The inflation moment
Inflation has remained dormant for a long time, with years of below-target and weak inflation, but we are now reaching a delicate juncture where inflation is taking the driver’s seat in financial markets. Whether this is just temporary or will prove persistent is the crucial question and at present there are two conflicting inflation narratives. A series of voices claim that inflation is just temporary. In contrast, others warn about the possibility that inflation will turn structurally higher than initially thought because of economic growth, upward pressure on wages, a fiscal push, strong consumer demand and rising supply constraints (commodity side). In the end, something structural is just something temporary that has lasted. We think it is unlikely inflation will pick up only for a few months and then return quickly to about 2%. Rather, we think this is the start of a journey towards a mid- to long-term period of higher inflation and lower growth compared to the current consensus. For the Fed, there is limited room for policy mistakes as the loss of control of the yield curve is a rising risk at this stage. We outline our convictions below:
- Tactically reduce risk, moving from moderately long to neutral. We have entered an uncertain and riskier environment – volatility is rising and the equity-bond correlation is turning positive. We believe it is important to remain cautious and lock in some gains in risk assets. Taking a strategic view, some exposure to equities is warranted against a backdrop of higher inflation and inflation volatility. In equities, investors should seek some protection against the bursting of the tech bubble. This means being cautious on interest rate sensitive stocks, while preferring dividend yielding stocks and real asset exposed stocks. Equities will do OK in absolute terms as long as inflation is not breaking the anchored territory. Nevertheless, the risk-adjusted performances of a balanced portfolio will be challenged by the changes in the equity-bond correlation (turning positive). Investors should favour shorter duration assets, fixed income and FX carry, equity cash flow yield, real estate, value and the low volatility factor.
- Equities: seek a barbell approach, favouring cyclical quality value on one side and defensives on the other. In tactically moving to a more neutral stance on equities, investors should keep a value/cyclical preference vs. growth, while also balancing this with some defensive positioning. As mentioned earlier, the market is due for a pause, during which we believe it would be wise to move to neutrality in equities, including in more cyclical markets such as emerging markets and Europe. Most importantly, this market pause could help further clean up some excesses in the market and will continue to support the rotation from growth to value.
- Bonds: stick to short, active duration and moderately long credit. This means reducing duration, in particular in the US, and waiting for better entry points. Investors should be agile in playing duration at this stage as phases of undershooting and overshooting can offer tactical opportunities. Yet while reducing some of their short stance when the time comes, investors should resist the temptation to go long duration. For the coming years, the direction of rates is up. This will not be a straight journey, but the trend is there. This means that in FI, investors should look at opportunities at curve levels, where we continue to expect the US curve to steepen, and at opportunities in short duration higher yielding assets such as HY and EM bonds with a short duration bias.
- EM: facing the threat of vulnerability, China and Asia in focus. EM are also due to be under pressure amid rising yields. On the dollar side, the mid-term trend is downward as the Fed balance sheet and the US fiscal budget dynamics are the dominant factors. However, short-term challenges remain in an emerging world still characterised by the vulnerability factor, with retreating global trade and rising inflation. China and some Asian countries will be the winners and their currencies will be the critical channel to adjust relative prices in the new regime. The Renminbi will be the Deutschmark of the region, leading to a fast-rising status of cash and government bonds in Renminbi in global portfolios as a store of value given their positive real returns.
Looking ahead, markets will have to walk the inflation journey. We are approaching the end of the first leg, characterised by strong rotations, on the road to the peak. We will soon be entering leg two, the peak phase. This is still relatively positive for investors as inflation is not seen as a threat to growth but a complement to reviving economies, but the more we advance into this phase, the higher the risk of nasty surprises. The next leg will be about what is left of the peak (most likely not the Goldilocks regime markets are currently pricing in).