Economy – The Cleanest Dirty Shirt
Central bankers are now faced with a policy choice of the cleanest dirty shirt, having put themselves well behind real outcomes experienced in the economy. The likelihood of policy error is now very high, having missed the start of the current expansion by some margin. The best policy options are now off the table, having to deliver a soft landing on a much smaller landing zone. Available options will be fewer and harsher, exacerbating the potential for a negative shock. Parallels between the current episode and the 1970s appear eerily similar, with real outcomes or ex‐post inflation outcomes across asset markets being equally deficient. Importantly, ex‐ante, real prospects seem challenged after weighing up the likelihood of sustained higher inflation over the medium term. With anticipatory inflation being so high, this effectively underpins poor real outcomes for wages, returns, and the broader nominal economy.
The disconnect between the real cash rate and the real neutral rate is still the elephant in the room. Central bankers appear to be avoiding this difficult conversation. The real rate in Europe is now circa ‐8.6 per cent with neutral sitting around 2.5 per cent real, a near 10 per cent gap. The assumption underpinning neutral rates is that a tightening of policy will have an elastic response with inflation albeit this is in a normalised economy, far from where we are today. The supply side of the inflation ledger is still a long way from finding a market‐clearing level with this tension formulating in higher longer‐run inflation expectations. Anticipatory inflation is now seeping into wage negotiations and will result in higher actual nominal wages over the next 12‐24 months. Unique factors are pushing up against the long‐held principles which underpin inflation targeting regimes, such as the requirement to supply goods at the lowest cost. Fundamentally, the consumer psyche has shifted to a willingness to support higher costs for better long‐term environmental and sustainable outcomes, this is untested in all prior inflationary episodes. In practice, this means much of the supply chain is non‐commercial and somewhat insensitive to price signals and return outcomes. Consequently, we now have a persistent non‐commercial element distorting inflation outcomes until scale is achieved in alternative sources of energy and pockets of the supply chain. We believe that due to currency debasement and the resultant negative real costs to ‘money’, other priorities have the room and runway to take broader priority as the relative costs are now less. Either prices for commodities will have to go a lot higher or the real cost of money i.e. interest rates will have to increase to shift the thinking here. It appears the most likely outcome is a combination of the two. This is very much a supra secular thematic and will play out over the decade, if not longer. Preparing portfolios for much higher real rates should remain a priority.
Markets – Sell in May or Here to Stay?
Throughout May high yield spreads went wider, touching year‐to‐date highs in Europe and the US. Levels are now consistent with those reached during the volatile months of the 2020 pandemic. However, a sharp reversion toward the back‐end of the month saw high yield markets closing almost flat. Consequently, volatility levels dropped across both markets over the month but are still tracking substantially higher year‐to‐date. Having become more accepting of the inflation landscape, the ECB is clearing the path for a July depo rate hike and the winding down of its Asset Purchase Programme (APP) at the start of July. The Fed raised the target for the fed funds rate by 50bps to 0.75‐1 per cent during its May meeting, with Chair Powell pointing to 50bp hikes in June and July and then 25bps until the neutral rate is reached. In Australia, interest rate markets were pricing 35bps for June RBA pre meeting, with sequential 25bp hikes or more until a circa 4 per cent cash rate is reached. With robust growth data and elevated inflation, now reaching 5.1 per cent (highest since 2001), this has further lifted expectations of a 40‐50bp rate hike for the RBA’s June meeting this week and a trajectory of 1.75per cent by year‐end. Cross market volatility started the month at higher levels with the VIX remaining elevated and in line with prior months, subsequently reverting to lower levels of 26.19 per cent in the US and the Australian VIX finishing at 15.4 per cent.
Inflation‐linked bonds and real yields moved higher over the month, with the US 10‐year real yield increasing 20bps to close the month at 0.19 per cent. There was significant capital structure volatility experienced throughout May. Senior EUR financials tightened ‐4.8bps, our preferred proxy for senior preferred. European high yield widened by 9.7bps with elevated at‐the‐money (atm) volatility of 55 per cent. European Investment grade (IG) tightened by ‐2.7bps with elevated atm volatility of 54 per cent. AUS ITRX tightened ‐2.1bps. Similarly, in the US, investment grade tightened by ‐4bps with elevated atm volatility of 56 per cent. US high yield closed flat at 461bp (up 0.2bps) with atm volatility of 55 per cent. EUR Financials SUB tightened ‐13.3bps. Across bond ETFs, IBOXX (Corporate Investment Grade) and HYG (Corporate High Yield) closed slightly up by 1.5 per cent and 1.2 per cent.
Australian government bond yields were higher over the month: the 3‐year yield increased 13.5bps (from 2.71 per cent to 2.84 per cent), and the 10‐year yield increased 23bp (from 3.13 per cent to 3.35 per cent), approaching the near 8‐year high of 3.6 per cent. This was supported by faster rate hikes by the RBA and robust growth data. The US yield curve flattened, with the 2‐year yield decreasing by -16bps (from 2.72 per cent to 2.56 per cent), and the 10‐year yield decreasing ‐9bps (from 2.94 per cent to 2.85 per cent). The 10‐year approached the 2018‐high of 3.15 per cent during May (month high of 3.13per cent), driven by strong job growth of 390K jobs added in May, and the unemployment rate steady at the 1969‐low of 3.6 per cent. Early signs of reduced uncertainty in global yield curves are starting to present; however, levels remain elevated year‐to‐date. In Australia, interest rate volatility in the 1‐year part of the curve dropped to 95.7bps (‐28.5bps), 3Y finished at 3‐month lows of 103.36bps (down ‐23.8bps), and 10Y was 110.13bps (down ‐10.5bp). Similarly, in the United States, interest rate volatility decreased. In the 1‐year part of the curve, volatility finished at 129.84bps (down ‐32.3bps), 3Y was 126.41bps (down ‐26.3bps), and 10Y was 112.67bps (down ‐18.5bps).