Market Forces 001

Market Summary

The start to the year for the financial markets has been rocky to say the least. The S&P is down close to 9% both year to date and from it’s 3 Jan 2022 peak and the NASDAQ now is firmly in correction territory down 13%. Bond prices have decreased, with 20-year treasuries now yielding above 2%.

Whilst a scan of the press attributes this to a multitude of issues. At its core, this sell-down is being driven by inflation, and more specifically, the impact of inflation on interest rates (central banks only real tool to deal with, or attempt to deal with rising prices, is increasing the policy rate). We have discussed our inflationary concerns over the past year, so now is an appropriate time to revisit this key issue.

At its core, inflation can be viewed as a consequence of too much money chasing too few goods (demand-driven) or supply pressure (supply-driven). The current environment can be characterized by both. On the supply side, we have seen rising commodity and oil prices exacerbated by a significant increase in shipping rates, and on the demand side, we have seen a robust recovery out of the pandemic with solid economic growth and low unemployment.

Markets function as discounting engines, so the key issue is not the last inflation print, but rather what price increases consumers will experience over the short to medium term, how materially this will impact on personal consumption (a key driver of economic growth) and whether central banks (the Fed and Bank of Canada) will need to do more on rates.

The underlying increases in commodity prices alone are inflationary. The supply chain issues we have seen compound this issue, and are by themselves a key issue of concern.

Shipping rates have started to moderate somewhat with the Freightos Baltic index, the China to US East Coast, and China to US West Coast down 12%, 20% and 24% respectively from September 2021 highs. Despite the welcome respite seen over the past months, shipping rates remain at elevated levels and given the lag between transport price increases and on the shelf prices, this inflationary pressure remains despite the roll in shipping prices.

A Fed paper from 2016 (article) concludes that every 15% move in international shipping costs results a 10bp increase in core inflation one year later. Applying this finding insight and looking at varying lags, we can see the how shipping costs increases lagged by six and nine months respectively impact goods prices.

Rolling forward this analysis suggests that shipping will remain a key inflationary component over coming months. This heightens the risk that inflation becomes structural or entrenched, as consumers, facing elevated living expenses, begin to demand increased compensation. The resultant increase in labour inflation is far ‘stickier’ and would start to impact the services component.

Considering this, despite the move in rates seen to date, the risk remains that the market’s expectation of rates needs to rise further.

Your Model Performance (net-to-client, third-party audited):

At McIver Capital Management, we recognize that this has significant potential implications for financial markets and are continually monitoring and assessing whether it requires any tactical changes to client portfolios.

Our approach to portfolio construction is rooted in Modern Portfolio Theory, and we believe we are well positioned for the current environment with our exposure to gold, real return bonds, and equities exposed to the agricultural sector.

Sincerely,

McIver Capital Management
Paul, Mark, Neil, Warren, Matt