Putin, inflation, rate hikes: How to weather the volatility ahead

Charlie Jamieson

Jamieson Coote Bonds

We cautioned investors that 2022 would likely see the removal of three key policy accommodations which would likely occur over the year. This would include Quantitative Easing programs being wound down, Central Banks adjusting monetary policy to higher interest rates and significantly lower fiscal government spending within the economy. Our view was this would lift volatilities and cause headwinds for financial markets as the year progressed. Sadly, the addition of a Russia/Ukrainian conflict has turbo charged volatilities and tightened financial conditions considerably, as energy prices have skyrocketed combined with many asset classes experiencing falls in value.

The conflict is absolutely harrowing to watch for humanity. Putin’s invasion of Ukraine presents markets with ongoing uncertainty and challenges Central Bankers to tighten monetary policy into an energy crisis. Consumers are now facing significantly higher prices due to rising energy costs which will likely be combined with higher debt servicing costs, and this should cool discretionary spending over the year. As energy is highly inelastic, the immediate impact for the economy is profound.

We believe that such developments can slow the pathway of rates hikes from Central Bankers, as growth will likely fall much faster due to higher energy and commodity costs. Our forecasts show the RBA should begin hiking rates at its August Board meeting, increasing the cash rate from 0.10% to 0.25%. Additional rate hikes in the calendar year will continue as the RBA’s requirements of full employment, 2-3% sustained inflation and 3% wages, are getting close to being met. This should leave the RBA cash rate between 0.75% and 1.00% by Christmas, pushing mortgage costs higher. Watch the video to hear more.


Transcript

Hi, I'm Charlie Jamieson, Chief Investment Officer at Jamieson Coote Bonds, and this is a review of markets in February, 2022. Well, we'd caution investors over the earlier part of the year that huge policy change across 2022 would generate a lot of headwinds, but the developments, very sadly, in the Russia-Ukraine conflict add a huge amount of volatility and uncertainty to the outlook. Clearly there's been a substantial energy shock as a result of this, we need to wait and see where the energy will finally find its new levels, it's still rallying at the moment. And there's a huge shock potentially for other industries, Ukraine is a huge food provider for the European people and other markets, and a huge natural resources provider, particularly for things like semiconductors, which is really important in the inflationary story through the medium and longer term.

Prior to this conflict we'd been looking for inflation to start to moderate, driven by a moderation in things like used car prices. So used car prices is the highest component of the US inflation data at the moment, and they went flat in January, and they were actually negative 2% in February. And that makes sense, they've had a huge run, they were up nearly 40% last year, and a really big push into that inflation outcome. And so that moderation is an encouraging development prior to the Russia-Ukraine conflict outbreak. We don't know where this will all land, obviously the raw materials for things like semiconductors, which caused that blockage in new car production and hence pushed a lot of people into used cars, and obviously the pandemic pushed people into commuting in a car rather than sitting shoulder to shoulder on public transport, where that will land for this type of complex.

But the energy inflation is the major story, and it's certainly much higher in the short run, and that will have a dampening effect on demand the longer it stays up there. 

Now this complicates things for central banks tremendously because we have a situation where because of these higher energy prices, it's clearly quite restrictive on growth in the medium term, but they've still got this inflation problem, and it's not going to go away now because of these short term moves in the commodities complex.

We do think that the central bankers will move a little slower than markets are estimating. Certainly here domestically, we got our wages data that we were waiting for in February, which we think will mean that RBA are not in the markets, risk raising interest rates until August, which has been our base case prediction. We've been following a sequence for central bank rate hikes, and it's been running through New Zealand, the Bank of England, the Bank of Canada, which finally raised interest rates, the Federal Reserve, which will surely raise interest rates at their March meeting, and then moving on to Australia and potentially the ECB. I think we can park the ECB for now, clearly European assets are under a lot of sufferance at the moment as a result of this conflict. The conflict just isn't that far away, Kiev is a two hour flight from London, and I know sitting here in Melbourne, if there was that kind of conflict in Brisbane I'd be feeling pretty nervous as a European citizen, not that the English are European anymore.

But we've got to expect that this conflict goes on for quite some time, it feels to us like Putin is very motivated to do a lot of damage to the infrastructure of the Ukraine, to sadly push a lot of people into refugee status. We can only hope that there's a resolution to this, but if there is a resolution to this we're right back into thinking about inflation and the normalisation of policy, which we've spoken about over the earlier part of this year. We've also got to consider though that the conflict could sweep in some NATO countries, or the US, and become a much bigger conflict, and that's really terrifying as a global citizen, and let's all hope that we can find that resolution and restore some peace in stability.

But for now, volatilities are going to remain very high. The bond markets had actually had a poor month in February, again, adjusting for what has been this incredible expectation of central bank rate hikes. 

We think that's going to be very hard to achieve if the economies are already slowing, the rise in energy prices is as a material taxation really, it's a very inelastic part of the economy, but it does take money out of consumers pockets, and it will change discretionary spending. 

But clearly it can have that initial burst of inflationary impact, which means that we won't moderate in the inflation construct as we had expected with the base effect that will occur from April onwards.

So there's a lot to monitor here, we still see a lot of headwinds, sadly, for assets across 2022. Thankfully, for many Australian assets, via their huge exposures to commodities and the like, are doing much, much better than many other foreign markets when we look across, say, the equities complex, and that's a good news story, Australia should be well insulated from all of this, but I don't think that it changes the RBA's expectation to move a lot faster. We know that they do follow the movement of other central banks, and they've been very, very consistent in their messaging that they want to go slow and they will be at the back of the pack, and there's nothing to suggest that they're going to leapfrog forward to us in this moment as we see things currently. So our expectation remains that the RBA will start hiking in August of this year and get to somewhere between 75 and 100 basis points as a cash rate, so say 1% cash rate by Christmas, assuming there's not a large escalation in this conflict.

The bond markets, though, are priced for an awful lot more, so we feel that there is actually reasonable value in the bond markets, not withstanding their recent under performance, but it's very difficult to see with already moderating house prices in inner Melbourne and inner Sydney, rate hikes are only going to add to that velocity, and certainly the psychology starts to change when sellers are now realising that they might not have as big a window as they'd otherwise expected, and buyers are becoming a little bit more cautious and stepping back, and just that change from the bid offer of the whole marketplace can change pricing quite considerably, and there's already been some articles suggesting that in those inner city regions, which really do lead a lot of the time, there's already been some substantial price falls, to the magnitude of 3 to 5%, which is a big change from the trend that we'd otherwise experienced.

We've got to believe with higher mortgage fixings, and remember a lot of those mortgages roll off sweetener fixing terms, the one something mortgage, or the 2% something, incredibly low interest rates that roll forward in '23 and '24, which will naturally tighten the economy quite substantially. 

So we see 2022 as the window where the RBA do need to get going if they want to normalise policy and take back a little of that extraordinary emergency accommodation that was provided in that COVID period of early 2020. And we've got no reason to expect that shouldn't occur, ex some horrible outcome with regard to this conflict overseas. But there is an awful lot price, the markets are expecting that the RBA can go well, well, beyond that. We, when we join the dots through the economy, just think that there would be too much damage and it wouldn't be an easy thing to deliver on, and so we've got to believe that in the second and third derivative things interact with those changes, and it's very unlikely that we can make it all of that way.

That's probably not that dissimilar to our updated view is after this conflict of where other global central banks will be. Historically we've had rate hiking cycles in the US that have either been 75 to 100 basis points and then that's the end of the cycle before we're looking to cut rates again and provide accommodation, or they go a lot further and they have something like 300 to 500 basis points. Now I think we can all agree, given the debt levels that have been created and the leverage that's in the system, it's very unlikely that we're going to be able to raise rates 3% to 5% without causing an awful lot of damage for funding rates, for discount rates, for mortgage rates for those folks that have borrowed a lot of money to buy expensive assets. There would be a disinflationary selloff, or a deflationary selloff, as a result of the credit problems that would bring to the market.

So we think that's a lot lower, and certainly this energy complex is tightening financial conditions considerably. It means the central banks have probably got less to do, they're going to use the conflict and the uncertainty of as a buffer to hope that inflation finds its feet. At the moment clearly commodity prices are racing forward, but they will find their new levels soon enough. I think with Russian oil taken out of the global market it's about a 12% reduction in supply, but it is very inelastic. So prices have got to go up high enough to destroy demand, or to change behaviours, and that will certainly happen over the course of the next few months.

With a lot of uncertainty ahead I guess the major thing, which we always suggest, is that diversification has got to be a great strategy. 

There's so much uncertainty, I think anyone that tells you they know exactly the way that this is all going to land should be avoided at all costs. There's just so much going on in this macro space at the moment, and a lot of it is very, very difficult to have any kind of absolute on. So we've got to be cautious with our own portfolios, and we would encourage you to be cautious with your own as well. Thank you very much.

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Charlie Jamieson
Chief Investment Officer
Jamieson Coote Bonds

Charles is a co-founder of Jamieson Coote Bonds (JCB) and oversees portfolio management of the Australian and Global High Grade Bond and Dynamic Alpha investment strategies. Prior to JCB, Charles forged a career as a seasoned bond investor from...

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