6 to 12 November: Worst Case Scenario

Last week, developed market bonds and equities fell in unison. These moves were of course small and, in the context of a blockbuster year for equities alongside another positive total return for fixed income, of little isolated significance. Nonetheless, given “risk-free” bond yields in many currencies now trade near the zero lower bound, it is a reminder that, in the next crisis, traditional “balanced” asset allocation may not protect a portfolio.

In particular, we view inflation as the most sizeable tail risk for markets. As a reminder, global inflation has steadily fallen over the past 40 years (see chart 1). In our opinion, this has been driven by more pro-active monetary policy, ageing populations, technology and increasing leverage. The question now is whether the maturing cycle, with unemployment at multi-year lows, could start to stimulate increasing price pressures, therefore forcing higher interest rates and bursting the world’s liquidity filled bubble.

Our take is that, for now, this is unlikely. The forces of secular stagnation are the equal of tightening capacity utilisation and thus this “worst case scenario” will not be realised in the current environment. However, this is not to say we are positive on the longer-term outlook. The developed world continues to live beyond its means, with very low probability of generating sustained and sufficient real growth. Moreover, monetary policy has reached its limit. This is to say, moving beyond quantitative easing (to helicopter money or large negative rates) will challenge faith in fiat currency – and it is this that could unleash the inflation tsunami.

Last week, oil continued its march higher on the basis of uncertainty in Venezuela and unrest in Saudi Arabia (arrests of officials and members of the royal family, as well as the apparent detention of Lebanese PM Saad Hariri in connection with his refusal to confront Hezbollah). US oil inventories however rose, which suggests some ability for US producers to offset any reduction in global supply.

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