The Fed could cause long-held investor assumptions to reverse

If the Federal Reserve must jam down hard on the monetary brakes because of persistent upside surprises in inflation, there may well be a significant correction in bond and equity markets, challenging multi-asset investors.

According GSFM investment strategist’s, Stephen Miller, such a scenario would challenge multi-asset investors, potentially reversing long-held assumptions regarding asset return correlation.

“That is, equity returns and bond returns become positively correlated in the worst possible way - in extremis, both deliver negative returns,” said Miller.

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“Clearly the search for differentiated portfolio exposures uncorrelated with conventional equity or bond beta looms as a particular challenge.

At the ECB virtual Sintra Conference earlier this week, Federal Reserve chair Jerome Powell told central bank chiefs that the “current inflation spike is really a consequence of supply constraints meeting very strong demand, and that is all associated with the reopening of the economy” and while “it’s very difficult to say how big the effects will be in the meantime, or how long they will last, but we do expect that we’ll get back, we’ll get through that”.

However, according to Miller, the Fed had consistently underestimated inflation through this year. Last week the median projection of the Fed’s preferred core personal consumption expenditure (PCE) measure of inflation was upwardly revised again for 2021 to 3.7% (from 3.0% in June and 2.2% in March).

“Nevertheless, bond markets appear accepting (although somewhat guardedly in recent times) of the ‘transitory’ inflation narrative,” said Miller.

If investors wanted to be defensive, Miller said inflation-linked bonds or absolute return/‘unconstrained’ bond funds were worth some consideration.

“Gold or precious metals in general may also be a candidate even if gold’s traditional role as an inflation hedge is undermined somewhat by rising bond yields increasing the opportunity cost of holding gold,” said Miller.

“Commodity baskets, which are accessible to investors in exchange traded funds (ETF) form, are another candidate, particularly if inflation is to be more persistent due to supply bottlenecks and even if individual commodity returns can sometimes be highly volatile.

“Measured foreign currency exposures can also be useful. Higher US bond yields seem to have supported a higher USD of late, although it is very early days yet.

“The RBA lagging the global normalisation of policy rates may put downward pressure on the AUD, although stronger global activity growth and higher commodity prices might offset that.

“Certain defensive equity exposures can also play a role (the future fund has in the past cited consumer staples as a good defensive type asset).”

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