It has been a wild few weeks within debt markets – sharp sell-offs, even sharper rallies, and then a renewed sell off. Movements in equity markets have looked tame by comparison. Bond markets are certainly having to process a lot of conflicting information – inflation, deflation, politics and a mountain of potential issuance next year following what was an amazingly quiet year for debt issuance in 2023.
This year, governments the World over have economized on issuing duration, preferring instead to issue T bills and / or to run down their existing cash reserves. Whether these policies were simply a reaction to the Truss-Gilt Market debacle in the UK, or in the hope that yields will be lower next year, or as part of a grand “price fixing scheme” is not clear, but what is clear is that these seemingly expedient policies have inflicted real damage on the economies.
Running down public sector cash reserves such as the US’s “Treasury General Account” represents a genuine monetary easing, as can the use of T bills as a funding instrument under certain circumstances. The fiscal authorities have therefore been guilty of easing monetary conditions at a time during which the central banks were (supposed to be…) fighting inflation. Moreover, all the “mucking about with the markets” and the creation of a huge duration issuance programme for the future has not been a “good look” for governments.
The general population will of course not know – or even care – about the intricacies of the government maturity profile, the Treasury General Account in the USA or the Fed’s Reverse Repo Facility, but certainly they will have been only too aware that something happened mid-year. Financial markets rallied and, in so doing, they provided an “information signal” that all was well in the World, a message amplified by the financial media.
For any company or individual struggling with weak profits, cash flow or wage trends, this will have told them that they were probably doing relatively badly at a time when others must be doing well and that they should be raising their prices accordingly. The extra liquidity also helped impact commodity markets. It is of little wonder that we have seen an inflation pulse impact the system – at a global level.
We believe that the World is today occupying an inflation / deflation knife edge position. Quite simply, non-traded goods prices and in particular property prices are currently too high relative to goods prices and wages to allow the economic system to function. Below, we offer a seemingly trivial but we believe important example of just what has gone wrong with the World.
Many commentators – and in particular those that believe in the power of wealth effects – have tended to welcome rising real estate prices. However, houses are not simply an asset, they are also a basic human requirement for life and house prices are a large part of anyone’s subsistence costs. Last month, a probably well-meaning group of elected representatives on our little island suggested that, if the provision of childcare was increased, the working population might be increased by as much as 6% as parents became better able to return to work. To this end, they suggested subsidizing pre-school fees. The problem is that every preschool is already full, there are simply no available places. The two (principal) barriers to entry in the industry are the cost of premises and even more importantly a shortage of staff; the £10 per hour wage on offer is insufficient to allow workers to pay their own accommodation costs and so there are chronic staff shortages in the sector. Wages in the sector might need to “double” and hourly childcare costs rise by at least a half to solve the supply problem. In order to afford these fees, would-be working parents would then themselves need higher wages…It seems that we either need higher inflation or house price deflation to make the system function more efficiently over the longer run. At the very least, this disequilibrium must be corrected before secular stagflation takes hold – rising prices and supply-constrained output growth.
One possible route – or on one side of the Knife Edge – would be an over tightening of effective monetary conditions that collapses property prices, causes distress in the financial system and a Japan-like slump within the domestic economy. On the other side is the scenario in which the central banks do not get control of inflation, with the result that a wage price spiral occurs that eventually restores affordability to housing and non-traded goods prices in general. The latter is of course the “picture” that central banks created over the middle of this year.
Between these two paths (which once you start on can be hard to reverse) lies the middle ground, in which there is a little goods price inflation and a little property price deflation. This middle ground is largely a mathematical slow unwind of years of inappropriate policies; it is feasible but difficult to achieve.
There have been times during the last 18 months during which the Fed has looked to be successfully navigating the thin path along the top – 2022 did see some non-traded goods price deflation and some goods price inflation but the “summer easing / AI rally seems to have tipped us back into a more generalized inflation, at least in the real economy. As we note above, the Risk On rally did not stop at financial market prices.
To further complicate matters, if you were to visit with senior commercial bankers, those involved in the CRE space or even CMBS markets, and perhaps even some of the PE world, one would find evidence of mounting deflationary pressures. The US banking system has become risk averse, it is cutting funding to the private markets, and we gather that the clock is very definitely ticking on the Real Estate bad debt / CMBS downgrades / repricing events.
For the debt markets at the moment, we therefore have contrasting signs of inflation in the real economies but deflation in the banking system. We have the prospect of huge issuance but, for calendar reasons, not just yet. There may yet be YCC waiting in the wings. We also have uncertain politics, be it in the outcomes of recent elections, approaching elections or even talk of incumbent leaders behaving like scared “rabbits in the headlights” (at least two that we have been told about). Arguably, there is a question over the competence of past, current, and future leaders. Throw in the awful geopolitical situation and you have recipe for instability.
However, this cannot now be considered as being “normal instability”. The middle path is so narrow and the nature of Knife Edges is by definition that once you fall off, you keep falling. On the inflation side there would be a compromising of the Demand for Money, endemic inflation, and a disaster in debt markets (albeit one that might be temporarily delayed if the authorities resort to YCC for a time). On the deflation side of the Knife there would be a rush for cash and a rally-for-the-ages in fixed income.
Over recent weeks, markets have wobbled from looking down one side to looking down the other – and then back again. It is a brave trader that would step into these markets. We would recommend small positions or simply hugging one’s benchmark at the long end. At the short end, there is now the chance of higher rates, although we suspect that central banks would rather not move for a while.
There is of course a non-zero probability that the centre path will be achieved – perhaps a 25% probability. However, we suspect that there is a 45%-30% split between inflation and deflation prevailing and, as we note above, if we fall down the Knife Edge the markets will keep going – once the direction is established one can load up on risk following the trend. In the near term, long term debt markets are likely to remain unstable – perhaps a year end rally then a new year sell off as EZ issuance ramps up? Once the medium term trend becomes established – and we suspect that it will be an inflationary one – there will be a chance to build positions.
Disclaimer: These views are given without responsibility on the part of the author. This communication is being made and distributed by Nikko Asset Management New Zealand Limited (Company No. 606057, FSP No. FSP22562), the investment manager of the Nikko AM NZ Investment Scheme, the Nikko AM NZ Wholesale Investment Scheme and the Nikko AM KiwiSaver Scheme. This material has been prepared without taking into account a potential investor’s objectives, financial situation or needs and is not intended to constitute financial advice and must not be relied on as such. Past performance is not a guarantee of future performance. While we believe the information contained in this presentation is correct at the date of presentation, no warranty of accuracy or reliability is given, and no responsibility is accepted for errors or omissions including where provided by a third party. This is not intended to be an offer for full details on the fund, please refer to our Product Disclosure Statement on nikkoam.co.nz.