for short duration which has an attractive asymmetric return-risk profile to the likely evolution of rates).

In the QE world investors in high grade debt and cash paid an option premium to keep them out of trouble in a very uncertain world (central banks stood by as buyers). It was binary – little return for assets supported by central banks, potentially big returns for assets that were at risk from the debt-deflation nexus. Today is not like that. Cash provides income, there is little need nor incentive for investors driven by the need to build wealth to take interest rate duration risk. The market has rewarded risk takers in credit and equity and the macro backdrop looks as though that will continue. But there may be a reckoning ahead when the 2% inflation framework of developed market central banks is seen to have no clothes.

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 30 May 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.