As hostilities between the US and Iran move towards a resolution with the signing of the Islamabad Memorandum, the bull case for the global economy runs something like this.
A sustained reopening of the Strait of Hormuz should drive down energy costs and bring inflation expectations back towards more comfortable levels. In turn, central banks will then be able to adopt the more dovish policy stance many investors anticipated at the start of the year, providing support for both equity and bond markets.
If only things were so simple.
Investors are right to welcome the gradual reopening of the Strait of Hormuz, but we do not believe that this development will fully resolve the underlying inflation challenge facing the global economy.
Instead, the end of a temporary shock may simply redirect attention to the forces that have been pushing inflation higher for several years. Chief among them is deglobalisation.
For much of the past three decades, globalisation acted as a powerful disinflationary force. If the conflict in the Middle East has shown us anything, it is that this regime is now over and that the inflationary fallout could be significant.
The long march of deglobalisation
While the imposition of tariffs by president Donald Trump last year significantly raised the cost of traded goods, in a sense it was simply the latest sign of a sustained acceleration in deglobalisation.
The trade dispute between the US and China that began in 2018 raised tariffs, increased input costs and fed through to consumer prices. China became a less attractive low-cost manufacturing hub for access to the US market, prompting businesses to rethink how and where they produced goods.
The pandemic transformed what had previously been a policy choice into a practical reality. Shipping bottlenecks, semiconductor shortages and energy disruptions created a synchronised global inflation shock.
Businesses responded by moving away from ‘just in time’ supply chains towards ‘just in case’ models, accepting higher storage costs and inventory obsolescence risks.
Geopolitical developments have reinforced these trends. Russia's invasion of Ukraine triggered sharp increases in energy and food prices, and Europe's experience has been particularly instructive.
A series of shocks has highlighted the region's dependence on external production and global supply chains, reinforcing the case for greater self-sufficiency and more resilient industrial policy.
The result of all of this is reshoring, nearshoring and friend-shoring, which typically involve relocating production to regions with higher costs than the locations they replace. At the same time, supply chains become more fragmented, reducing economies of scale and increasing costs across production networks.
Those costs ultimately flow through to companies and consumers, and the result is a world in which inflation is likely to remain structurally higher than it was during the previous decade.
A headache for central banks
This presents central banks with a dilemma. Supply-driven inflation is generally less responsive to weaker demand than inflation generated by overheating economies.
At the same time, higher debt costs risk undermining investment at the very moment governments and businesses are attempting to rebuild productive capacity.
Without substantial investment, deglobalisation raises the risk of slower growth alongside persistent inflation.
Lessons from history
Fortunately for fixed income investors, history provides valuable lessons on how to approach this shift in the market regime.
When inflation remains persistent, bonds and equities tend to become more positively correlated. As a result, investors can no longer assume that duration will provide the diversification benefits it delivered during the era of globalisation and low inflation.
That has important implications for fixed income portfolios. When short-dated rates offer positive real returns in developed markets, there is little need to take substantial duration risk. Adding the credit spread available from short-dated investment grade securities can provide the potential for strongly positive real returns with lower volatility.
Even if energy prices continue to fall significantly from here, investors should resist the temptation to conclude that the inflation problem has been solved.
Deglobalisation continues to exert upward pressure on costs, suggesting that inflation is likely to remain more persistent than markets became accustomed to over the previous decade.
In that environment, we believe that compounding returns at the short end of the curve remains a compelling approach.
Simon Prior is fund manager of Premier Miton Corporate Bond Monthly Income. The views expressed above should not be taken as investment advice.