Last week’s personal consumption expenditure index (PCE) – a key measure of inflation that the Federal Reserve places great emphasis on growing 3.1% – the highest reading in thirty years. Readers might wonder if such an obscure measure is important to their lives, but it is arguably one of the most important indicators for financial markets in recent months, and perhaps sets the tone for the rest of the year. the year.
The high PCE reading, following many other high data points, and specific trends in inflation – from house prices to wood prices to used car prices – indicate a resurgence of the inflation – not simply as a post-COVID rebound phenomenon that is driven by an explosion in consumer spending and complicated by base effects – but rather as a new trend. If so, it will be a very important driver of financial markets, real estate and private assets, in large part because investors have not had to deal with inflation for decades.
There is some comfort in the fact that bond yields barely budged when the PCE was released and the stock markets (i.e. SPX) pushed to new highs, suggesting that markets are already digesting the history of inflation. Their courage, however, can be tested by two related risks.
The first is that we are on the cusp of an average trend, a sustained rise in prices, of which the already very tight labor markets are an important component. Another is that, consistent with how they have underestimated inflation over the past decade, the world’s major central banks are lagging behind the inflation curve, leading to high volatility in the bond market first, then a rise in interest rates.
In particular, emerging inflation will challenge many investment funds, sovereign wealth funds and especially family offices. Family offices, unlike larger funds, may have less ability to question new tectonic trends in economies and to frame the financial response to them. Additionally, the asset allocation of many family offices tends to be more rigid – in terms of reflecting the family’s underlying business and the CIO’s journey.
Family Offices are on display
Many family offices, struggling with issues such as succession and wealth planning, may take a longer-term view of investments and, in this regard, need an intellectual buy on the mid-term trend of l ‘inflation.
In this case, war games or scenario planning can come in handy. On the inflation front, there could be three scenarios.
Scenarios for an inflationary world
‘Status quo’ – after a brief “peak-induced rebound”, inflation fell back to the 2% rate with which central banks and the markets were content. In this case, investors would not face a major disruption, but rather continue to juggle very expensive stock valuations with expensive bonds.
‘Bornw reeparture ‘ in this scenario, prices continue to rise and workers demand higher wages. Both earnings and valuations are undervalued, and the Fed’s early failure to respond is wreaking havoc with currencies. Gold and soft commodities are on the rise, with the sad consequence that emerging economies are hit hard by rising food prices, causing unrest. Private assets – real estate, especially private equity and private credit, are now severely affected by the reassessment of credit risk.
‘Hyper“- in this scenario, there is a sustained rise in inflation, which proves to be self-sustaining as investors aggressively buy commodities, oil and other inflation hedges while emptying bonds and stocks. Real estate is suffering severely from the rate hike by central banks.
Of the three scenarios, the middle one is perhaps the most likely in that the markets are not yet positioned for disruptive inflation at a strategic level. Beyond short-term hedges and the liquid market, there are bigger questions to ask – apparently by family offices and smaller asset managers – about more strategic assets. Does higher inflation mean we’re at the peak of the residential and commercial real estate and private equity cycle – where valuations are rich and debt levels high.
If not, is this the time to move on to purchasing strategic assets such as brands that have pricing power or are “value games”, and potentially take a closer look at farmland.
With markets so far relatively calm in the face of rising prices, it’s time to think about the long-term inflation outlook, but not much.