Geopolitical tensions and policy uncertainty are contributing to a murky economic outlook around supply chain disruptions—and their possible impact on inflation.

 

Today we’ll examine the monetary policy landscape and the potential role of fixed income in portfolio positioning.

 

Declining inflation trends have been established across much of the global economy, with tighter monetary policy proving effective in managing inflation. Inflation measured by the U.S. Consumer Price Index (CPI) has fallen 6% since its June 2022 peak. RBC Economics expects this trend to continue, and forecasts the headline inflation rate falling to 2.3 % and Core CPI inflation (which excludes food and energy) declining to 2.5 % by the Q4 2024.

 

However, the hotter-than-expected January U.S. inflation data reported this week underscore risks that inflation could remain above the Federal Reserve’s 2 % target for a prolonged period. CPI rose 3.1 % year-over-year in January, ahead of the 2.9 % year-over-year consensus forecast, while the Core CPI increased 3.9 % year-over-year and has barely budged since October.

 

Financial markets responded to the data with volatility; equities fell, and bond yields rose to a lesser degree, highlighting that inflation risks and their consequences still merit close observation.

 

These inflation risks should be incorporated into a broader investment strategy - specifically opportunities in global debt markets. Although global supply chain disruptions can be seen as a fairly benign, rising geopolitical tensions warrant attention given their potential to produce supply disruptions and a sustained decline in global manufacturing activity. While the challenges facing global shipping today are different than the logistical backlogs associated with the COVID-19 crisis, the resurgence of geopolitical pressures in the Middle East has forced many vessels to avoid the Red Sea and Suez Canal passage.

 

The result has been a meaningful rise in global commercial shipping costs. These regional tensions also raise the potential for elevated energy prices as market participants grow concerned over the insecurity of future supply.

 

On the production side, elevated input costs and sluggish goods demand have induced a contraction in manufacturing activity throughout the global economy. This contraction has been aggravated by a broad and protracted slowdown in China’s manufacturing sector, which supplies a sizeable portion of global goods. Due to the integrated nature of Sino-European industrials, similar trends have materialized in Europe’s manufacturing sector. Labour shortages in certain service-oriented portions of the U.S. economy have also aggravated service sector capacity issues.

 

If goods and services are short in supply and logistical challenges worsen, consumer prices may rise, particularly if demand conditions evolve. Robust consumer demand conditions—especially in the U.S.—pose inflationary risks at this point of the business cycle and may push central banks to stay hawkish, in our view. The buildup of excess savings, sturdy wage growth, and a healthy labour market in developed countries have strengthened household balance sheets.

 

This points to a continuation of strong consumption levels and could give goods and services providers leeway to raise prices without materially suppressing demand.

 

Higher corporate pricing power can prove inflationary, but a high degree of concentrated demand can also create imbalances. This was shown following the COVID-19 crisis when household spending shifted from goods to services.

 

The premature loosening of monetary policy and a longer-term rise in trade protectionism are key risks to declining inflation trends.

 

Central banks in developed economies have remained committed to achieving their objectives with policymakers generally acknowledging these risks, as evidenced by their recent pushback against markets’ dovish rate cut expectations. However, there is a risk that policymakers may prematurely stimulate the economy with interest rate cuts before inflation is anchored at target levels.

 

• Even in a well-intentioned bid to avoid recession, stimulative policy that is executed too swiftly, or incorrectly, could reignite excess demand and fuel inflation.

 

• Wars in Ukraine and the Middle East, as well as heightened Sino-American tensions in a busy election year, have increased policy uncertainty and further accelerated the shift towards more fragmented trade relations.

 

• Tariffs on imports—which are essentially tax levies—and general trade protectionism risk dissolving the cost-saving effects of global trade and driving prices higher.

 

Fixed income valuations have undergone a larger adjustment than equity valuations and provide a return profile that is compelling, irrespective of the inflation outcome. More specifically, opportunities arise in developed-market government bonds given their low risk profile and competitive returns relative to corporate credit.

 

If inflation rises or remains above target, current elevated yield-to-maturity levels provide shock-absorption potential for portfolios in the event that yields rise in response to new inflation premiums.

 

One way to illustrate this capacity to absorb higher inflation is through a ratio known as yield to duration. This ratio represents the upward change in yields (or, conversely, the downward movement in bond prices) required over the next 12 months for a bond index to generate a forward 12-month return of 0.0 %. This allows investors to appropriately assess the potential downside that could be realized if bond yields rise.

 

In March 2022, U.S. investment-grade debt markets only had 20 to 30 basis points (bps) of shock absorption. Today, as a result of higher interest rates, inflation, and shifting term premiums, investment-grade debt markets have developed a buffer of roughly 85 to 100 bps.

 

Higher starting yields in fixed income create an opportunity to prepare portfolios for a wide range of potential economic outcomes. Robust shock absorption, elevated yields, and an improving quality of aggregate global debt markets continue to provide some sanctuary from inflationary risks in portfolios.

 

As always, please let me know if you have any questions or comments.