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#WellSaid

Our investment professionals share and challenge each other’s views, creating a diverse marketplace of ideas for the Wellington Blog.

Every quarter, the Wisdom of Wellington team surveys around 100 of our Wellington colleagues across different investment disciplines and locations to get their views on what we see as the key macro questions of the day. The results can pinpoint where the firm’s views differ from the consensus and can also reveal important shifts in our collective thinking.

The latest survey shows that, while the risk of a US recession is still considered low by historical standards, the probability of stagflation has increased. In our previous survey, 50% of participants noted the risk of a significant upside surprise in US inflation, but that figure has now risen to 63% (Figure 1).

FIGURE 1

The probablity % of a significant US inflation surprise has increased
At the same time, our respondents thought the economic cycle was…

MACRO
Benjamin Cooper
Ben Cooper
CFA
Multi-Asset Strategist
London
Juhi Dhawan headshot
Juhi Dhawan
PhD
Macro Strategist
Boston

The US Federal Reserve’s (Fed’s) message on inflation has changed. Fed Chair Jerome Powell recently characterized supply shocks, bottlenecks, and disruptions as “frustrating” and as “holding up inflation longer than we had thought.” The Fed’s mea culpa is small consolation for investors whose portfolios have not been positioned optimally for a longer-than-expected period of higher inflation.

The question now is: Has inflation already peaked? The short answer is no, in my opinion.

The systemic nature of supply shocks

Inflation is being pushed higher by three catalysts — labor, raw materials, and transportation — that are interrelated in ways that…

MACRO
THEMES
Nanette Abuhoff Jacobson
Nanette Abuhoff Jacobson
Global Investment and Multi-Asset Strategist
Boston

Today’s record gas prices in Europe and Asia come with wide-ranging ramifications that investors need to be aware of.

Natural gas has been cheap for so long that investors and policymakers may have underestimated its pivotal role in modern-day economies. Now a combination of factors is driving steep increases in European and Asian power prices with the real possibility of shortages. Looking beyond the immediate repercussions we see significant investment implications.

In the short run, high power prices could mean:

  • Switching from gas to oil — Typically, only developing countries use oil for power generation as oil is easier to access and transport, but if shortages were to occur, Europe and East Asia could…
MACRO
MARKETS
Eugene Khmelnik
Eugene Khmelnik
Global Industry Analyst
London

With a sustained rise in interest rates in the coming months a distinct possibility as of this writing, we thought now would be an opportune time to take a close look at some potential impacts of higher rates on clients’ fixed income portfolios. To do so, we compared the hypothetical five-year performance of the Bloomberg US Aggregate Bond Index under three different illustrative scenarios that could play out going forward: 1) rates remain unchanged; 2) rates rise abruptly; and 3) rates rise gradually (i.e., over three years).

Key takeaways for fixed income investors

A few of our main takeaways from this analysis were as follows:

  • While abrupt rises in rates might lead to short-term drawdowns in fixed income portfolios, they can at times be desirable for longer-term investors, given opportunities to…

At long last, a more concrete timeline has been unveiled for the much-anticipated removal of US monetary policy accommodation. The Federal Open Market Committee’s (FOMC’s) September 2021 statement and Chair Jerome Powell’s press conference indicated that the FOMC could begin tapering its large-scale asset purchases in November 2021 amid ongoing economic improvement, and that the process could be concluded as early as mid-2022.

The FOMC increased its inflation forecasts and decreased its growth outlook, as labor supply shortages and supply-chain bottlenecks have created greater inflationary pressures than the FOMC previously anticipated. The rising inflationary risks also led the median FOMC participant to now expect the FOMC to hike interest rates three times by the end of 2023 (closer to market pricing) and an additional three times by…

MACRO
Jeremy Forster
Jeremy Forster
Fixed Income Portfolio Manager
Boston

In a June 2021 white paper, A source-based approach to managing inflation risk, co-authored by our colleague Adam Berger, we laid out what we believe are the five most likely sources of higher inflation over the coming decade. One of them was climate risk or, more specifically, the potential for input price shocks caused by the ongoing trend of global climate change. Since this inflation source may not be on many investors’ radar, we’d like to revisit why we think climate change is inflationary and suggest strategies to help reduce the threat to client portfolios.

The relationship between climate change and inflation

  • Overview: A price shock to a systemically important input price will tend to spur higher inflation as businesses pass it on to consumers, leading to “cost-push” inflation. While this has historically been due to geopolitical forces driving oil prices, we believe the impact of climate change on a range of commodities will be…
MACRO
SUSTAINABILITY
Samouilhan_Nick
Nick Samouilhan
PhD, CFA, FRM
Multi-Asset Strategist
Singapore
Joy Perry
Joy Perry
Investment Director
Boston, MA

Two recent developments — the accelerating focus on ESG and more aggressive policy interventions — could well change the way we invest in years to come. My perspective is that of a fixed income manager, but I believe these developments will impact all asset classes.

ESG focus

A growing societal and market focus on environmental, social, and governance (ESG) issues has kickstarted a reallocation of capital, which creates new opportunities and risks for fixed income and other investors.

  • Higher inflation

In my view, the increased focus on ESG may contribute to higher inflation, at least in the short-to-medium term. Implementing environmental considerations, for instance, while desirable from a societal perspective, may involve short-term cost adjustments. This seems particularly relevant in the context of…

MACRO
SUSTAINABILITY
THEMES
Marc Piccuirro
Marc Piccuirro
CFA
Fixed Income Portfolio Manager
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After a lengthy absence, inflation has finally returned to the US, but for how long depends on who you ask. Many observers, including the US Federal Reserve (Fed), continue to expect today’s inflationary pressures to be more or less “transitory” in nature. Market pricing suggests that many investors share that belief.

However, here are five reasons why I believe US inflation could prove to be far more enduring than widely expected by the Fed and market participants.

  1. A still-early economic cycle: The US economic cycle is still in its very early stages, as shown by the recent high level of…
MACRO

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Brij Khurana
Brij Khurana
Fixed Income Portfolio Manager
Boston

In my opinion, the answer to the question above is “less than most people expect.” I think life will return to “normal” in ways that may be hard to imagine amid worries about the Delta variant. Early in the pandemic, my colleague Eunhak Bae wrote the following about living through 9/11 in New York City: “In the immediate aftermath, it seemed like no one would ever fly on a plane again. That obviously turned out not to be true. Today, it may feel like the world has changed for good. But I believe humans are blessed with selective memories and a desire to revert to what they know, so people will once more buy things, go see things, and congregate to share experiences.” When I first read those words, I thought the reversion to normal would happen much more quickly than it did, but I still think that’s our destination, perhaps within the next six – 12 months.

Why inflation will be an exception

The big change I foresee is in inflation, which has been unusually low for an extended time (1.4% over the decade ended December 2021 and 1.6% for the trailing 15 years). We have seen in past crises that economic stimulus tends to be harder to…

MACRO

ARCHIVED

Adam Berger
Adam Berger
CFA
Multi-Asset Strategist
Boston

There is a sense that the world is slowly “getting back to normal,” after more than a year of COVID-induced economic lockdowns and other restrictions. Unfortunately, many countries — and even some parts of the US — are still grappling with more contagious and virulent strains of the virus (e.g., the so-called “Delta variant”) and troublingly low COVID vaccination rates. We are not out of the woods yet. But broadly speaking, the global economy has been recovering with the aid of accommodative fiscal and monetary policy, supporting the strong performance of risk assets and the ongoing rotation from growth- to value-oriented exposures.

The threat of rising inflation is a bogeyman now. Amid supply/demand imbalances in labor and other factors, we believe inflationary pressures are likely to persist in the period ahead. Against this backdrop, our investment outlook remains largely pro-risk, but is tempered to some degree by what we see as…

MACRO
MARKETS

ARCHIVED

Nanette Abuhoff Jacobson
Nanette Abuhoff Jacobson
Global Investment and Multi-Asset Strategist
Boston
Daniel Cook headshot
Daniel Cook
CFA
Investment Strategy Analyst

Figure 1 highlights the six-month trailing correlation between the S&P 500 Index and the 10-year US Treasury bond as of 20 July 2021. This stock-bond correlation has shot up over the past six months or so from near all-time lows to its highest levels since before the 2008 global financial crisis. What does it mean?

Figure 1

Six-month stock-bond correlation

First, one caveat: The equity-bond correlation can be volatile, particularly amid fears of monetary policy tightening — for instance, a sharp spike around the…

MACRO
MARKETS

ARCHIVED

Nick Petrucelli
Nick Petrucelli
CFA
Portfolio Manager
Boston

Many investors are increasingly seeking to protect their portfolios from the looming threat of higher inflation. Against this uncertain backdrop, I believe collateralized loan obligations (CLOs) can provide one source of refuge given their floating-rate coupons (yields), which would rise as short-term interest rates moved higher. Attractive current income relative to other credit assets and broadly positive CLO fundamentals further bolster my conviction in this often-overlooked asset class.

Where I stand on the inflation debate

Core US inflation spiked sharply in April and May 2021. For the three-month period ended in May, the Consumer Price Index (CPI) rose by 8.3% annualized, the biggest gain since the early 1980s. This has naturally exacerbated recent inflation concerns, raising questions around whether higher inflation will be transitory or more sustained. US interest rates have risen amid expectations for higher inflation, resulting in negative total returns year-to-date (through 31 May) for many fixed income sectors, especially longer-dated fixed-rate assets.

My take: While some of today’s inflationary pressures may indeed be short-lived, particularly within…

MARKETS
THEMES

ARCHIVED

Alyssa Irving
Alyssa Irving
Fixed Income Portfolio Manager
Boston

The global macro discourse has shifted over the past few months to a debate around “good” versus “bad” inflation. I think there is a better way to frame it. In my view, as we look ahead, the question should be: will we see a continuation of the status quo or are we on the verge of a regime change? I think there is a high chance it will be the latter.

Over the past 20 years, there have been a number of instances when inflation has jumped higher. Often this has been due to higher energy costs, occasionally a response to strong demand and sometimes tax changes. Each time, the jump has proved short-lived, but has acted as a tax on consumers, eroding the purchasing power of households by squeezing real wages. In response, consumer spending has slowed, and the economy has cooled. In effect, these temporary bouts of inflation acted as an automatic stabiliser on the economy. Was that bad inflation? For households, yes — but not for…

MACRO

ARCHIVED

John Butler
John Butler
Macro Strategist
London

Whiffs of the long-awaited “taper talk” around US monetary policy are finally in the air. The Federal Open Market Committee’s (FOMC’s) June 2021 statement and press conference indicated that the FOMC has discussed when it ought to start tapering its large-scale asset purchases amid the ongoing economic rebound and mounting inflationary pressures.

The FOMC upgraded its US growth and inflation forecasts, yet kept its unemployment rate forecast unchanged, as labor supply shortages in an environment of strong consumption are leading to higher inflation than the FOMC previously anticipated. The increasing inflationary risks also resulted in the median FOMC participant now expecting to hike interest rates twice during…

MACRO

ARCHIVED

Jeremy Forster
Jeremy Forster
Fixed Income Portfolio Manager
Boston

As I consider various potential sources of market volatility over the coming months, the one I believe poses the biggest threat to today’s constructive backdrop for risk assets is so-called “bad inflation.” The costs of intermediate goods and inputs to production are climbing at their fastest pace in decades, which presents a likely headwind to corporate profit margins. Additionally, commodity prices are all rising in unison, be it coffee, corn, lumber, sugar, wheat, or gasoline, further straining corporate and consumer budgets.

Where the Fed may be wrong

The US Federal Reserve (Fed) has repeatedly stated its intention to “look through” the inflationary surge we’re seeing today, which it views as transitory. The Fed seems to assume that supply will quickly come back online as the economy reopens and recovers, allowing pricing pressures to abate. I hold a different view. I suspect that productive capacity for commodities in particular will not bounce back as swiftly as the Fed is forecasting. To be clear, I believe much of today’s bad inflation is being driven, either directly or indirectly, by these rising commodity prices and will therefore prove “stickier” and more stubborn than the Fed expects.

A paradigm shift in the making

As I see it, the public companies that have been rewarded the most over the past decade have behaved more or less like rent-seeking monopolies. Many investors covet steady, predictable cash flows to which they can apply a low discount rate. Conversely, some of the best…

MACRO

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Connor Fitzgerald
Connor Fitzgerald
Fixed Income Portfolio Manager
Boston

The job gains cited in the May 2021 non-farm payrolls release fell well short of what the market had hoped. A fluke? Maybe, but this disappointing jobs report suggests to me that US inflation dynamics are beginning to shift from “demand-pull” to “cost-push” inflation.

The perils of cost-push inflation

Demand-pull inflation is the upward pressure on prices that occurs when aggregate demand outpaces aggregate supply. Cost-push inflation, by contrast, is caused by increased costs for raw materials, wages, and other inputs to production. The latter type of inflation tends to be much more harmful to an economy, as it forces companies to choose from among three distinct (and all undesirable) options:

  1. Seek to cut their capital costs elsewhere to preserve profit margins
  2. Invest in productivity-boosting solutions to reduce their labor costs
  3. Pass their increased costs on to consumers in the form of higher prices

The most probable scenario, in my judgment, is…

MACRO

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Brij Khurana
Brij Khurana
Fixed Income Portfolio Manager
Boston

“We suggest that a budget constraint be replaced by an inflation constraint.”
— Three MMT economists in a 2019 letter to the Financial Times

MMT in a nutshell

Modern Monetary Theory (MMT) is often dismissed as a fringe concept regarding unlimited government spending, but it’s a bit more nuanced than that. Basically, MMT holds that a nation’s budget doesn’t (or shouldn’t) really constrain spending because the government can always print more money if needed. Thus, it’s the “real” economy — the production, purchase, and flow of goods and services — that truly matters.

Taking it a step further, the government can theoretically spend as much as it wants to until said spending begins to create excess demand, thereby generating inflation, at which point the government should…

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Nick Petrucelli
Nick Petrucelli
CFA
Portfolio Manager
Boston
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