sign up log in
Want to go ad-free? Find out how, here.

Uncertainty is rising in the near term. And there is even greater uncertainty ahead in the long term. Fixed income investors are likely to require higher yields from bond investments, says Hamish Pepper

Bonds / opinion
Uncertainty is rising in the near term. And there is even greater uncertainty ahead in the long term. Fixed income investors are likely to require higher yields from bond investments, says Hamish Pepper
Mountains rising from placid lake

  • Most economists expect historically high inflation to moderate over the next year, but the near-term outlook is uncertain.
  • Over the long term, changing structural inflation forces may create even greater uncertainty for investors.
  • The possible end of the great moderation – the period of relatively benign economic cycles - that has prevailed for most of the past 40 years - may see fixed income investors seek greater compensation (term premia) to part with their money for long periods of time and presents an upside risk to bond yields.

navupdated

Most economists expect historically high inflation to moderate over the next year, but the near-term outlook is uncertain. Inflation should decline as long as tradable inflation pressures don’t worsen and monetary tightening works its way through economies. We may have passed the inflation peak in most countries and the global economy is returning to more sustainable levels of growth. However, the ongoing war in Ukraine and China’s zero-tolerance COVID approach are key risks to the economic outlook. Both could keep inflation elevated for longer and weigh more heavily on global economic activity.

Over the long term, changing structural inflation forces may create even greater uncertainty. For much of the past 40 years globalisation, demographics and digitisation have been helpful disinflationary forces. Along with central bank independence, greater demand for less volatile services over goods, and deregulation, these factors have contributed to a period of low volatility in key macroeconomic variables since the mid-1980s that is often referred to as the “Great Moderation” (see figure below). However, over the coming decades it may just be digitisation (technological advancement) among these factors that helps economies to contain inflation pressures. An additional structural inflation force may have also emerged in the world’s effort to tackle climate change via de-carbonisation.

nav5

We expand our discussion of each of these structural inflation factors below:

De-globalisation

Global trade allows countries to specialise and goods to be produced at the lowest cost. Global trade probably peaked just after the global financial crisis (GFC) and has been steadily declining since (see figure below). Structural drivers of the decline include rising protectionism (think Trump and Brexit), but cyclical drivers have also contributed, such as weak business investment (that tends to be trade-intensive) that was related to higher economic uncertainty.

De-globalisation may accelerate after COVID-19 exposed the vulnerability of a “just-in-time” inventory cycle and increased the incentive for countries to develop local supply chains to minimise future disruptions. This will ultimately be a more expensive product source, however.

nav6

Demographics

Baby boomers have blessed the world with a large, experienced and productive work force over the past 30 years – helping to reduce upward pressure on wages. However, as large parts of the world reach older age over the next 30 years, they may no longer be available as an input into production but continue to demand goods and services – both of which will contribute to inflation (see figures below). Demand by these older people will be concentrated in labour-intensive service sectors, such as healthcare. Natural rates of population growth (births less deaths) are unlikely to make up the shortfall and likely accelerate the push towards robotics and technology to help.

nav7

De-carbonisation

The world has largely embraced the need to slow climate change via a reduction in greenhouse gas emissions. Measures to disincentivise carbon, such as carbon taxes, are likely to increase the cost of fossil fuels which the world is still very reliant on (see figure below). For example, 60% of the world’s current electricity production comes from fossil fuels (NZ 20%; EU 40%; US, China Japan and Australia are between 60-70%). Harsher government measures, such as imposing deadlines for the use of fossil fuel assets, and geopolitics may force fossil fuel generation to be replaced – with the associated costs likely passed on to consumers.

The impact, however, may be moderated by the lower cost of some low-carbon alternatives. The International Energy Agency, for example, expects onshore wind to have, on average, the lowest Levelised Costs of Electricity generation (LCOE) in 2025.[1] Although costs vary strongly from country to country, this is true for a majority of countries (10 out of 14). Photovoltaic Solar, if deployed at large scale and under favourable climatic conditions, can also be very cost competitive. Offshore wind is also experiencing major cost declines.

nav8

The possible end of the great moderation may see fixed income investors seek greater compensation to part with their money for long periods of time and presents an upside risk to longer-dated bond yields. Term premia can be estimated from fixed income securities and represents the compensation that investors demand for the risk that interest rates change over the term of the security. The US 10-year Treasury term premium[2] has increased from all-time lows of -0.90% in the middle of 2020, to 0.30% today. The average since 1990 is 0.80%, however, suggesting upside risks to longer-dated bond yields. The Reserve Bank of New Zealand’s equivalent measure[3] for NZ tells a similar story, having increased from all-time lows but currently well below its long-term average (see figure above).

In addition, any persistence in higher inflation can be expected to lead central banks to have a bias towards setting cash rates somewhat higher than we have seen over previous years. This reinforces the likelihood that bonds yields trade in a higher range.

For equities, if this scenario plays out, there may be some challenges as expectations about medium-term inflation and interest rates are revised higher. Once this is factored in, the bias towards lower equity prices should cease, and be replaced with a greater level of volatility. For investors, there are opportunities amongst all of this for active investors, but they will also need to review their willingness to be exposed to higher levels of market volatility.


[1] LCOE tries to capture the average net present cost of electricity generation for a plant over its lifetime (including building and land costs). LCOE = sum of costs/sum of electricity produced. Values at 7% discount rate.

[2] Using the Kim and Wright (2005) method. For more detail see here.

[3] For more detail see here.


This article is here with permission. It was originally published here. This does not constitute advice to any person. www.harbourasset.co.nz/disclaimer

We welcome your comments below. If you are not already registered, please register to comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.

29 Comments

The NZD/ AUD is devaluing rapidly (in USD terms) due to rising global risks with Chinese lockdowns, high inflation and food prices. It'll be interesting to see if NZ/ AU behaves more like emerging markets (EM) like LATAM and South America with households piling capital into real assets and real estate by buying the dips to preserve their purchasing power and avoid the real currency devaluation.

Up
3

"Buy the rumour, Sell the fact"

Assets have been used as a protective mechanism for the last 15 odd years (Buy the rumour), at least.

It's just as probable that 'now' is the time that the stored liquidity will be released (assets will be sold across the board) to fund Life, at whatever level one is accustomed to.

 

Up
5

Uncertainty is rising in the near term. And there is even greater uncertainty ahead in the long term. Fixed income investors are likely to require higher yields from bond investments, says Hamish Pepper

Today, by contrast, the world already seems to have topped out of the 2020 “recovery” which quite clearly was never a recovery (see: jobs). From that low point, now the twin pain of consumer prices unlike in modern memory especially for essentials further combined with basically the world staring into the abyss of yet another recession by which to pile more misery on top (basically the same as summer 2011, only prices faded much faster back then).

And if it the global trend will indeed continue to go on this way, as it has for well over a year, then “inflation” will have solved itself without any need of Jay Powell and the FOMC. This is, you’ll note, another one of those good news/bad news situations.

This is why the yield curve inverted months ago and today it is inverted even more so (in the key middle section). The Fed, however, is going to do what it is going to do based on the CPI’s past conditions regardless of onrushing recession risks. Link
 

Up
5

We are going to enter an era of persistently high interest rates (well, "high" with respect to values we have been accustomed to, but normal in historical terms). Housing will cease to be a passive speculative vehicle, and in the medium/long term housing values will be, in real terms, only a fraction of current values. The next decade will be brutal for housing speculation in NZ, as values will return to be in synch with economic fundamentals and the current bubble will deflate.

The OCR peak will be over the 4% threshold, and it won't decrease substantially from this level. After a painful and long flight with inflation, reserve banks will have no appetite for restarting it. There is no such a thing as a free lunch.

Up
13

Thanks for your opinion

Up
6

I agree money has to have value reflected in fair interest rates or everything becomes and has become distorted beyond belief.

Up
4

It would be a very good thing for productive work to be more valued and speculation on land less so than the last couple of decades.

Up
1

Good grief. Bondholders have always required higher returns. Bondholders will be given the returns that the people in charge decide they will get. That is what has happened over the last few years. It will not change. Bond holders have had the value of their money taken off them big time lately. Check any pension fund balance. Scary. This will only change if share buying people are denied access to cheap moneyprinting.

Up
2

The RBNZ slowly ratcheting up  "what we will do"......is like intentionally "boiling the NZ frogs" slowly.   I see them going way higher than the current tops of 3.9% OCR - they will be forced to, to defend our dollar,  and stop the inflation boheamouth thats ahead of us.

The shocker 8.6% CPI figure out the US this morning......will force the FED to use its claws and teeth to draw serious blood out of the US economy with increasingly agressive rate hikes in the months ahead.  NZ will need to follow in lockstep.......one problem,  the USA housing market has had a miniboom,  NZ has had a MEGAboom. 
NZ has a watermelon housing/ponzi market compared to the USAs grapefruit! 

Up
12

I keep hearing that "most economists expect inflation to moderate."

Why? As far as I can see, just because. After whole careers built in a deflationary environment, they still can't believe their lying eyes.

The way I see it, inflation can't come down until we've been hit by a massive markdown in asset values and recession. That hasn't happened yet. Ergo, we'll keep seeing inflation. CPI won't slow down until the bust is actually underway.

Up
19

Agree totally Sam B I can't follow their reasoning we have offshore risk still high through the war , energy prices are skyrocketing,  food prices affected leading to new records in food prices . The optimism by economists seems totally unfounded,  the US is still recording record inflation but yet still economists see through it , really . If we think a couple of interest rate tweaks will stop it in its tracks we are dreaming. 

Up
8

Yes

just received some insurance renewal notices 

Increases of 11% & 8%

It just goes on and on

Up
4

I also think inflation will moderate, why?  Because higher interest rates are going to take a lot of disposable income out of the economy.  I think early 2023 will be recession time, as many people will have tightened their belts in the 2nd half of 2022.  This means, in my opinion, that inflation will reduce.

Up
5

Quite possibly, yes -- but they're all calling for the inflation to start abating now or soon, before that process has had any time to take place. 

Up
5

A leaderboard of economists' forecasts would be a useful addition to the site. Also add 'commentators' in there. 

Remember 'transitory' inflation? What happened to that? Or was that just a cute, truthy sounding piece of jargon that was easy to parrot? Google remembers.

Up
4

the same experts that said it was transitory only !!

Up
0

99 out of 100 armchair economists have identified the root cause of inflation.

https://brrr.money/

Up
2

We should get 2 armchairs  , then  ... one for Orr , the other for Robbo  ...

... perhaps that'll clarify their vision  ...

Up
1

Imagine thinking the central authorities' response to issues was creating them. 

At best they're increasing or decreasing the gravity of wider problems.

Up
1

Yeah, lets just ignore supply chain issues and energy costs. I'm sure they've played no part.

Up
0

Baby boomers have blessed the world with a large, experienced and productive work force over the past 30 years – helping to reduce upward pressure on wages. However, as large parts of the world reach older age over the next 30 years, they may no longer be available as an input into production but continue to demand goods and services – both of which will contribute to inflation (see figures below). Demand by these older people will be concentrated in labour-intensive service sectors, such as healthcare.

Interestingly many economists believe that population aging is a net deflationary force. I've never got a good rational on why they think this though.

Up
1

The great moderation is finished. What you see for the next decade is spikes. Straight up and straight down. Inflation spikes up and down. Interest rates spike up and down. Just like before the great moderation.

David Chaston reporting on the US deficit. 'Over the past year, this deficit has shrunk more than half to just over -US$1.1 tln from -US$2.8 tln in the prior fiscal year.'

by Jfoe 'Also known as the fastest destruction of cash in private sector bank balances in history. Last time the US ran surpluses (1999 / 2000 - 23 years ago!) a sharp recession quickly followed.'

The money printer went brrrrr for a long time before there was inflation. Why? Two reasons -

1/ Govts made massive FISCAL stimulus during the Covid period. Inflation started during this period. If the money printer goes brrrrr (monetary stimulus) but only rich people can spend the dollars then nothing happens. If the money printer goes brrrrr but the govt gives the dollars out to all and sundry then spending goes to the moon. Because lots of poor people are actually spending the money in the general economy rather than rich people putting it all into various asset classes.

2/ The oil price spiked. Then food prices. 

 

It looks to me like businesses are passing on some of their costs and as a result people are starting to buy less stuff. Because they can't afford to buy more stuff. Sooner or later business profits will fall. The oil price only stays high for so long and then it drops - with a bang. 

The US is still the only game in town. Europe is probably going into recession. China is sinking fast. Once the FISCAL money tap is turned off in the US then its game over for the world economy and you'll be left pushing on a string with all your money printers. 

Up
1

*Peter Zeihan has joined the chat*

Up
2

1. Actually it's been useful in teaching us how to prevent recessions that are cause by falling demand. We now know that consumer spending will turn on a dime if you post them cheques. It's crude but if you are staring into the abyss writing a cheque is tiny compared to the cost of traditional fiscal stimulus programs.

2. Eventually the cost of energy almost dictates the price of everything because it is such a bottleneck.

China is entering a terminal decline but it may not be that happy about accepting its new place in the world. Carrot and a big stick needed.

Finally, just make sure your country makes something you can sell for USD, if you do you're golden. If you don't your on the path Sri Lanka is walking.

Up
2

How is China entering a decline?  Goings on in china are so important they are directly affecting the rest of the world week to week.  You then say oh make sure your country  something you can sell in usd and youre golden. 

China makes a huge part of the goods for the entire world in many industries and its all sold in usd

This forum used to have some smart boomers but these days the quality is declining

Up
0

How is China entering a decline? 

Demographic decline, the destiny of China to half its population in 30 to 45 years is already baked in because the birthrate has been too low for too long and there is virtually no net migration to offset declines. The working age population will fall faster of course.

I suppose what I'd ask is why you believe China's fate would be any different?

Up
3

I think we all forget the biggest force of all... most people just want things to be OK and political and economic policy over time is usually about stability for the masses. There will be volatility (spikes) because news travels so much faster now, however globalization worked because on aggregate, almost everyone involved wanted it to work.

If not China then there are many other countries ready to host your factory, Mr Businessman. Meanwhile investment into nuclear power was expanding even before the war.

https://www.rystadenergy.com/newsevents/news/press-releases/Nuclear-inv…

Up
1

They have doubled interest rates and tanked mortgage applications.  Investors can seek what they like, but they still need to find a willing borrower.

Up
1

On what do you base the ridiculous claim that inflation has already peaked in most countries

Up
2