Francis Scotland
Brandywine Global, part of Franklin Templeton, presents a more optimistic view on inflation in its latest macroeconomic update.
Francis A. Scotland, Director of Global Macro Research at Brandywine Global says “The financial and monetary variables point to a positive direction. Inflation is the final piece in a falling line of dominoes. What went up in 2020 and 2021—cryptocurrency, commodities, real estate, economic growth, and inflation—have retreated in perfect sequence starting late 2021 and early 2022. Now it is inflation’s turn.
“We believe keeping conditions tight until inflation has receded to target is a strategy for overshooting the objective and moving straight to deflation. A lot of lip service—but perhaps not enough credence—is given to the notion of policy lags. What the Fed implements today affects the economy months or years later. The retreat in inflation seen since June of last year has little to do with Fed policy, in our view. The reaction to what the Fed has done or is going to do is yet to come.”
He says the world is out of sync on many other issues.
“The Fed wants things to slow; China’s leaders want things to pick up; the European Central Bank’s (ECB’s) monetary vise already has the economy in a technical recession, but it must do more because of stubbornly higher inflation; and in select emerging countries policy is even more stringent than in the U.S., judging by yield curves.
“This divergence explains why global growth is uneven and argues for much reduced inflation. China’s reopening has fizzled due to feeble domestic consumption. Nothing could be more crystal clear about the state of domestic demand in China than its inflation data.
“According to the latest data from China’s National Bureau of Statistics, core CPI is close to zero, producer prices are falling, and China is exporting its deflation to the rest of the world. Efforts to reflate the system with public policy are compromised by a number of factors. China’s augmented budget deficit is probably already over 10%, based off an April 2022 report by the Institute of International Finance. The authorities do not want to boost leverage, nor do they want to fire up property speculation.
“However, the priorities of President Xi Jinping are the biggest impediments to rebooting China. Under his leadership, anti-corruption, national security, oversight of private companies, property speculation, and the stability of the Chinese Communist Party have taken priority over economic growth. President Xi did a U-turn on COVID containment late last year and elevated growth as a priority in the wake of public protests. But the follow-through has been tepid.
“ECB rate hikes have already led to a technical recession, but it seems likely to worsen because of the economic zone’s stubbornly high inflation rate. Europe’s monetary profile is horrible, in my view; banks are not lending—annual growth in lending to both households and businesses dropped close to zero in April, according to the ECB.
“Bank lending is much more important in Europe than the U.S. and accounts for the majority of financial intermediation. The poor lending data rhymes with the June production manager surveys, showing a generalised contraction in European manufacturing. Meanwhile, the non-manufacturing survey is barely holding above 50. One reason for the stubborn nature of inflation is fiscal policy. Roughly 800 billion euros in fiscal support have been provided to EU business and households to help offset energy costs,” says Scotland.
In this scenario, we are bullish bonds across our portfolios through investments in Treasury bonds, mortgage-backed securities (MBS) bonds, and select emerging market bonds, adds Scotland.
He says “The biggest pricing anomaly in the fixed income markets is the U.S. yield curve, more extremely negative than at any time in modern history except for the early 1980s. Yield curves in some emerging countries are even more inverted. We believe the risk/reward profile warrants long duration positioning. Everything mentioned earlier points to a bull steepener in the yield curve.
“A Fed-provoked recession could trigger a bond rally; our base case of falling inflation and a mild economic downturn would also support the bond market but with less upside.
“There is some near-term risk to the upside in yields if the Fed continues to raise rates and nominal GDP growth remains strong a while longer. However, history shows GDP itself is a poor early warning indicator of a sudden drop-off in activity, the data generally remaining firm right up to the moment it weakens.
“On the currency front, I believe the U.S. dollar is overvalued based on most metrics but not in the extreme. In addition, tight monetary policy and expansionary fiscal policy is typically constructive for a currency, which is the current policy backdrop in the U.S. Consequently, our foreign currency allocations out of dollars are on a selective bilateral case-by-case basis. Companies have not been complaining about the strength of the dollar despite wider current account and trade deficits. Similarly, the dollar has not responded much to Treasury Secretary Yellen’s admission that Americans should expect a decline in the greenback as the world’s reserve currency as China, Russia, and some other prominent countries look for ways to dethrone it and escape potential U.S. sanctions.
“The reality is that no other major economy has the depth of capital markets, the institutional infrastructure, and the laws that could replace dollar hegemony for now. It is hard to picture what will provoke a meaningful retreat in the dollar this year given the Fed’s determination to restore low inflation, not to mention the darkening outlook in Europe.
“Expectations that the euro could rally because the Wagner rebellion in Russia might hasten an end to the war seem a bit optimistic given that Putin has no history of retreat, only escalation. The threat of confrontation with NATO in the event of Russia using nuclear weapons or blowing up the Zaporizhzhia nuclear power plant suggests that there are tail risks at least in both directions.
“Nor does China’s desire to support its economy seem overly bullish for the renminbi or, therefore, overly bearish for the dollar. Longer-term U.S. fiscal degradation could lead to massive tax increases, which would be very negative for the currency. The only positive in that equation is that most of the Western world is in the same boat,” says Scotland.
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