The ongoing global regime shift towards higher interest rates and less liquidity will lead to significant shifts in corporate investment and resource allocation.
Given the structural inflationary pressures, we expect central banks to be less able than in the past to intervene when pursuing monetary policy to extend expansions and shorten recessions.
Disruptions and dislocations associated with more volatile economic cycles have already created opportunities for active pension management, as illustrated by the dramatic rise in interest rates in 2022. We expect to welcome further opportunities as regime change progresses.
The Business Cycle
A business cycle is the overall state of the economy, going through four phases: expansion, peak, contraction, and trough.
Factors such as gross domestic product (GDP), interest rates, employment and consumer spending characterize each phase of the cycle.
The expansion phase is characterized by economic growth, increased consumer spending, rising employment figures and higher inflation. Declining economic activity, falling consumer spending, rising unemployment and lower inflation define a contractionary period also known as a recession.
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Central banks use monetary policy to influence the business cycle by controlling the supply of money and credit to the economy. Central banks can influence economic activity and help maintain stability by adjusting interest rates and using other monetary policy tools, such as B. increasing their balance sheet (quantitative easing or QE) or reducing it (quantitative tightening or QT).
During an expansionary phase, a central bank can raise interest rates — as many have done in 2022 — to slow economic activity and prevent inflation from accelerating too quickly or embedding itself in the economy.
Higher interest rates make borrowing more expensive, which can discourage consumers and businesses from spending and investing.
During periods of slowing growth, such as in the aftermath of the global financial crisis (GFC) or during the abrupt contraction of COVID-19 in 2020, a central bank may lower interest rates to encourage borrowing and spending to stimulate economic activity and raise inflation more generally.
Which is important to policymakers: cyclical or structural inflation?
Cyclical inflation results from fluctuations in the business cycle and is related to the vicissitudes of the economy. It is usually temporary and monetary policy tools such as interest rate adjustments can reverse it.
In contrast, structural inflation refers to inflation caused by long-term factors built into an economy, such as B. Supply and demand imbalances, deglobalization, demographics and decarbonization.
Structural inflation is persistent and difficult to combat, and requires fundamental changes in the economy to address it. We began to experience such challenges in 2022 after the peak of the COVID-19 pandemic as supply chains broke and companies rebuilt them, often bringing them closer to home.
In the coming years, we expect labor and energy costs to push up structural inflation.
Labor’s share of national income (the amount of GDP that is paid out in wages, salaries and social benefits) has declined in developed countries and to a lesser extent in emerging economies since the 1980s. In the near term we expect higher returns on labor relative to capital and an end to the trend we have been witnessing since the 1980s. Why?
- demographics. Aging populations and declining birth rates have led to falling participation rates and tighter labor markets.
- Policies aimed at reducing supply chain risk, income inequality, and funding benefits for an aging workforce that hasn’t saved enough may require an increase in debt-fueled government spending.
As a basic economic input, energy costs are inherent in all goods and services. We expect energy to be another source of structural inflation for a number of reasons, including:
- Supply and demand. With the growth of the emerging countries, the demand for energy will continue to rise. At the same time, energy-hungry economies are depleting many of the world’s largest carbon-intensive energy reserves.
- The transition to decarbonization. Governments around the world are implementing policies aimed at reducing the use of carbon-intensive energy sources while increasing the use of renewable energy. Until sustainable energy achieves economies of scale, these regulations will likely lead to higher energy costs.
Shorter boom and bust cycles ahead
Central bank inflation targets emerged and spread around the world in the 1990s and 2000s. Although somewhat arbitrary, many major central banks in developed markets, including the US Federal Reserve, ruled that annual inflation of 2 percent was consistent with price stability.
Until recently, inflation, as measured by the CPI, has been generally stable and low over the past two decades, lingering at around or below 2 percent, particularly from the global financial crisis to the start of the pandemic in 2020.
This gave central banks considerable flexibility to lower interest rates and even implement unconventional monetary policies such as QE when economic growth slowed.
Cheap money led to debt-driven widening of business cycles and shorter contractions. Central bank intervention is not a new phenomenon; Historically, since the Fed’s inception in late 1913, monetary policy has prolonged expansion and curtailed contraction.
It is interesting to note that the average post-Fed expansion lasted almost twice as long as the pre-Fed period, while the average post-Fed recession shortened by almost half compared to the pre-Fed average. The most recent expansion, which ended with the outbreak of COVID-19, set a record 128 months, almost two years longer than previous expansions.
‘Transition’ to ‘sticky’ inflation
The inflation narrative in 2021 was “temporary,” meaning high inflation was temporary and would not last.
However, as inflation skyrocketed and remained higher than expected over the last year, the key term used to describe inflation became ‘sticky’.
While inflation appears to have peaked after central banks raised interest rates sharply in 2022, our views on the labor and energy factors driving structural inflationary pressures suggest that inflation may remain above the Fed’s target longer term will stay.
This turnaround in the post-GFC easy money era could keep interest rates relatively high to prevent a resurgence of inflation and limit central banks’ ability to meaningfully lower interest rates or ease monetary policy to avoid a recession to shorten or expand an expansion.
With expectations of higher structural inflation and limited central bank support leading to shorter and more volatile business cycles, we believe that successfully capitalizing on credit investment opportunities requires a manager with a proven ability to capture episodic opportunities in oversold areas of the market.
As central banks continue to withdraw liquidity with higher interest rates and QT, portfolio size becomes an important consideration as it becomes increasingly costly to buy or sell cash collateral, and particularly to reposition larger portfolios. Higher transaction costs for larger portfolios could reduce returns for investors.
We believe the best way to source alpha during regime change is to proactively add and decrease credit and interest rate risk as market conditions change, quickly switch sector exposures, selectively add risk to specific issuers and to choose favorable investment points within the capital structures.
While we expect economic cycles to become shorter and more unpredictable going forward, there will always be opportunities for investors to spot opportunities, including niches, in the fixed income market.
