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Rikkert Scholten (RS): Not only over the past years, but basically over the past decades or so, investors have had so much support from central banks, stimulating market conditions and beefing up returns from that respect. And I think we have to become accustomed to a period where that is no longer necessarily the case. The Fed Put is no longer necessarily there.
Erika van der Merwe (EM): Rising inflation has become a growing concern for consumers around the world. It's also wreaked havoc in financial markets lately, owing to fear and uncertainty about what happens next with interest rates, prices and economic growth. This after central bankers and analysts have been reassuring consumers and investors for nearly two years that they need not fear rising prices. So what precisely is the deal with inflation? Rikkert Scholten is a strategist in Robeco’s Global Macro team and Bob Stoutjesdijk is portfolio manager for Robeco Global Total Return Bonds. Welcome back to the podcast, gentlemen.
So we spoke just over a year ago about inflation worries. And at that point, there were concerns about the fact that the combination of very stimulatory fiscal policy and monetary policy would trigger high inflation, particularly once economies started opening up again. And today, we are still dealing with these worries, and I think they've become much more acute. For instance, the Pew Research Center reported in May 2022 that US citizens now consider inflation to be the top problem facing their country. And this is by a substantial margin over any other concerns, fears and worries that US citizens have. So we know consumers are battling to pay for pricier food, housing, energy, etc. But from an investors’ perspective, and that's to whom we’re talking, why is higher inflation such a big deal? And we've seen significant repricing in financial markets, Bob.
Bob Stoutjesdijk (BS): Inflation is important for investors for a number of reasons. One, it impacts growth. It impacts expectations, which in the end impacts interest rates, and interest rates impact valuations. Another important effect that we're seeing is in the past decade, we've been seeing QE and ever lower interest rates propping up financial assets and now we're nearing basically the end of it. Actually, we're going to see the reversal of it. We're going to see QT (quantitative tightening) and higher nominal interest rates. And that basically pulls away the underpinning of many asset classes like equities that rely heavily on interest rates, but also bond returns, credit returns and emerging market debt.
RS: Investors have had so much support from central banks over the past years. And I think we really have to become accustomed to an episode where that is no longer the case and that will really have an impact on investment returns, probably.
EM: So looking, Rikkert, at the market reaction, we've seen, so fixed income is your domain, but also in equities and other financial assets. Is this the taper tantrum that everyone's been fearing and trying to avoid?
RS: To some degree it is. And we saw the start of that reaction already quite a while ago. But there's also, let's say, genuine concern about the level of inflation and are we returning to those pre-Covid levels again? And you see that back in, for instance, the inflation-linked bond prices. You see it back in the response in, for instance, long-term interest rates in Europe. Are our central banks willing and able to tighten enough to bring inflation back to those levels? That's a concern. In addition to that, the connection between inflation and the growth outlook is now being made. Up until not too long ago, the concerns on inflation were there, but on growth people were still relatively upbeat. But it has changed, especially after the commodity prices started rising after the Russian invasion of Ukraine. Now you see recession fears popping up. So, there's really a change of tone, and it's not just inflation.
EM: So what you've described, Rikkert, was almost an evolution of evidence of trends in economies globally. Now, despite this unease that we have now, that we've seen in markets, it seems though, as though policymakers were in denial about it for some time. There was much talk about high inflation being transitory. This word was used quite a lot. And let's listen to some brief statements from the Fed and the ECB chairs over the past 18 months or so, particularly on this topic, to paint the picture of what the central bank messaging had been.
Audio fragment: We're not even thinking about thinking about thinking about raising rates. We're totally focused on providing the economy, the support that it will need. We think that the economy will need highly accommodative monetary policy and the use of our tools for an extended period. I think the word transitory has different meanings to different people. To many, it carries a time, a sense of short lived. We tend to use it to mean that it won't leave a permanent mark in the form of higher inflation. I think it's probably a good time to retire that word and try to explain more clearly what we mean.
From an ECB point of view and I believe commission point of view as well, because we concur on that front, we do believe that inflation numbers in 2021, which we will see rising, are of a temporary nature and rely on temporary factors. So our assessment is that inflation in 2022 will return to lower levels and will decline.
EM: So that was, of course, Jerome Powell and Christine Lagarde speaking back then. So of course, it's easy to look in hindsight and, you know, almost smile about this. But why has the sustained rise in inflation been a surprise for policymakers?
BS: I think it all has to do with the persistent nature of supply disruptions. Obviously, when you go back two years, then we had the pandemic starting. Everybody thought it was one wave, the typical V-shaped recovery was mentioned. But then the W-shape came and then the third wave came, and that all led to a persistent nature of some of those issues. That has been further propelled also by the war in Ukraine, putting a lot of pressure also on commodity prices and also scarce resources. And that means that you see some sort of flywheel effect, additional effects causing additional effects, and you see it petering through in inflation expectations. You see it also a bit in wage growth. And that means that now the inflation dynamic is very different than at the time when we were talking about it being transitory. So it's also about persistency and uncertainty.
RS: And it's a nice collection of comments that you just showed us. And to be fair, a lot of people were anticipating much lower inflation rates than we are currently seeing. But what you can, let’s say, where you can criticize these policymakers for is that they were slow in the response function and not necessarily in what they did with the outbreak of the pandemic. But they were very slow in taking away accommodation. And I'm talking particularly about the Fed and also about the ECB.
EM: So pumping in liquidity into the system.
RS: Continue to pump liquidity in the system while some other central banks were already starting to withdraw. So it is not as if there are no examples out there of central banks who were much more proactive in taking away or reducing liquidity.
EM: And who is that?
RS: Well, for instance, the Bank of England, many of the emerging central banks have taken such steps. So the examples are out there. And in hindsight, I think it's fair to criticize, for instance, the Fed for being in the transitory camp for too long. Initially, I think you cannot blame them at all. They did a lot of good stuff when Covid hit us.
EM: I want to look at this point that you made about being too long, delaying the reaction. And a lot of this comes down to policy error. So up to now, the risk of policy error, but from here onwards, there's also the potential risk of that. So here's Mohamed El-Erian, Allianz economic advisor, who's been extremely outspoken recently in the media. And here he is talking to CNBC about policy error.
Audio fragment: So there've been three mistakes made. And your interview with Ben Bernanke actually pointed out to them, this is very unusual. I don't think people quite realize how unusual it is for a former chair to say this. But the first policy mistake was the mischaracterization of inflation. The second policy mistake was when they corrected the mischaracterization, they didn't move fast enough. And the third one is that they haven't been as brutally honest with the world as they should be in terms of the difficulty of soft landing this economy. So that is what's going on. The next policy mistake, I think, is going to be not to get stuck in the muddled middle between dealing with inflation expectations properly or alternatively dealing with the recession risk properly.
EM: Well, I'd love to hear your reactions on that. And also what I've heard Jerome Powell say. We do our best at the moment in real time with the information we have. And we are not working with instruments that have surgical precision. So, of course, that raises the worry about from here onwards what will happen next.
BS: Well, obviously, it's very rare for a central bank to forecast a soft landing. So there's one thing when they sit in a room and define monetary policy, and there's another thing when they communicate to markets. So, yes, they are probably aware that if you tighten monetary policy in a world with very high food and energy inflation, which works as a tax on consumption and investments, that there is a risk that the economy slows down much more rapidly than they would expect. It's also a bit evident, right? But we now also see in the UK, so the Bank of England is basically now coming out, which is very rare for a central bank, basically saying, well, all the tightening that we're doing in this world with all the uncertainty, etc., basically means that probably we're going to see lower growth next year. So yes, there is awareness, but it will never be as outspoken as El-Erian tries to argue here. It's pretty rare to see that happen.
RS: For instance, ideally what central banks like the Fed would want to see is a reduction in this huge amount of vacancies, job vacancies, while at the same time keeping the unemployment rate stable. Well, that will be a very hard job. If you look at historical data and the Fed has collected data all the way back to 1955, you see that almost never in history it was possible to bring down vacancy numbers and not cause a rise in unemployment. I think they're willing to take that risk because the economy simply cannot function properly with this kind of level of inflation. So it's a risk that they're willing to take, but it's very likely that this will lead to consequences for the labor market that go beyond just the reduction in vacancy rates.
EM: Right. Let's talk about what it is that the central bankers are up against. If we're talking about them battling inflation, what are the inflationary drivers here?
BS: Well, I think obviously what we've mentioned before is the persistent nature of a number of supply chain and logistical problems. So we still know, for example, that there are issues in the chip and the semiconductor sector. So, for example, if you want to buy a car, then there's a high risk that that new car doesn't have a radio, for example. That also leads to higher used car prices. We also know that if you want to import goods from China, for example, then you need to pay a very hefty price to get the container shipped over here. At decades high are those prices. And we still working off those things and they will probably still be with us this year and next year. And obviously, you also have a very big component coming from the energy markets. Historically high gas prices, we have had issues also with the fossil fuel investments, because during the pandemic, there was a large cut of capex in that area. So we're dealing with a structural shortage now, and that's leading to a high level of inflation. And an important element there is that when you look at services components, that you also see services inflation being a bit higher than what it was before the pandemic. Because we also have a number of labor market issues, we have shortages in particular sectors, and that's also driving up the price of labor in that sector and that's also driving up the price of the end consumer. So it's those four categories that basically drive the higher level of inflation.
EM: To my mind, Bob, what you've described now, these are more on the supply side. So what about on the demand side? We've had all of the stimulus going on. Do you not see a role there?
BS: That's a very interesting question, but also very difficult one to answer because we had this reopening after the pandemic. So what we've been seeing in the past few quarters of data, people went out to restaurants, they booked vacations, etc., and that has been keeping up growth relatively well. But obviously at some stage, you have done your thing. You won't go to the restaurant three times a week, you won't book another travel or you won't buy another car. So that will slow. So from a demand perspective, it's better to look at what the demand side of the economy is rather over the summer rather than now, or looking back a bit. And when you, for example, look also at the monetary tightening that's coming and also the high level of food energy prices, that limits spending. So when you look at the modal household, they struggle at the moment to really consume. So the demand side of things would be much slower over the summer.
RS: Yeah, well, one particular element that I think is a concern is that when you talk about the shifting nature of demand, for instance, the over-heated state of the housing market is leading to a higher rental inflation. Now that's probably going to cool down, at least we see first signs of a cooling down in the housing market now. But what you get now is that while initially you had car prices, all sorts of durable goods where inflation was elevated and it still is, you now see the more sticky elements of inflation getting more elevated, like rental inflation, like medical services, those kind of elements of which the prices are changed less rapidly, but they are called sticky for a reason, right? So a main concern is now that you need to get sticky inflation down and that requires really a more substantial monetary policy response, which probably will have consequences.
EM: And the role of expectations, right? So expectations and the whole idea of policymakers trying to anchor expectations and certainly in the case of the Fed and the ECB, it's about keeping it around 2%. So is this a real risk then when people start becoming accustomed to higher levels of inflation? Are we headed for a higher inflation regime?
BS: Well, if you look at markets and if you look at surveys, then it certainly seems that way. So, for example, when you look at market expectations of inflation, they are well above the Fed's target or the ECB target. When you look at surveys, households and companies are basically saying that they expect next year and the year after to see very high elevated prices. In that sense, what they don't want to end up with is that those expectations filter into higher wage demands and higher wage settlements, because if that happens, then you can have the risk of a wage price spiral. And to be fair, perhaps in the US you see a bit of tentative evidence that that's happening. You see that also a lot, for example, in Eastern Europe and many emerging markets, in the euro area that isn't the case. But that's something that they really want to anchor.
RS: It's a risk there, right? At this point in time, you can still curb that risk. And if you look at wage growth in Europe, it's still relatively benign. If you look at US wage growth, it's already quite a bit higher. Fortunately, we see the first signs of stabilization there now of wage growth after months and months of acceleration. But you're now at the point that you need to do something to make sure that it does not get embedded. And that's the phase we're in right now. You cannot say that it is already embedded, but there's a risk.
EM: So we've spoken a lot now about the US, about Europe. Can you give us more color on other regions, including emerging markets, Asia, LatAm?
BS: Sure. From a global perspective and when we look, for example, at emerging markets, then we typically define the three regions. So you have LatAm, you have Eastern Europe and you have Asia. To start with LatAm, basically already when the pandemic just started, all those central banks there already engaged in tightening because they were faced with high levels of inflation, because their currencies went down, there were shortages and they really stealth tightened. When you, for example, look at real interest rates, Brazil is the only country in in the world who has a decent amount of positive real yield out there. When you look at Asia, that's the other basically detrimental opposite, they've never done that tightening. So basically they lowered interest rates even and they didn't have those many logistical and supply effects because mainly loads of goods and services are produced there and doesn't have to be shipped.
EM: Are you talking about China in particular now or Japan?
BS: For China and Japan, we will make a bit of an exception because Japan is a secular country in its own right. So they've had their deflationary process ever since the eighties. High level of debt, corporates paying off, consumers really disliking price increases. And that’s still the case today. So still, you don’t really see any form of wage prices or wage increases out there. Prices are relatively stable, except energy.And China is also a problem in its own right. It has a bloated property market that's slowly imploding a bit. When you look at the total amount of debt of the economy, that's really high and it cannot really afford high interest rates. You're looking at an ageing population and you're looking at a regime where the financial system is closed. So hardly any impact from the currency and that keeps inflation low. So if you look at core inflation in China, that's still coming down and that's really the opposite. And then the final one is Eastern Europe. And I think if you can really draw the analogy with the seventies and eighties, what happened in the Western world, that's now happening in Eastern Europe. You really have a proper wage price spiral over there, inflation levels of somewhere between seven and 10%, but you have wage increases of more than that. And that is a sort of a flywheel effect and that's causing inflation to just creep higher and higher. So from a global perspective, there are notable differences.
EM: Thanks, Bob. Now, from an investor perspective, both of you are investors in the fixed income realm. So how are you positioned for whatever scenarios? Presumably you have a few scenarios going there, high inflation, weaker growth. So this nasty combination, stagflation, because perhaps the remedy from the policy makers could be more painful than the ailment. How are you positioned?
RS: We have been underweight, let's say, in short-term interest rates for quite a while. So those are the ones that are expected to move the most when the central banks hike interest rates. What you see now is that a lot of rate hikes are being priced in. And I'm talking about the Fed, I'm talking about the ECB and many other developed central banks. So while that was an interesting position for us for a long time, the amount of tightening now priced in is reaching levels where if that would indeed materialize, it would become pretty painful for the economy. So we think that a selling short-term interest rate exposure was the trade. And we are now moving slightly, step by step, away from that. And if what the market is pricing in will indeed take place, we will somehwere during the summer reach interest rate levels in the US for instance, that were pretty painful back in 2018 during the last tightening cycle of the Fed. The question is: can an economy like the US economy already sustain higher interest rates? I think that will be a key question over the summer and I would like to see some evidence for that.
EM: And a factor there, right, is higher levels of indebtedness. So there's a greater sensitivity to interest rate changes?
RS: Exactly. And of course, real interest rates, so interest rates minus inflation, are lower. But that doesn't mean that there can’t be a whole market debate out there once you start reaching those levels we saw in 2018. So I think it’s quite an interesting period we're moving into, in that sense. Because it's not as if central bank policy is the only uncertainty out there at the moment.
EM: Name a few others.
RS: Well, war in Ukraine, for instance. So we see enough reasons to be concerned on the investment outlook from that perspective. And maybe we see some opportunities to go long in bonds again from that sense.
EM: So you're talking about bonds. Bob, can I ask you on the credit side? So in other words, the consequences for companies issuing debt?
BS: What you currently see, for example, in the high yield market, that market is almost closed. Spreads widened a lot. The absolute yield is so high, and there's also quite a bit of risk aversion among investors that those companies struggle to issue debt. And that's still fine for now because they have liquidity buffers, etc., but longer out that has economic consequences, especially if those companies cannot refinance. So hence that's also one of the reasons why we are cautious with credit in our portfolio and we have been also for time. Because also credit is not an asset that you want to have when inflation is really, really high, because of the tightening of the central bank that's then coming and that pushes down growth. And hence we are underweight.
EM: So the risk of default with that debt. And on the investment grade side?
BS: Obviously also spreads have been really tight, last year. That was for us the moment to be underweight and we still like to be underweight also there, because we expect a bit of perhaps a recessionary outcome, and spreads need to reflect that. And we're not there yet. We're getting there, but we're not there yet. A bit the same as Rikkert’s example, as buying duration in the US, probably over the summer we reach levels that reflect pure fundamentals.
RS: But there is one silver lining too. Of course, we have had a huge risk-off episode in markets, in equities as well as in bonds. But for the bond market, at least there's one silver lining, that at least we are moving away from a decade-long period where there were only lower and lower interest rates, and the attractiveness of fixed income as an asset class was eroded by that. And now finally we're getting some yield back. So while this is a painful period, of course, for investors in bonds and also investors in equities, that is a silver lining when it comes to the outlook for potential returns.
EM: Related to that: not only are yields rising, but because of the uncertainty, does that give you more trading opportunities, sort of having to position yourself in the market of much movement?
BS: Yes, it’s basically the end of a long period of QE and ever lower interest rates. And that reversal basically means the reintroduction of volatility. Interest rates, volatility has never been as high as now. The fix is getting there, but not yet. But it causes a large amount of opportunities across economies. For example, the Bank of England is much faster than the euro area. The US is perhaps slower than New Zealand, so that all creates some sort of additional cross-market opportunities. There are loads of asymmetric opportunities there for us where we can dive into, in currencies because we also like to be underweight those Asian FX markets that we just discussed, because we expect more weakness to come off the higher inflation. So yes, the re-introduction of volatility means much more opportunities for us.
EM: As a team you do a lot of historical research on what's happened previously in different cycles. And I came across a quote where Jerome Powell was saying: “We’ve had 11 tightening cycles. None have looked like this.” But if you were to say, does this remind you of anything you've seen before? And I'm just thinking of the seventies when you saw oil prices going up, where there was a war. Are there comparisons?
RS: Yes there are comparisons with the 1970s and the parallel is a combination of monetary tightening with higher commodity prices. So there is a parallel, but be aware that it took quite a period of monetary tightening and a huge shock to commodity prices to get there. And also they had the whole labor market setup that was different than what we are used to, right now. As Bob just pointed out, in Eastern Europe, maybe it looks a little bit more like the setup we had back then. But for many economies, there's less risk of a wage price spiral than it was then we saw back then. Nevertheless, these are moments in time when central banks really have to step in and make sure that these higher inflation levels do not get embedded, because then you get a situation that has a lot more 1970s risk attached.
EM: And do you feel we are in good hands? I mean, Volcker stepped in in the late seventies, quite dramatic policy action there. Today, where we are, are we in good hands with our central bankers?
BS: That's a very tough question. I don't know. I think in the past 18 months, we've seen central banks struggling with this. First with the transitory view, and then it wasn't transitory. And then they were preparing the markets for tightening. And now they are talking about even stealth tightening. Even our own Dutch central bank governor Knot is talking about a 50 basis point rate hike, which was unheard of a year ago. So that also tells me that they also don't really know. So are we in good hands? I don't know.
RS: I think as you mentioned, in response to the period of high inflation in the 1970s and early 1980s, you got a period of central bank independence being stressed. And if you look at how central banks have been operating more recently there, they have become more political institutions than they were before. So the independence has been less, let's say, prevalent than what was the case before. And we need independent policy to curb current inflation levels.
BS: And, and there I'm a bit doubtful that we're actually going to see that. Perhaps in the US, perhaps in the likes of countries like New Zealand or Canada, but in the eurozone, can the ECB really materially tighten monetary policy while keeping Italy's interest rates under control? I don't know. I'm a bit skeptical there. And I think also the example in the UK with the Bank of England now also basically saying, well, we're not going to over-tighten so fast as we've tried to tell to you a few months ago, simply because there's also pressure from the political arena on them, not to move too fast or too aggressive. So I think time will tell, but I think this is a very unusual period because basically before the pandemic, I think the financial cycle was coming to an end. The pandemic came, yes, technical recession, but all the support basically lengthened the cycle. And now here we are. With high levels of inflation, a labor market that's very tight, a yield curve that's inverse and central banks that have to balance this. And I don't know whether that will be a soft landing, but my base case would be that I'm skeptical there.
EM: In closing, if we were to speak again in a year's time, what would your hope be and what would you hope to be talking about, then?
RS: The soft landing that we just witnessed over the past half year, which was so unlikely but materialized nevertheless.
EM: Bob, do you agree with Rikkert?
BS: Yes. But also there I think it's good to bear in mind that we can focus on the short term and on the soft landing. But we shouldn't forget that all major economies are still carrying overload in debt. We haven't had a proper default cycle for years. So we shouldn't forget that recessions also are here to help us out and clean the economy so that we can move on forward in a much more sustainable way.
EM: Bob and Rikkert, thanks so much for joining us again and for your insights and to bravely continuing with your investment theses and success.
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