Historically, rising inflationary Pressures have created depressions at bond market prices and sent the cost of capital upwards along an arguably predictable trajectory. However, we are facing a unique set of circumstances in the current market environment – in part due to the extreme levels of dependence on central bank (CB) support.
Asset Values – A Larger Part of the Story
Asset prices are more relevant to market dynamics than in previous inflationary periods. Recent research from Macquarie highlights that we are facing economic growth that hinges on a combination of US demand, Chinese economic growth (commodities, real estate & infrastructure), as well as CB action (with most importance on the Fed, BoJ, and ECB). 1 Movement in asset prices, has compounded this trend. Economies have grown with asset prices over the past few years, fuelled further by increased leverage. This was in stark contrast to previous episodes when increased productivity and declining inequalities supported demand and wealth creation.
Volatility – the Bane of Asset Based Value?
It is not a new phenomenon for volatility to wreak havoc on asset-based economies. However, investors need to keep this in mind in the current set of circumstances. While inflationary pressures appear to be growing, we cannot discount the potential and looking increasingly persistent, the impact of higher volatility. Higher volatility combined with higher capital costs (through higher bond yields) have the potential to set economic growth off course through contracted demand. Investment and consumption, two vital components of GDP, are typically sent lower when high volatility takes grip – let alone when it catches substantial numbers of investors off guard as in this past week’s events.
The research from Macquarie highlights that previous academic studies found a 10% SPX contraction has the power to reduce the six-months forward trajectory of US GDP growth rates by 50bps- 60bps.1 Further to this, a decline in the ratio of US net household assets to disposable income from the current record level of ~7x to the historical average of ~5.5x, would directly lead to plummets in spending rates as personal saving rates would rise from today’s historical low of 2.4% to at least 4%-5%.1
Balancing Inflationary Pressures
One might wonder why the CBs have had such a sharp turn in priorities. For the last few years, the primary concern was supporting markets rather than implementing measures to reinforce against future downturns. Now inflation has become the core focus. With inflationary pressures heating up from a mix of wage and commodities growth CBs are finally placing their attention on an area that arguably poses the most danger to market stability. If inflation does drift much higher, this will limit the current CB support mechanism – potentially creating a spike in bond and FX volatilities as well as the US dollar, stalling global liquidity and hindering reflationary momentum.
Moving forward there are even still more factors that exacerbate the fragility – highly leveraged financial instruments, computer trading, and passive investment strategies have only added to global asset interdependence. CBs will need to take swift, albeit well targeted, action in balance sheet management and rate changes. China will play a vital role – while further tightening will reduce inflationary pressures, it will also add to market volatility. This is a delicate balance to navigate. Overall, with macro volatility on the ups and the broader trickle-down potential, a flight to quality might surface sooner than expected.
1Macquarie, CBs & asset-based world, "Can we survive a return to normality?" 6th February 2018