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Picture: 123RF/GOPIXA
Picture: 123RF/GOPIXA

Paul Volcker, who chaired the US Federal Reserve from 1979 to 1987, is most famous as the central banker who slayed the inflation dragon, unleashed by energy shocks (the Arab oil embargo and Iranian revolution) and central bank policies that were excessively pro-growth, ignoring supply-side inflation drivers.

Volcker’s aggressive monetary tightening might have induced a recession, but it lowered US inflation sharply and ushered in a long period of muted price hikes, which underpinned the equity bull market that started in the early 1980s.

Much of the world is experiencing another inflation spike, with both supply- and demand-side drivers that share similarities with the 1970s but are in many ways also unique. A toxic mix of excess demand and insufficient supply has resulted from Covid-19-induced demand shifts, inflexible “just-in-time” supply chains, early-pandemic corporate pessimism, unprecedented levels of monetary and fiscal stimulus, and most recently (and most importantly) a global energy shock triggered by Russia’s invasion of Ukraine.

The inevitable result is rising prices. For much of the post-global financial crisis period the primary challenge facing global central banks was the opposite: excess global supply and insufficient demand, leading to stubbornly low inflation and sporadic deflation scares. This bias is likely to have prompted the initial reaction to view the spike as “transitory”, something that is likely to roll over into deflation as higher energy prices feed into the base. This view has proved to be highly optimistic, despite an apparent peaking in supply chain disruptions as the war has dragged on and energy prices have continued to escalate, feeding through to consumer prices — with a lag as corporate hedges roll off.

We find ourselves in a situation considered almost unthinkable in a prepandemic world, as we hear dusty old phrases like “overheating”, “behind the curve”, and “wage-price spiral”. Policymakers are left in an invidious position: tighten monetary policy only moderately, hoping not to compound the negative growth impulse already presented by the existential cost-of-living squeeze, and risk an unhinging of inflation expectations that ushers in a high inflation world not seen since the 1970s, or alternatively tighten policy aggressively in the hope that rapid action quickly staves off the inflation scare.

The latter course of action has emerged as the preferred option, the lesser of two evils as it were. The lessons of Volcker and his predecessor support this choice but also teach us that it is a fine line to walk, with an uncomfortably high probability of “over-tightening” and tipping the economy into recession.

It is possible that policymakers manage to thread the needle between “fire” and “ice” — the mythical “soft landing” — but for now markets are more concerned with the increasing probability of the extremes of too hot or too cold, both of which have unpleasant implications for asset prices.

Stamping on the brakes too hard is likely to trigger an earnings recession of indeterminate extent, a risk further complicated by an elevated earnings base reflecting revenue and margin expansion in technology, consumer goods and commodities that far exceeded the compression in pandemic-affected service industries.

Equity markets would be pressured by this, and potentially bonds too, at least initially, should this episode appear “stagflationary” at first (high inflation accompanied by low growth), but ultimately this should prove positive for bonds as the slowdown causes inflation to peak.

On the other hand, more persistent above-target inflation is sure to require even higher real interest rates in time, constraining economic activity in a more protracted fashion and raising the cost of capital for business across the board. Again, history tells us markets like low (but positive) inflation and that in most other cases market-implied discount rates tend to rise, capping equity returns as earnings multiples fall, and fixed income returns are hard to come by as inflation reduces the attraction of nominal cash flow streams.

As usual, SA capital markets present their own nuances to the story. Inflation has also risen, but to date the extent has been far milder relative to our own history than witnessed in developed markets. SA CPI has risen to about 1.3 times the 10-year average, while this ratio is 4.1 times in the US. Again there are multiple causes here. SA has a history of relatively high inflation, corporates actively hedge currency and input costs and, most importantly, the levels of both monetary and fiscal stimulus during the pandemic were by necessity far more constrained, leaving the demand side of the economy still weakened and only supply side factors to drive inflation.

While this might all sound a touch depressing, uncertainty and shifting probabilities will undoubtedly throw up opportunities for investors with sound frameworks and calm heads. While many might be tempted to run for the safety of cash in the short term, real cash yields remain poor despite rate hikes.

This is therefore only useful if viewed as temporary “dry powder” that provides optionality to deploy into riskier assets as opportunities present: either into bonds as the slowdown gains traction and inflation moderates; or into equities at more attractive valuations as their inflation protection qualities come to the fore.

• Mommsen is co-CIO and head of equities at Matrix Fund Managers.


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