From a temporary inflation narrative linked to pandemic-induced supply chain disruptions, we have fallen into a persistent inflation narrative. A prolonged energy-supply dislocation next to wage inflation pressures have taken over as main drivers. OECD central banks decided to adopt a frontloading policy rate normalisation approach. With a lag, central banks expect core and headline inflation figures to track a disinflationary path, reaching readings with a 2% handle by the end of 2023. Such base case scenario rests on assumptions that allow for a broad-based rebalancing of supply-demand conditions across product and services. It relies on short-term demand destruction, an uptick in unemployment figures and retreating wage demands. At best, reduced geopolitical tensions, a truce in the Russia-Ukraine war and more diplomacy in global trade stand-offs might lead towards less volatile economic and financial market conditions.
However, an “Okay, Houston, we had a problem here’ announcement is in place. We detect that persistency becomes entrenched across indicators and outcomes. First, we stumble into persistently high geopolitical uncertainty alongside persistent zero-growth or shallow recessionary conditions. Second, we detect increasing tensions between labour and capital factors after decades of flat or low real wage growth. From anecdotal outcry, driven by friendly unions, labour tensions might become more persistent supported across society and less-friendly syndicate action. Third, instead of returning to the mean, we notice that equity, credit spread, rate and FX volatility persists at higher levels. We’ll briefly touch upon each of the above.
Geopolitical variables have multiplied. Great power politics stages a comeback by weaponising economic policy. Sanction-based frameworks reveal and intensify frictions and fault lines. Global growth is becoming victim beyond consensus expectations. Protectionism breeds well in a sanctions-littered economic landscape. Recessionary conditions –shallow but lingering– and geopolitical uncertainty will become persistent. The political elite sees no other outcome than to embrace protectionism. Protectionism that otherwise becomes the playing field of populists. US protectionism is embedded in the Inflation Reduction Act or CHIPS Act. EU protectionism-light programmes also see a new dawn through, yes, also a Chips Act next to various EU programmes geared towards strengthening the internal market. The REPowerEU plan to save energy, produce clean energy and diversify our energy supplies will be funded at EU level and support EU sectors and companies in realising required large-scale infrastructure projects.
Expect ESG scrutiny across social factors to lead to increased visibility on labour conditions in general and living wages in particular. Increased insecurity around healthcare and energy affordability will push companies to reward workers properly across value (supply) chains. Respect for human capital will lead to higher business model scores, a lower reputational risk profile, potentially leading to higher valuations. Yet, social factor considerations still rank low against the supremacy of the capital factor. The current liberal system can count on supporting monetary and fiscal ‘subsidies’ in order to sustain itself. Also here, fault lines become visible. Returning to our global watch, we notice high and persistent tensions building between western short-term liberal policies and autocratic, centrally-driven long-term policies towards common prosperity. These new realities create anxiety and discomfort as they become persistent.
Persistent high societal, geopolitical uncertainty and persistent economic indicator volatility has led to volatility across asset classes that sticks. Between March 2020 and today, the equity VIX fear index averaged 25. It seems that pandemic-related stress morphed into other stress factors that have been holding the VIX range bound between 20 and 30 versus a 10 to 20 range over the previous decade. A similar picture appears across bond markets. The MOVE index (a measure of implied volatility across US rates) has upheld within a 100 to 150 range, whereas post GFC (Great Financial Crisis of 2008) till end of 2021, a 50 to 100 range was common. The JP Morgan Global FX volatility index maps perfectly on top of the MOVE index. Same conclusion:
FX volatility is here to stay. Central bank policy rate normalisation and persistence at an upper-bound for longer backstop this conclusion. Finally, credit spread readings across investment grade and high yield CDS indices has shifted towards a higher bandwidth, reflecting higher default and restructuring probabilities.
A regime switch got executed over 2022. Proof lies in the persistent character of indicators and outcomes. We crave for mean-reversion, but we are not getting it. We will need to adapt. Under persistent high uncertainty, expect real rates to remain uncomfortably high for longer.
Momentum investing or a bulk beta approach (passive solutions) should make room for research-driven processes. Skill-based sector convictions and hand-picked security selection will deliver above-average risk-adjusted returns. Active management was persistently under pressure from passive product. That might be the only corner in the market where persistency will be interrupted.
