The debate over the onset of inflation may be over, but the game of guessing its impact on markets is only just under way.
It remains possible that upward pressure in some prices will prove to be transitory, as central bankers led by Federal Reserve officials successfully argued when quelling a bout of market concern about inflation earlier this year.
But evidence of inflation in key measures across major economies is now irrefutable and the focus is shifting to hedging against the effect of price rises on markets and businesses. Evangelists for assets that supposedly offer a hedge against inflation have been quick to stress the virtues of their own holdings.
Gold has traditionally been extolled by its holders as the ultimate inflation hedge and its recent weakness against a backdrop of rising consumer and producer prices has not diminished this enthusiasm.
Evidence of inflation in key measures across major economies is now irrefutable and the focus is shifting to hedging against the effect of price rises
Bitcoin is also touted as an inflation hedge, with a growing number of market veterans joining cryptocurrency specialists in talking up its virtues. Billionaire fund manager Paul Tudor Jones appeared on CNBC in late October to cement his status as an elder statesman to the crypto bros.
First, he warned about the dangers of inflation.
“It is probably the single biggest threat to – certainly financial markets – and probably I think to society in general,” Jones said.
“Crypto would be a great inflation hedge,” he added. “Clearly it’s winning the race against gold at the moment.”
Inflation angst
Other veteran fund managers and market historians may be able to cast their minds all the way back to the last great inflation scare – eight months ago in March 2021.
The 10-year US Treasury yield pushed above 1.70% and the 30-year rose above 2.5% on concern that the Federal Reserve was proving indifferent to signs of inflationary pressure.
Bitcoin didn’t work very well as a hedge to that particular bout of inflation angst, as the temporary rise in benchmark debt yields coincided with a series of downward lurches for the cryptocurrency from a historical high of over $60,000 to troughs that were roughly 50% lower in the following months.
By late October bitcoin had tested new highs of almost $67,000, however, so it may turn out to be a hedge against a new age of inflation after all.
Market participants are certainly willing to propose the thesis that virtually any asset they favour can perform strongly when core prices are rising.
Russ Koesterich, a senior portfolio manager at BlackRock, joined Jones in pointing out that gold has not worked as a counterbalance to rising inflation indicators recently, although he proposed a different solution.
“The better hedge is focusing on equities with pricing power that can keep up with sticky inflation,” Koesterich argued.
It doesn’t help that the liquid bond markets that should be reflecting the likely impact of higher inflation in future rate rises are now sending mixed signals.
Banks should be able to manage the impact of rising rates that are designed to combat inflation. But what about their most important clients?
The US five-year breakeven inflation rate – as calculated by the Federal Reserve by comparing benchmark Treasury yields with inflation-linked bonds – hit 3% in late October.
That was a new high for the rate in its two decades of calculation and also hit the ceiling for the Federal Reserve’s own target for inflation, which seemed to indicate a strong market conviction about persistent inflationary pressure in the coming years.
The most liquid rates markets – across multiple currencies – are not convinced about the secondary effect of likely anti-inflationary moves in the form of policy hikes, however.
The Bank of England indicated that it is likely to be the first major central bank to implement a hike in its policy rate when governor Andrew Bailey said that “we will have to act” to counter inflationary pressure.
His remark in an online panel discussion on October 17 predictably pushed up gilt yields, but concern soon mounted that that the central bank might choke off UK growth with premature hikes.
This fear was reflected in an inversion in the sterling curve, with longer dated forward rates falling below those for shorter forward indicators for the first time since the global financial crisis of 2008.
The Federal Reserve is sticking to its script that a prolonged period of tapering of asset purchases will precede any formal rate hikes, but by late October, curve flattening, although not outright inversion, was seen in the dollar interest rate markets.
Confusing outlook
This confusing outlook isn’t helping executives in sectors that are exposed to interest rates to convince investors that they are effectively inflation proof, though that hasn’t stopped them from trying.
Barclays now ex-chief executive Jes Staley has always been a glass-half-full kind of guy and he retained his customary optimism when discussing the potential impact of higher rates on his bank’s quarterly earnings call on October 21.
“Generally speaking, higher rates are positive in both wholesale and consumer business,” Staley said, adding that wider bid/offer spreads and higher volatility could be beneficial for fixed income trading revenues.
Barclays finance director Tushar Morzaria added that the bank’s structural hedge of interest rate derivatives is also positioned to benefit from a rising rate environment, although that benefit could be reduced if the sterling curve fails to steepen as anticipated.
Banks should accordingly be able to manage the impact of rising rates that are designed to combat inflation. But what about their most important clients?
In the same week that Staley gave his bank a clean bill of health on exposure to higher rates, Blackstone president Jon Gray remarked that his firm is advising its private equity portfolio companies on how to cope with inflationary pressures.
Blackstone is currently the biggest alternative asset manager in the world, with $731 billion under management at the end of September and a goal of hitting $1 trillion in the coming years.
Its size and diversity should help to protect Blackstone from the impact of inflation, but the same may not be the case for smaller alternative asset managers with more concentrated portfolios. Two UK supermarkets that are being sold in leveraged buyouts show the risks that could emerge.
Asda and Morrisons both face serious problems in managing the impact of inflation on their core businesses from supply chain-linked increases, higher wage demands and the threat that bigger retailers will attempt to win market share by declining to pass on their own cost increases to consumers.
The two firms will also face this inflationary challenge with enormous debt burdens from their recently agreed private equity-backed buyouts and the potential to face significantly increased refinancing costs if interest rates are higher when they need more money.
Rating agency Moody’s warned in late October that the private credit market for lending to buyout groups poses a systemic threat, in part because it can make the associated leverage in the market difficult to quantify.
There are plenty of reasons to worry about the impact of inflation on companies and their owners that conducted buyouts with bank loans and publicly rated debt, and at leverage ratios that are widely known.
The potential for the private credit market – which is now valued at around $1 trillion – to throw up further unwelcome surprises due to the knock-on effects of inflation is obvious.
