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The Federal Reserve

Wealth Insights | Bonds

The Fed’s Emergency Room

There is no doubt that high inflation is a serious problem. It weakens real consumer spending, production and employment. But more insidious, the uncertainty and volatility it generates can weaken long-term investment and “feed on itself” with greater wage and business costs, slowing trend economic growth. At present, the US CPI is running at 8.6% with the Fed’s preferred measure, the Personal Consumption Expenditures Deflator, also running high at 6.3%. Unlike the CPI, which changes very slowly in composition, the PCE deflator measures prices of what consumers buy in a flexible basket.

But when looking at the source of inflation, one must assess whether it is internal or environmental. Several major elements of today’s inflation are external: food and energy supplies disrupted by the war in Ukraine are generating upward price pressures and human suffering for those with the least secure household budgets.

  • Transportation and logistics seem to be the larger part of the shock rather than actual output losses in both Russia and Ukraine. In theory, these issues could resolve more quickly than a permanent loss of productive capacity. But futures markets assume a level of lower prices in any case.

  • In CIO’s view, the Fed has underestimated meaningful evidence of healing already underway. A few examples: real consumer spending is decelerating overall while real retail sales fell in April and May, which will lead to slowing labor demand in time; US wages have risen just half as much as prices in the year-to-date, supporting the view that labor is not “the issue”; home sales are falling at a double-digit rate as affordability deteriorates. All this suggests the more flexible elements of inflation will, over time, come down.

  • The peak impact of expected Fed tightening will be felt most severely in 12-18 months. Rapid tightening steps will lead to material economic weakness in the year ahead, rather than immediately.

Chart: US Retailer Inventories Y/Y%

Portfolio Considerations

  • CIO reiterates its current asset allocation, 2% overweight global equities including a 4% overweight to commodity producers and oil services shares (thus -2% for other shares). Fixed Income and cash are 4% underweight. However, US fixed income is about 6.5% overweight as our FI underweight remains focused on very low-yielding Japanese and European government bonds (-10%). CIO is maintaining its allocation to natural resources. Looking forward, Citi strategists will need to carefully assess commodity price risks on the potential for weakening global demand. However, very broad supply disruptions remain from the conflict in Eastern Europe and alternatives to Russian output remain in high demand.

  • “Pro-cyclical” Fed tightening argues for higher US fixed income allocations and cautious equity positioning. CIO continues to believe broader financial markets cannot find stability until interest rate markets define a range. With this in mind, despite the steep correction to date, CIO kept its tactical focus on high quality US fixed income and equities with strong dividend delivery in industries with the most durable demand. As of mid-2021, US Treasury yields had already doubled from the crisis-period lows. After another doubling in yields, the losses suffered in the bond market suggest a potential window of opportunity.

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