The Fed’s announcement last Thursday that it will now target an ‘average’ inflation rate of 2% is a huge game changer for investors and asset allocators, says Philippe Gijsels, head strategist at BNP Paribas Fortis.
‘The importance of this policy shift is simply enormous,’ says Gijsels. ‘Although the market impact was initially limited.’ This was because the Fed had communicated its change in policy very well. Already before the announcement, markets were in a euphoric mood, with new all-time stock market highs being recorded every day.
‘I see this as a continuation of the policy under Greenspan, which has been pursued since 1987,’ says Gijsels. ‘Lowering interest rates and QE are integral elements of this. The difference is that the Fed has now openly stated what they have been doing for some time. It is quite possible that inflation will overshoot to 2.5% and more in the coming years [without the Fed reacting to it by raising interest rates].’
Avoiding a Japan scenario
The Fed’s biggest fear remains deflation, Gijsels believes. ‘The Fed absolutely wants to avoid a scenario such as in Japan or Europe. Yield curve control is therefore absolutely possible. Long-term interest rates must not be allowed to rise too much, because that would put pressure on the stock markets.’
Gijsels draws a historical parallel with the policy under president Carter in 1977. ‘The Fed’s dual mandate was created in times of massive inflation. Everyone believed in the Philips curve, the relationship between inflation and employment, but its importance has weakened or even ceased to work. So they now have completely abandoned it.’
In 1982, Fed Chairman Volcker successfully put an end to sky-high inflation by raising interest rates drastically, but now deflation is the big enemy instead of inflation. ‘And I believe the Fed will succeed’, says Gijsels. ‘We must prepare for an era of higher inflation. Now that fiscal policy is cooperating and governments are pumping money into the system on a massive scale, their efforts can bear fruit. Ultimately, all the money created will end up in the real economy. Interest rates should rise too, but the central banks will do everything in their power to prevent that.’
A new era
Gijsels emphasises that we, as investors and asset allocators, must prepare for a new era of higher inflation. ‘We are now closing the post-Volcker period. Eventually, gold and real assets will be the go-to areas. Equities and real estate will also benefit. And savers will once again be at risk.’
Gijsels shares another observation on value stocks: ‘The recovery potential of value stocks is also considerable, because these companies are valued very cheaply in relation to growth, and can also respond to a recovery of the global economy. At the moment, however, everything that generates a lot of cash flow in the future is worth a lot because the discount rate is zero. Companies that will only make a profit in five or ten years’ time are now rewarded for those future profits. It is a highly artificial situation, but the message is very clear: invest in real assets during such a period.’