With no end in sight to the US-Israeli war with Iran, and tensions escalating once again over the weekend, investors are bracing for more volatility. Inflation fears have ramped up significantly, reflected clearly in government bond markets where rising yields show rate cuts being priced out and rate hikes increasingly being priced in.
With the 2022 inflation spike still fresh in the minds of investors and central bankers, this is not surprising. However, there are important differences in the economic and monetary conditions that existed then and those that exist now.
Demand-side inflation drivers are largely absent today. In 2022-23, pent-up consumer demand for goods and services following the Covid-19 lockdowns was further boosted by fiscal stimulus, which in the case of the US involved putting significant cash directly into household accounts. In addition, interest rates were effectively at zero (see Exhibit 1) which inflated asset prices, while tight labour markets drove real wage growth higher, amplifying the wealth effect on consumption. Finally, with activity curtailed, and helped by various support packages, consumers accumulated ample savings buffer during the lockdown period.
Many of the supply-side drivers of the 2022-23 inflation spike are also absent today. Then, global supply chains were still fractured following Covid-19 with parts shortages in many industries, congestion at ports and shipping backlogs. Russia’s invasion of Ukraine caused an energy price shock (which certainly echoes today), with agricultural prices spiking. The zero-Covid policy in China, which persisted longer than most expected, also contributed to manufacturing and industrial parts disruptions. Added to all this, central banks were caught behind the curve as inflation ran hot, with rates kept low and stimulus policies remaining in place, allowing inflation to de-anchor.
Current inflationary fears are very much driven by the supply-side shock, as the Strait of Hormuz remains closed to much of its normal traffic levels. With the Strait accounting for around 25% of global oil supply and around 20% of global liquified natural gas (LNG) supply, the surge in energy prices, if maintained, will impact transportation, manufacturing and food costs, reaccelerating inflation that in many regions had yet to fall to central bank target levels following the spike of 2022-23. In addition to energy, roughly 30% of fertiliser trade transits the Strait of Hormuz, which is elevating prices just as planting season arrives for crops such as corn and soy.
So, while a lot of the drivers for the 2022-23 inflationary crisis are absent, this should not give investors too much comfort given the unique systemic importance of the waters that border Iran. There are also new challenges that were not present in 2022, namely weaker growth (certainly in the US), weaker labour markets and tighter fiscal headroom. Monetary policy is at best at neutral in the Eurozone and US, and probably still restrictive in the UK. Therefore, while the immediate impulse has been to fear inflation, there is a secondary concern here of slower growth and possible stagflation.
Of course, all these fears are predicated on the Strait being closed for an extended period, and markets are grabbling with the volatility of both negative and positive headlines, resulting in big swings in both commodity and government bond prices. Looking back at other Trump administration-induced bouts of volatility, the most rewarding trade has been to buy risk into the sell-off and wait for the rebound, which has become widely known as the ‘Taco’ trade (Trump always chickens out). Markets got their first real taste of Taco since the conflict began on Monday as President Trump revealed he had postponed threatened attacks on Iranian power plants for five days after “good and productive conversations” regarding a “total resolution” of hostilities, a claim swiftly denied in Iranian media.
Despite the resulting bounce in risk assets, this scenario remains different. First, reversing course on a war is not as easy as relaxing demands on tariffs and trade. Second, the longer the war continues, the more medium- and long-term damage may be done; energy capital expenditure decisions have long lead times, and when production is curtailed or stopped, it cannot be swiftly restarted. Shipping will take a long time to normalise, while insurance costs will remain elevated, business confidence will remain subdued and expansion and hiring plans will be delayed. If market projections for rate hikes prove correct, tighter financial conditions will reduce growth and impact consumer confidence and activity. Growth fears could contribute to lower spending by consumers in the month ahead, a stark difference to the demand-led inflationary shock of 2022.
For fixed income investors, the current environment makes asset allocation decisions unusually challenging. In government bond markets, yield curves are now replacing rate cuts with rate hikes, and while we had viewed the bar to further tightening as being high, comments from the European Central Bank (ECB) and Bank of England (BoE) last week were certainly hawkish. With the 2022 inflation spike still anchored in public consciousness, central banks are unlikely to repeat their “transitory” rhetoric again and will be keen to demonstrate that this time they are ahead of the curve. Containing wage expectations will be a key objective, though the weaker labour market conditions should also help to avoid the aggressive wage increases which contributed to inflationary pressures in 2022-23.
Markets may also be pricing fiscal strain, given energy shocks simultaneously erode tax bases and create political pressure for household support measures. In the UK particularly, where fiscal headroom is already constrained by the fiscal rules, Gilt yields may be reflecting renewed borrowing concerns as much as BoE hiking expectations; the scale of the rates move is otherwise hard to reconcile with the domestic growth outlook.
Beyond rates, avoiding direct exposure to affected sectors in credit positioning is obviously a priority, though in practice eliminating indirect portfolio exposure to the current backdrop is very difficult. So far, credit spreads have behaved reasonably, and negative price moves in fixed income are being mainly driven by the rates markets. However, the longer the current uncertainly persists, the more the narrative will shift from inflation to growth, and wider credit spreads would typically follow.
Despite these fears, sensibly priced new bond issues on days where sentiment is better continue to be extremely well supported. This shows confidence in the strong fundamental picture and supports the theory that many funds are prudently positioned and have cash to spend. In addition, as mentioned above, when markets are showing signs of significant stress, the Trump administration has on many occasions changed course and supported a rebound.
While a full reversal is not so easy in this situation, given the rates markets have already repriced, and quite aggressively, and with many asset managers prudently positioned, there haven’t been too many signs of panic selling in the markets. However, for us, despite our defensive stance and bias towards higher quality credit, the asymmetry of outcomes favours further risk trimming rather than adding.
