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Hedge Clippings | Friday, 18 June 2021
Last week's Hedge Clippings warned that while the economy was going "gangbusters", sooner or later there would be an uptick in inflation, and actual (or expectations of) inflation would then create upward pressure on interest rates.
On cue, the US Federal Reserve this weeks signalled that it has adjusted its outlook for inflation, hinting that it expects to increase interest rates by the end of 2023 as the post COVID economy gathers pace, and not 2024 as per their previous thinking.
While not everyone agrees that the inflationary pressures will be permanent, equity markets will certainly take notice. Whether this is a bad thing or not depends on one's point of view: Markets have also been going gangbusters over the past year or so, and in fact, apart from the short sharp dip as COVID hit, have been on a QE/cheap money binge for almost a decade.
Whilst nobody likes to see equity markets retreat into bear market territory, sometimes a correction or two along the way prevents things getting overheated, and overheated markets tend to create greater problems in due course. Just remember 1987, or the lead up to the GFC, when on both occasions the market "corrected" by about 50%.
We are not of the view that inflation will become rampant, as given the levels of household and corporate debt even a small increase in interest rates will have a significant impact on the economy. Interest rate moves rarely - if ever - occur in isolation, so even two rate increases of 0.25% will, relatively speaking, be significant from current levels.
And 2023 - if that's how long it takes - is still a long way off, but there's no doubting the Fed has raised the starter's flag. Of interest will be the minutes of this week's meeting, due to be released on July 7, followed by the next meeting of the FOMC due in November.
Markets are forward looking, and will deal with any signals from the Fed as they normally do. We suspect most active fund managers are keeping a close eye on their risk levels as a result. Passive funds - and therefore their investors - don't have the same flexibility, and they will rise and fall in line with the market. Given the weight of money that has flooded into index and passive funds over the past 5 years or more, the risk is that paradoxically markets will be more volatile than they might normally be.
Whatever "normal" is.
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