Prospect of peak inflation improves outlook for fixed interest assets

US inflation data also suggests inflation could have peaked at 8.5% in July from 9.1% the previous month. It’s reassuring to see inflation is drifting lower globally for the right reasons, including the easing of supply chain constraints and lower energy and food prices. The chart below shows the contributors to the most recent inflation print. Barring higher shelter prices, it indicates the key drivers of the easing in inflation are new and used cars, energy and food prices. 

In the meantime, the Federal Reserve continues to raise interest rates aggressively to withdraw liquidity from the system and quell inflationary pressures. Its efforts are still working their way through the financial system and likely to continue to impact global market sentiment in the second half of the year. The one big contributor to still rising prices is shelter, which is linked to property prices and hasn’t yet felt the impact of higher rates. But with property prices now coming down, so should shelter prices - as said, with a lag! 

Is this an outlier call?  

In our view it is not, as market pricing shows investors are not buying into a higher-for-longer inflation story, but, instead, expect inflation to drop sharply. The chart below contrasts US Consumer Price Inflation to US break-even Inflation. While inflation may be close to a 30-year high, it is also fair to say that the market is pricing for inflation to come down from its highest rate in the last 30 years.

That said, markets are also driven by sentiment, and do not like uncertainty. The elevated levels of inflation across the globe, paired with aggressive adjustments in short-term rates by global central banks, have led to significant interest rate uncertainty. This is reflected in the chart below, which measures volatility across a range of various factors. It shows that the US bond measure of market volatility across the term structure is now tracking three standard deviations above its long-term mean – well above the levels of volatility in other asset classes. What is interesting to note is that bond market volatility was only higher during the Great Financial Crisis and Covid-19 pandemic.

An opportunity for fixed interest assets 

Volatility is commonly seen as the pricing of uncertainty. However, where an evidence-based, systematic process is used to cut out any emotional decision-making, volatility can also be viewed as an opportunity to create certainty and exploit market mispricing. This generates attractive investment opportunities and real rates that are higher than they should be. For this reason, at Prescient we remain positive on South African bonds and inflation-linked bonds. At the front end of the curve, we are strongly optimistic about SA income assets with a fixed term in the 1, 2 or 3-year space. These asset classes are all trading at historically high real rates. 

Furthermore, it is our view that the scenario priced into markets may not even materialise. Over the recent weeks, members of the Federal Open Market Committee (FOMC) have begun to acknowledge downside risks to economic activity, noting that long and variable lags associated with monetary policy transmission raise the “risk that the committee could tighten the stance of policy by more than necessary to restore price stability,” and that the full impact of rate hikes on consumer prices was “not yet apparent,” setting the stage for an eventual pause in the rate-hiking cycle.

What’s more, the phrase “path back to two percent” rather than just “back to two percent,” implies some FOMC participants’ willingness to ease policy in the intermediate term, should there be “firm” evidence of inflation receding to the Fed’s 2% inflation target. This also tallies with the minutes of the last FOMC meetings, in which participants indicated “it would likely take some time for inflation to move down to the Committee’s objective.”

While we do not expect—and economic data does not suggest—an imminent Fed “pause” or “pivot”, the language of the July minutes signals that the overarching sentiment from FOMC participants is it may be “appropriate at some point to slow the pace of policy rate increases” to assess the cumulative effects of policy tightening. 

Therein lies the opportunity. At Prescient, our point-in-time data analysis will guide us to position our funds for a peak in inflation in a timely fashion. We base our investment decisions on a rigorous process, with our investment themes guiding our decision-making, supported by statistically verifiable facts. But as human beings we are also optimists and the above data suggests a certain ambiguity to the prospect of a looming recession. If it does materialise, it’s not yet clear cut whether it will run particularly deeply.
 
We know that recessions are part of the business cycle, as is the repricing of asset classes. We have already seen markets sell off, and a slew of asset classes are looking to be undervalued. Once again, our data-driven approach will help us identify and process information quickly and confidently, enabling us to adapt with speed and remain well positioned for any challenge the future holds. DM/BM

Author: Bastian Teichgreeber – Chief Investment Officer at Prescient Investment Management 

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