Rates Inflation and Tapering

Vivek Paul, UK Chief Investment Strategist, BlackRock Investment Institute, Ben Edwards, Lead Portfolio Manager, Corporate Bond Fund & Co-Lead Sterling Strategic Bond Fund, BlackRock, Felicity Percy, Head of European Fundamental Fixed Income Strategy, BlackRock

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Monetary policy has not been exempt from the effects of the pandemic. Policy makers have pushed the limits as businesses were deliberately shut down. Extrapolating from rebounding GDP is not a reliable indication for UK investors on where next for inflation, interest rates, tapering and fixed income markets.

The policy revolution may lead to markets mis-reading data signals

This is not a typical business cycle recovery, and policy moves have been nothing short of revolutionary of late. Markets could be over-extrapolating recent data, believing that UK rate tightening is on the horizon, even though UK GDP growth may have peaked in the second quarter. The economy remains 4.5% smaller than before the lockdown began; the US has more than fully recovered.1

Both economies share some characteristics, however. Household savings have risen, labour shortages and inflation are up too. The UK Consumer Price Index (CPI) is heading for 4%, but the short-term trajectory is only half the story. More importantly, both the US and UK could see inflation of 2–3% over a medium-term, five-year view, not the 1–2% we are accustomed to.2

Central banks are not the only ones to have loosened the purse strings. Furlough and other support programmes have quadrupled government spending, leading to an unprecedented rise in government debt. As debt rises, so do repayment costs, making them more sensitive to rate tightening and adding a political dimension to monetary policy. That’s partly why the Federal Reserve (Fed) explicitly moved its inflation targeting framework to allow for inflation overshoots. The Bank of England (BoE) has also indicated its willingness to be flexible, by reducing the point at which it will stop reinvesting bonds from a rather distant 1.5% to 0.5%. We think that reinvestment could continue to 2025 on the current trajectory.3

In all, cash rates will stay lower for longer, hence BlackRock’s asset preference for equities at this time.

Must watch fiscal policy for clues of what happens next

The Covid-19 recession has also shown that monetary policy cannot lift demand alone. Quantitative easing trickledown has been replaced by targeted fiscal policy, which has worked much better, faster. Monetary policy has become a mere funding tool for politicians everywhere who have discovered that if they do not spend, someone else will replace them and promise to do so. The Fed and other central banks will have to follow the spending narrative, supporting fuller employment and social aims.

The Fed will most likely lead, with the European Central Bank the perennial laggard. The BoE will sit between the two, depending on the economic data.

Volatile supply and demand is creating tail risks for inflation

Lumber, aluminum, computer chips and shipping are suffering shortages and sharp moves in pricing. Wages are under pressure, and housing and renting costs are responding.

Some elements may be dismissed as transitory blips with very specific causes. But what if they collectively become more challenging?

If true, we might not be facing a higher, but benign, inflation outlook. Instead, there is a real risk of an inflation breakout and a tail risk for all assets and all investors. That is why BlackRock has been defensive in credit, with shorter duration across our portfolios. Institutional portfolios are close to their indices and retail are underweight.

Structural demand is strong, but investors need to be nimble

Chief executives tend to focus more on their shareholders, not their debt holders. The recent past has been different, with cost-cutting and dividends deferred to focus on balance sheets. Credit quality is improving and the list of firms on credit watches is shrinking. Banks, insurers and utilities remain quality holdings. Airlines, airports and hospitality face more issues.

Structural demand for fixed income remains very strong, despite low yields.  Long-term investors will retain or add to their core allocations but, like BlackRock, need to be nimble on allocations around turning-points in the cycle.

There is also increasing demand for ESG opportunities and a huge increase in supply of green, social and sustainability linked bonds.  The UK’s sovereign green bond will be eagerly awaited. ESG or not, issuer quality remains the priority.

1 Source: IMF, policy responses to Covid-19, July 2021
2 Source: ONS, August 2021
3 Source: BoE, 2021