Your mortgage rate is about to spike to 5%. Here’s how you can navigate this new environment.

• Inflation in the US is showing little signs of cooling, forcing the Fed to take one of the most drastic measures in recent history – raising rates by 75 bps. 

• Inflation is likely to stay higher for longer due to: (1) worsening supply-side issues in commodity markets, and (2) rising wages due to the tight labour market.

• Permanently high inflation is an unlikely scenario. At some point, base effects and demand destruction will come into play.  We expect inflation to moderate, but will likely remain higher than pre-pandemic levels.

• Investors who have gotten used to living in an era where inflation is not a major problem and cheap credit is readily available should be prepared for significant changes. 

The US economy has come a long way since the beginning of the pandemic. After the initial shock, it experienced a stunning recovery, posting some of the strongest growth numbers in recent decades. The massive pandemic stimulus, along with the earlier-than-expected economic recovery, powered the US to be among the top performing equity markets in 2021. 

But on hindsight, most economists now agree that the stimulus measures may have been way too generous (Figure 1). This, combined with one of the tightest labour markets seen since the onset of the pandemic, has played an integral role in driving inflation to the highest level since 1981. 

Figure 1: Money supply in the US saw a sharp increase since the onset of the pandemic

After moderating in April, inflation unexpectedly accelerated in May, with the headline CPI rising by 8.6% year-over-year. While the increase was broad-based, components such as food (+10.1%), energy (+34.6%), and shelter (+5.5%) were the largest contributors to May’s inflation numbers. 

Figure 2: US consumer prices rose by 8.6% year-over-year in May 2022, the highest since 1981 

With consumer prices showing little signs of cooling, the Fed has been forced to take some of the most drastic measures in recent history – raising rates by 75 bps (Figure 3). 

Figure 3: The Fed raised rates by 75 bps in June, the largest rate hike in over 28 years  

However, considering that monetary policy often works with a lag and the fact that inflation today is driven more by supply-side issues rather than demand, higher rates might not be effective in bringing down inflation, at least not in the coming months. As such, we expect inflation to remain elevated from now until 2023, before settling at around 4% in the longer term. 

Why inflation is likely to stay higher for longer 

1. Worsening supply-side issues in commodity markets

At this point in time, there are still several upside risks to inflation, such as the Russia-Ukraine crisis, COVID-19 lockdowns in China, and rising global food protectionism – all of which have the potential to add to inflationary pressures, but are unfortunately beyond the control of the Fed. 

An escalation in the Russia-Ukraine crisis is perhaps one of the most critical issues, given its potential to have a significant impact on food and energy prices across the world - due to their importance in the global supply chain for both sets of commodities. 

Furthermore, raising interest rates is unlikely to have a meaningful impact on food and energy prices, as they are both driven by their own unique set of factors.

In the case of food, rapid population growth, coupled with supply-side constraints such as climate change, decreasing abundance of arable land, and rising fertiliser prices, is leading to shortages, driving food prices up. As a matter of fact, food prices were already on an uptrend even before Russia invaded Ukraine (Figure 4). This is mainly due to supply-side issues such as adverse weather conditions affecting crop yields and rising food protectionism.  

Figure 4: Food prices were already on an uptrend prior to Russia’s invasion of Ukraine

Back in 2021, China tightened controls on the export of fertilisers in order to stabilise domestic prices, a move that sent global fertiliser prices soaring. While the move is considered a “success” (domestic fertiliser prices have not appreciated as much as global prices), prices today are still higher compared to when the curbs were introduced (Figure 5). This also means that the Chinese government is more likely to keep these curbs in place, while the rest of the world will have to contend with higher prices for the time being. 

Figure 5: Rising fertiliser prices are propelling food prices higher 

With food protectionism on the rise, a growing number of countries are also resorting to similar measures to ensure self-sufficiency. Malaysia’s curbs on poultry exports and Indonesia’s palm oil ban are recent examples that show how food protectionism can add to inflationary pressures. Looking ahead, we expect higher prices to stay, at least until the various supply-side issues are resolved. 

As for energy, a confluence of events – the rapid global economic recovery, a long and cold winter that depleted stored energy supplies, and years of underinvestment in the oil and gas industry - all had a hand in pushing energy prices higher. Throw in the fallout from Russia-Ukraine war and that’s how energy prices are hovering near their highest level in this decade (Figure 6). 

Figure 6: Crude oil and natural gas prices have soared 

Just weeks ago, Gazprom, Russia’s largest state-owned energy giant cut gas supply to Europe via the Nord Stream 1 pipeline by as much as 60%, affecting more than a dozen European countries. Russia’s latest actions have reignited fears of a widespread energy crisis, sending gas prices soaring yet again. 

To make matters worse, there has been a severe under-investment in the oil and gas industry over the past few years. In 2021, annual investment in upstream oil and gas amounted to only USD 351 billion (Figure 7), despite the fact that 80% of the world’s energy still comes from fossil fuels. This is largely due to ESG concerns, and also because an increasing number of countries are transitioning away from fossil fuels and towards clean energy. 

Figure 7: Investments into the oil and gas industry has been falling over the years

While Europe has unveiled plans to speed up its transition towards clean energy and reduce its reliance on Russian oil and gas following the war, there is still much to be done and things are unlikely to change overnight. Similar to food, we expect energy prices to remain at elevated levels for the time being, or worse, go even higher should Russia decide to turn off Europe’s gas supply as we head into the winter season when energy demand is expected to be at its highest.

2. Tight labour market to drive up wages

Adding to the inflation problem is America’s red hot labour market. As the US started to reopen its economy, companies struggled to fill job vacancies. While the lack of workers can be attributed to a number of reasons, most are linked to the Great Resignation. 

For one, the US saw an increase in early retirements during to the pandemic. According to data from the Fed and Morgan Stanley, between February 2020 and 2021, the US retiree population rose from 18.5% to 19.3%, the equivalent of roughly two million people. Early retirement is estimated to be responsible for more than half the workers missing from the labour force compared to pre-pandemic levels. 

Another reason could be due to the surge in wealth during the pandemic. Thanks to the generous unemployment benefits and the surge in stock and housing prices, consumer balance sheets are much stronger than before, making workers more confident to stay out of the job market. 

The lack of workers has forced companies to raise wages in order to attract the talent that they need. While wages have started to rise, they have so far not kept up with inflation. This could lead workers to bargain for higher wages to preserve their purchasing power. Companies, in turn, will respond to rising wage and input costs by exercising their pricing power more aggressively. This is likely to add to inflationary pressures.

Under these conditions, we expect already-elevated inflation to persist for longer.

Higher for longer, but it doesn’t mean higher forever

While we expect inflation to stay higher for longer, it is unlikely to stay at the 8-9% inflation we’ve seen over the past few months. 

There are a few reasons why.

First of all, inflation is measured on a year-over-year basis. This means that for inflation to fall, the prices of goods and services don’t have to drop significantly, they just have to stabilise. 

Assuming that the price of crude oil continues to grow at the same rate it has over the past year, one barrel of crude oil will cost nearly USD 190 by 2024 – way above its peak in 2008.  On that note, we see inflation moderating by early 2024 – as we expect an easing of supply chain issues and the effects of tighter monetary policy to have kicked in by then. 

Permanently high inflation is also unsustainable because at some point, demand destruction will eventually occur, which will bring balance back to supply and demand – and to prices as well. Evidence of demand destruction is already starting to show for US gasoline in states with the highest gas prices. 

Last but not least, the Fed is strongly committed to bring down inflation even if it means causing a recession, as seen from their recent statements and aggressive rate hike policy. 

While we do not expect inflation to remain at 8-9%, we believe longer-term inflation is likely to settle at around 4% rather than the Fed’s 2% inflation target. Consumer inflation expectations are already anchored at a higher level (Figure 8), with the three-year ahead inflation expectation currently at around 4%. With labour shortages (a problem that will likely be exacerbated by an ageing population), a renewed focus on energy and food security, and a retreat from globalisation, we believe the world is heading into a new environment of higher inflation.

Figure 8: Three year ahead consumer inflation expectation is currently around 4%

A new reality of high inflation and interest rates is upon us

Many investors (especially the younger ones) are used to living in a time where inflation has not been a major problem, and ultra-loose monetary policy meant that credit was easily available, not to mention cheap. But with the impending rise in interest rates this reality that we have all gotten used to is about to change. 

Among the various downsides of higher interest rates, the most obvious would be the impact on the cost of borrowing for consumers. According to the SingStat, more than 70% of Singaporean’s household debt comes from mortgages, and the rest is made up by personal loans such as auto, credit card etc. 

In the wake of the Fed tightening, banks in Singapore have started to reprice their home loan packages. The median rate for a two year fixed mortgage has nearly doubled from 1.15% in December last year to 2.25% in May, according to Redbrick Mortgage Advisory. Borrowers with floating rate loans are also feeling the heat as benchmark rates such as the SORA have risen. 

Given that SORA is a backward looking rate and the Fed keeping to its aggressive rate hike plan, further increases should be anticipated. And if the SORA reaches the same level as it did back in 2006 borrowers with floating rate loans could see their mortgage rates shooting up to 5% (Figure 9).

Figure 9: Floating rate mortgages in Singapore are likely to see a significant repricing as the SORA rises

Positioning your portfolio amidst high inflation and interest rates

With economic conditions changing rapidly, now is probably a good time for investors to reassess their portfolios and position themselves accordingly. Here are a few ways to do so. 

1. Value over growth

In a rising rate environment, investors should look to reduce the equity duration of their portfolios by favouring stocks which derive their valuations more from current fundamentals (value stocks) rather than those which pay a large fraction of their cash flows in the future (growth stocks). Value tends to outperform growth during periods of high inflation and rising interest rates.

Those with growth heavy portfolios (e.g. heavy on US equities) should consider diversifying their equity exposure to include more value oriented equities as rates rise. To do so, investors can consider funds with a value tilt, such as the JPMorgan Funds - US Value Fund. Outside of the US, investors can also increase their exposure to markets with relatively more attractive valuations e.g Asia ex Japan, Japan and China.

Related Article: US: Value to lead the way

2. Commodity-related equities

With food and energy prices likely to stay elevated, or worse, trend higher in the coming months if supply side issues persist or the Russia-Ukraine war escalates, inflation is likely to stay higher for longer. To hedge against a rise in inflation, investors can consider commodity-related equity funds such as the Blackrock World Energy Fund or the JPM Global Natural Resources Fund. 

Related Article: A new commodities supercycle: Why oil could reach 150!

3. Short duration bonds

Lastly, for fixed income, investors should aim to reduce duration to protect against a faster than expected rate hike environment. Short duration bond funds, such as the Nikko AM Shenton Short Term Bond or the LionGlobal Short Duration Bond are two options worth considering. 

4. Asian high yield 

Investors can also consider Asian high yield bonds as they provide one of the highest yield per unit of duration, which can potentially provide some buffer to offset the rise in interest rates. Our recommended products for Asian high yield bonds include the Eastspring Investments - Asian High Yield Bond Fund. 

Related Article: The Asian high yield bond market is presenting attractive value for long-term investors

Table 1: Recommended products 

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.