Divergences and Pivots

by Erik L. Knutzen, CFA, CAIA, Chief Investment Officer—Multi-Asset Class, Managing Director, Neuberger Berman

The exuberant response to last Thursday’s inflation data suggests markets are primed for the “pivot”—but could they be extrapolating too far?

This week sees the release of Solving for 2023, our annual look ahead at the themes we believe will be prominent in the markets next year.

Our opening theme conveys three ideas. The first is that we think the next 12 months are likely to see peaks in inflation, policy tightening, bond yields and market volatility; and troughs in GDP growth, earnings growth and market valuations.

We are in a landscape of divergences and potential pivots. How far can inflation (and the response from central banks) diverge from economic growth? How much must inflation decline before monetary policymakers pivot, which in turn lays the groundwork for risk appetite and growth to pivot?

The exuberant response to last Thursday’s cooler-than-expected U.S. headline and core inflation data suggests that markets are primed for these potential pivots. They jump on any sign of them, and appear anxious to price for substantial re-convergence.

Back to the “Old Normal”

But that brings us to our second idea. We don’t see the pendulum swinging back to the post-2008 “new normal.” We anticipate more of a pre-2008 or even pre-2000 “old normal,” characterized by diminished globalization, with inflation, rates and the cost of capital structurally higher and asset valuations structurally lower.

That means we believe markets may be extrapolating too much from last week’s inflation data, discounting the possibility that inflation gets stuck in the 3 – 4% range for an extended time.

More broadly, it leads straight into our third idea. Because inflation and rates have adjusted upward quickly in 2022, and because there is still so much anticipation that a pivot will happen soon and see us re-converge on the post-2008 norms, we believe the impact of higher inflation and higher rates is only just beginning.

Disconnect

For example, take another divergence that appears ripe for a pivot: Japan’s monetary policy disconnect from most of the rest of the world.

The Bank of Japan is not only holding fast to negative short-term interest rates, it is also still purchasing long-dated government bonds as part of its policy of “yield-curve control.” As a result, the yen has sunk to a 30-year low. Central bank policymakers have expressed concern about a “big overshoot of inflation,” which is already close to a 30-year high. Moreover, they are literally running out of bonds to buy at the three points on the yield curve that they target.

Nonetheless, should last Thursday’s U.S. inflation print allow the Federal Reserve to pivot first, perhaps the Bank of Japan won’t need to pivot after all.

Our view on U.S. inflation makes us less hopeful. While the timing is difficult to pin down, we do think the Bank of Japan will need to pivot and, like the policymakers themselves, we do think it could be disruptive.

Anticipation

Japan’s monetary policy may be sustainable only in a swing back to the post-2008 “new normal.” And we think that goes for quite a lot of governments, companies and individuals that have gotten used to near-zero rates over the course of a decade.

The capacity to absorb structurally higher rates is likely to be key over the next year or two. The exposure of companies to higher costs and their ability to pass them on is likely to feed into wide dispersion in margins and stock price performance. And despite the volatility we’ve already seen in 2022, the underlying fragility of markets in these new conditions may still be hidden.

This is why we believe investors would do well to approach next year with caution and—as we describe in the last of our 10 Solving for 2023 themes—an eye for tactical opportunities. We think the volatility generated by pivots can continue to offer a favorable backdrop to global macro and other trading-oriented strategies. It could create value opportunities in assets that we favor for the long term, such as inflation-sensitive assets, private companies, and high-quality equities and corporate credit. And as higher rates work through the system, we anticipate increasing opportunities to provide capital solutions at attractive or even stressed yields as debt structures are reworked.

If 2022 is considered to be the year when inflation and interest rates adjusted to the new reality, 2023 is likely to be the year when we all have to adjust to that adjustment.