May you live in interesting times? Thanks, but no thanks!

Inflation is slowing as predicted (although not fast enough). US CPI has fallen to 8.3% (9.1% our last update) and property and shares have continued falling (as the Fed doesn’t seem about to reduce rates any time soon).

Consumer spending: this is the biggest component of GDP and the US consumer remains more resilient than expected.

Wages growth: wages growth is replacing the goods and fuel inflation (which has recently eased). This is a dangerous sign as it means inflation is becoming more entrenched and systemic, rather than cyclical.

Interest rates: the Fed will likely raise by another 0.75% (our fingers remain crossed). Rates seem to have reached a level that is no longer stimulating the economy - known as a neutral interest rate setting. It’s unlikely though that rates are quite high enough to break the economy sufficiently to slow wages /slow CPI.

Inflation: central banks are genuinely trying to slow inflation- by the end of the year, it’s predicted the US will soon be paying circa $1b per day in interest.

Governments and central banks are playing good cop / bad cop. Politicians the world over cannot resist the temptation to spend. Almost every govt is running a budget deficit (spending more than they raise in taxes). From electricity subsidies to covid payments, governments continue to stimulate economies thus adding to inflation. It should come as no surprise that elected officials are the good cop and unelected official (central banks) are being undermined and forced to play bad cop.

Until government spending is reined in (by moving towards a balanced budget), Central banks will be sorely tested. If they are indeed independent, then they will need to raise rates higher than they otherwise would if the government was genuine about addressing inflation.

In 1981 US debt was $3T- Now it’s 31T. Most of this debt was accumulated via extreme government spending during covid. The economic stimulus was 7x what occurred during the GFC. Now it’s the inevitable hangover, as the economy moves towards a new normal.

Alternatively, to achieve a balanced budget, governments could raise taxes. But Australia’s already one of the most highly taxed nations in the world. 100 years ago taxes as a percentage of GDP was 5%, in 2021 it exceeded 30%.

The chart below shows a pretty clear trend!

If politicians were to raise taxes, they would typicality target the wealthy. However, 6% of the Australian population already pays 50% of personal income tax.

Quantitative tightening (QT): central banks are about to reverse (very slowly), the QE that occurred during covid. This involves central banks selling the govt bonds they purchased over the last few years. This takes money out of the economy (reducing liquidity).

Until now central banks were the biggest buyer of govt bonds. Without the biggest buyer bidding up the price of bonds, the bank selling bonds and govts still issuing massive tranches of new bonds (to fund their deficits), who will buy them? Interest rates have to raise to attract new buyers who are prepared to lend money to already overly indebted governments.

This is why interest rates on 10yr govt bonds have risen 650% (0.6% to 4%). It’s not just home mortgage rates that are priced relative to bonds- all income producing assets are valued relative to bonds (ironically known the risk free rate).

Frustratingly the increased interest rates take at least 6 months to show up in the economy and the CPI numbers. So whilst there’s been large consecutive rate rises, we just don’t know if it’s worked, if it’s enough or if we need more.

There are leading indicators that the reserve bank rely on, but it’s not an exact science. Orchestrating a soft landing, the goldilocks scenario, is extremely difficult and the US Fed hasn’t always succeeded the way we hope.

Fortunately financial markets aren’t concerned with the here and now- they are forward looking. All the uncertainty that’s been discussed is already baked into current prices (if you assume markets are efficient).

Our interpretation of the long term bond market tells us that inflation will fall but is largely here to stay and won’t come anywhere near the targeted 2% (US) and 2-3% (Aust). Markets will evolve and find their new place.

Equity markets are telling us there’s a 50/50 chance of a soft landing- which we feel is optimistic. We still expect the lows of mid-June are likely to be retested. Hopefully this level of support holds and we see the rate rises start to have a real impact. Ideally this occurs before the end of year, giving central banks a reason to pause on interest rates.

Against this backdrop, our asset allocation positioning remains focused on managing downside risk. The thematic focus that we continue to consider at a portfolio level remain focused on two key aspects:

1. Maintaining an investment allocation that is suited to higher inflationary pressures.
2. At the same time, maintaining a broad-based investment strategy across the core equity and bond positions. We believe this to be important as it can provide further diversification and downside protection into the portfolios.

We remain vigilant, patient and proactive.