Are Markets Starting to Build in Long-Term Inflation?

By TruePublica: Norways’ sovereign wealth fund, the world’s largest, has warned that investors face years of low returns as the surge in inflation becomes a permanent feature of the global economy.

Nicolai Tangen, chief executive of Norway’s $1.3tn oil fund, told the Financial Times he was one of a number of people now taking this view in the fierce debate over whether the jump in rates was transitory or a lasting threat.

Consumer price inflation is running at its highest level for more than two decades in the world’s big industrial economies, in particular in the US, where the annual pace of price growth hit 7 per cent in December, up from just 0.1 per cent in May 2020.

In the UK, predictions of inflation in April 2021 undershot reality significantly with the Bank of England constantly revising up its quarterly forecasts to the year-end. Economists are now looking at the BoE raising rates at least bi-monthly. Bloomberg reports that markets are close to pricing in a rate of 1.5 per cent through half a dozen rate rises by the end of 2022, implying the biggest tightening of policy for any calendar year since 1997.

Tangen said the oil fund, which owns the equivalent of 1.5 per cent of every listed company in the world, thought inflation “could be stronger than what is generally expected” as the world experiences high demand and lingering disruption to supply chains.

“We are seeing it across the board, in more and more places. You saw Ikea increasing prices by 9 per cent, you have seen food prices going up, continued very high freight rates, trucking rates, metals, commodities, energy, gas . . . We’re seeing signs on wages as well.”

The former hedge fund manager said: “How will it pan out? It hits bonds and shares at the same time . . . for the next few years, it will hit both.”

Economists are divided over whether the surge in inflation will be fleeting. Some have argued that the pandemic caused a temporary shock to supply chains that coincided with a sharp economic recovery, which will ease over time.

Nouriel Roubini, advisor to the IMF, the Federal Reserve and World Bank thinks along the same lines as Tangen. “The longstanding negative correlation between stock and bond prices is an artefact of the low-inflation environment of the past 30 years. If inflation and inflation expectations continue to rise, investors will have to rethink their portfolio strategies to hedge against the risk of massive future losses.”

If inflation were to remain well above the US Federal Reserve’s (or Bank of England and ECB) target rate of 2% – even if it falls modestly from its current high levels – long-term bond yields would go much higher, and equity prices could end up in bear country. In that scenario, we’re looking at falls equivalent to 20 per cent or more.

And what this really means is that if inflation continues to be higher than it was over the past few decades (called the “Great Moderation”), a typical 60/40 portfolio (60 per cent in higher return stocks / 40 per cent in lower return, lower volatility bonds), that of traditional investment advice, would induce massive losses. The task for investors, then, is to figure out another way to hedge the 40 per cent of their portfolio that is in bonds – and attempt to make better gains than usual to beat inflation in stocks. No mean feat even for the very experienced investor.

Many economists still think that inflation will flatten out over ten years to something like 2.5 per cent, but Tangen said other factors, including more people retiring or leaving their jobs, strengthened his view that the rises were permanent.

The FT also reports that – “Both bonds and stocks started 2022 on the back foot, and investors’ longer-term expectations for mainstream capital markets are becoming gloomier. AQR Capital Management, a quantitative investment group, estimated that a classic balanced portfolio of 60 per cent stocks and 40 per cent bonds would return just 2 per cent annually after inflation over the next five to 10 years. That is under half the roughly 5 per cent average enjoyed over the past century.”

Large investors have sought to beef up returns with “alternative” investment strategies, including hedge funds, venture capital and real estate. Their assets under management grew to $13.3tn last year, according to data provider Preqin, which predicted the alternative investment industry’s assets would grow to $23.2tn by the end of 2026.

Norway’s oil fund only allows for investment in stocks, bonds and real estate. It had its fourth-strongest year for returns last year, posting a 14.5 per cent increase. Like many big investors, it has grown steadily since the global financial crisis in 2008, but Tangen went on to say that the party is over and warned. – “We will have much tougher times ahead . . .  we could see a long period of time with low returns,” he said.

 

 

 

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