We are seeing a lot of market angst over stubborn inflation in the US and, therefore, escalating concerns that interest rates will remain higher for longer. That has led to the rapid paring back of rate cut expectations and increased equity market volatility (mathematically, higher interest rate means lower stock valuations, all else being equal). And, of course, plenty of narratives attempting to explain the apparent vexing issue on why disinflation has stalled. The Screenshots below are just two of the many similar news headlines in the market today.
In one word, the market is confused. Frankly, so are we. Not about why inflation is proving to be more stubborn than what the market expects. Rather, we are more curious as to why the market is so confused. We have written about the end of the secular decline in inflation and interest rates over many articles in the recent past.
The market has been obsessed with each economic data point that is released, be it consumer price index (CPI), personal consumption expenditures (PCE), job additions or wages growth — looking for justification for the Federal Reserve to cut interest rates. What if they are missing the forest for the trees? Specifically, we think that expectations for inflation and interest rates to quickly return to the lows of the past decade are unrealistic, at least for the foreseeable future. In fact, the low CPI that we have grown so used to may be the exception rather than the norm, due to major events that are now on the reverse course. Case in point, CPI averaged 2.4% between 1995 and 2010 and in the 10 years prior to that, it was 3.6%. The Fed’s target of 2% CPI was only crystallised in 2012, at a time when the world was quite a different place. Indeed, the risk then was allowing inflation to fall too far below the 2% level (fearing a Japan-like deflation with low growth).
Inflation — and interest rates — had been declining steadily since the 1990s and had fallen further after the global financial crisis (GFC) up till the Covid-19 pandemic. There are many reasons for this, but two of the biggest drivers were geopolitics and globalisation. With the end of the Cold War — fall of the Berlin Wall in 1989 and dissolution of the Soviet Union in 1991 — the world entered a period of relative peace and cooperation among the major powers, leading to lowering of trade barriers and rise in global trade. This was reflected in great proclamations of the triumph of liberal democracies by political and economic historians such as Francis Fukuyama in his book The End of History and the Last Man.
The integration of China into the global economy following pro-market reforms in the 1990s and its accession to the World Trade Organization (WTO) at end-2001 were major milestones. It led to the massive influx of cheap labour and hollowing out of manufacturing in the US. Global supply chains became longer and more complex where cost optimisation was the priority, all of which drove the cost of goods lower and lower. Low goods inflation offset higher services inflation and kept overall CPI on the decline, which in turn drove interest rates lower (see Chart 1).
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We think this era of low and falling CPI and interest rates has ended. The world is in a very different place today. For one, the pandemic has taught businesses the risks of long and complex, just-in-time global supply chains, the benefits of near-shoring and at least some degree of supplier diversification and redundancy. Labour cost in China has risen steeply over the past two decades and the wage gap with the US has narrowed. There is a lower bound limit as to how much prices could continue to drop. Yes, the technology keeps improving and you would be getting better specs for a similar product, but this way of “lowering costs” cannot be adequately captured in CPI numbers.
Geopolitics is also coming back into play, with the Russia-Ukraine war, the widening US-China tech war as well as conflicts in the Middle East that are raising transport costs. The world is fragmenting into political-economic blocs, fuelled by growing protectionism and trade barriers in the name of national security. Case in point, the US is now pushing back against, instead of welcoming, cheaper Chinese exports. This is also due, in large part, to the failure of neo-liberal economic policies — the reliance on market deregulation, free trade and free markets to drive prosperity that have led to widening income and wealth gap of the people — that is resulting in the current global backlash. The focus on growing wages today is the pendulum swing against the excesses of capitalism of the recent past.
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All the above will limit the scope for continued disinflation in goods, at least for the foreseeable future. CPI goods shot up sharply during the pandemic but has since flattened out as supply chain disruptions reversed. Inflation is now being driven by services and, in particular, wages (Chart 1) — that are now catching up to the loss of purchasing power due to the pandemic CPI spike — and the cost of housing (a structural problem). We have previously written on both subject matters. A robust job market is giving workers greater bargaining power and a resilient economy is allowing businesses to pass on the costs through higher prices. Strong aggregate demand — from both consumer spending as well as government deficit spending — is underpinning the current inflation stickiness.
We do not expect the Fed to give up its 2% inflation target imminently. Ultimately, though, this target will have to be revised upwards, due not just to sticky inflation but also ever-widening fiscal deficits in the US. But raising the Fed’s target beyond the 2% level is not likely yet to be articulated because of serious consequences to the overall economy … but it will happen.
Brace for higher-for-longer interest rates, for more reasons than only CPI
We have little doubt that the Fed will cut interest rates, whether it be later this year or next. However, this does not necessarily mean lower borrowing costs for households and businesses. The Fed sets the short-term Fed funds rate but Treasury yields are determined by market demand and supply. The 10-year yield is particularly important, as it is the benchmark for pricing most corporate bonds and commercial loans.
Right now, the yield curve is inverted, that is, longer-term yields are lower than short-term rates, typically a signal for recession (which could still happen, though it is no longer consensus). When the Fed cuts rates, the yield curve will quite likely revert to its traditional upward slope — where longer-term yields are higher than short-term interest rates (because investors require compensation for risks, such as inflation and interest rates, and for delayed consumption). In other words, the 10-year Treasury yield may stay around, or be higher than, prevailing levels — 4.6% at the point of writing — even when the Fed funds rate is cut by say, 50 basis points, to 4.75% to 5% from the current 5.25% to 5.5%.
As we said, ultra-low CPI and interest rates are a relatively recent phenomenon, from the long-term historical perspective. In January 1990, the 10-year yield stood at 8.4% and in January 2002, it was 5.1% before falling all the way to 0.5% during the pandemic (see Chart 2).
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The secular decline since the 1990s was due to a confluence of factors, primary of which was inflation (due to globalisation as we wrote above). At the same time, China emerged as a huge buyer of Treasuries, reinvesting the country’s rising trade surplus with the US, which grew strongly in the 2000s. Similarly, Japan is a net exporter of goods to the US and another big buyer of US Treasuries (that is, the debts of the US government) (see Chart 3).
Additionally, the era of falling inflation and interest rates has been a boon to bond investors — its decades-long bull run delivering outsized capital appreciation for an asset class that traditionally offers stable but modest interest income. US Treasuries had the additional bonus of being near zero-risk investments. In the aftermath of the GFC, the Fed became the big buyer of Treasuries in the market, through its massive quantitative easing (QE) programmes — and one who is yield-insensitive (that is, it will buy at whatever price) to boot. In short, over the past three decades, there has been no shortage of demand for Treasuries.
But China’s holdings of US treasuries have clearly peaked and are in decline while Japanese investors may soon repatriate more funds to reinvest at home if domestic returns continue to rise after the Bank of Japan ended its negative interest rate and yield curve control policies. The Fed has stopped its QE programmes — effectively taking away one big, consistent source of demand for Treasuries. And central banks (of allies and enemies alike) are more likely to diversify their reserves, taking lessons from the weaponisation of the US dollar after Russia invaded Ukraine. The recent rise in gold prices may be indicative of this.
We are not saying that there will be a shortage of buyers going forward, at least not in the medium term as US Treasuries are still considered one of the safest assets to own. Though this could change if the US fiscal position continues to deteriorate over the long term. But market investors will surely be more demanding in terms of yields, and especially if capital appreciation prospects are likely to be significantly lesser than they had been when interest rates were in secular decline. Yields, as we said, are determined by market demand and supply. And there will be a growing supply of Treasuries in the market.
The US government must issue more Treasuries to finance its huge deficits and debts outstanding. The Congressional Budget Office forecasts government spending will continue to outpace revenue growth in its latest Long-Term Budget Outlook released in March 2024 (see Chart 4). It expects the budget deficit to rise from 5.6% this year to 6.1% by 2034. And total borrowings are estimated to increase from 99% of GDP to 116% over the same period. The higher borrowings are likely to exert upward pressure on interest rates, and debt servicing will also rise as a percentage of GDP. Neither the current Democratic nor Republican presidential nominees are inclined to cut spending and the latter will probably extend tax cuts, if elected.
In short, we should probably brace for higher-for-longer interest rates, and not just because the Fed is delaying its rate cuts in the short term due to sticky inflation. This will have widespread consequences, increasing the risks not only for the US economy but also the rest of the world, because of the central role of the US dollar in the global economy.
Economics and investing can be confusing and complex. There is no certainty, only possibilities. And knowledge reduces risks, even as it worries you more. We guess this is what makes investing fun, even if you are often wrong.
The Malaysian Portfolio was up 2.6% for the week ended May 8, outperforming the FBM KLCI’s weekly gain of 1.8%, thanks to strong gains from KSL Holdings Bhd (+7.0%), IOI Properties Group (+6.9%) and Insas -Warrants C (+6.8%). All stocks in our portfolio ended higher last week, lifting total portfolio returns to 194.7% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 12.3%, by a long, long way.
The Absolute Returns Portfolio also finished higher last week, gaining 1.4%. The top gainers were Airbus (+5.1%), Tencent (+4.1%) and Microsoft (3.9%) while Swire Properties (-6.6%) and OCBC (-2.9%) were the two losing stocks. Last week’s gains boosted total returns since inception to 1.8%
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