From growth euphoria to inflation blues
The past weeks have confirmed that phase one of the ‘great recovery’ is now behind us. We have entered a new sequence: PMIs decelerating from their peaks and concerns about the spread of the Delta Covid19 variant are features of it. Some cracks in the reflation trade that has lifted markets in 2021 have driven a pause in the cyclical/value outperformance. In contrast, the acceleration in inflation continues, with the latest numbers in the US once again far above expectations. Where things will land in terms of economic growth and inflation are the big questions now. On growth, future expectations have been revised downwards but on inflation markets believe the inflation pick-up is temporary. This means that while a few weeks ago the consensus was for ‘great’ higher growth with still-low inflation, in recent days we have moved to somewhat lower ‘good’ normal growth with still-low inflation. The next move may be more challenging, as the probability is rising that we are entering a scenario of uncharted territory, with lower growth and lasting inflation above central bank-target (strong housing market, mismatch in labour market). The inflation-versus-job-markets equilibrium is increasingly an issue for the Fed as economic growth decelerates and inflation risks look like they may last longer than expected. The window of opportunity for the Fed to start tapering is narrow and communication matters more than ever now. On the investment front, we stick to some key convictions to navigate this uncertain time:
- It is not a time to add risk, we maintain a neutral risk stance. We are approaching an inflection point on Fed policy and conditions could quickly turn more volatile as markets are still too complacent on inflation/yields. Any short-term correction in equities could offer better entry points. In fact, equities tend to perform better than bonds in an inflationary environment (but not hyperinflation). However, investors should remain vigilant on economic data and the Q2 earnings season to assess whether or not companies will be able to pass rising costs on to consumers and keep margins safe.
- Regarding equities, we confirm the value rotation call but are aware the road will remain bumpy. Markets face two concerns regarding valuations: (1) how rates will increase and how this will affect valuations; and (2) if growth stalls, how this will affect earnings and margins. We think the latter is driving markets more. But when there is clarity on growth and the potential spread of virus variants, the focus should return to rising rates and favour value once again.
- In bonds, a short duration stance is recommended, together with greater scrutiny on credit. When the Fed decides to announce tapering, investors could be forced to judge how that affects their credit exposure. Credit that is extremely sensitive to core yield movements should be avoided. Instead, the focus should be on businesses with the potential to improve fundamentals and credit metrics (sales growth vs. debt growth). CBs remain the key players in this inflation/growth trade-off. The ECB continues to appear dovish, as it switched from its lower-than-2% inflation target to a more symmetrical 2% inflation goal, where upside and lower deviations are equally undesirable. This review removes an inherent deflationary bias present in the previous system, which made above-target movements in inflation unacceptable. It also puts at the forefront the ECB’s green agenda in its asset buying. In China, the reality of slowing growth has resulted in the PBoC realising that economic momentum is slowing, leading it to end tightening by reducing the amount banks are required to hold as reserves. Given that Chinese demand now drives global demand and inflation, movements in the Chinese economy and money supply have the potential to affect DM. These differences in CB policies provide the opportunity to play relative value trades in bonds and FX. We see value in Chinese bonds and the CNY amid the prospect of their inclusion in global bond benchmarks (FTSE global index).
- In EM, some headwinds should be taken into consideration. While we do not expect to see a 2013-like taper tantrum, we are preparing for gradual hikes in US rates with a cautious duration stance and with selection in credit. In EM, the cyclical recovery is likely to be delayed, as infections due to the Delta Covid-19 variant have been on the rise because vaccination rates in EM lag those in DM. Against this backdrop, we maintain a prudent approach, in particular on LC markets.
To conclude, we think we have entered a new phase: the euphoria regarding growth has gone and the focus is now on inflation blues. Markets should not be worried about the Fed’s action at this point: for example, with regard to a scaling back of purchases in the mortgage markets. A little dose of tapering could help avoid nasty consequences and bubbles later on.