How hot is the inflation pot?
If the start of 2021 led markets to question the no inflation forever mantra, the debate has been hotting up in February, with the US 10Y inflation breakeven reaching its highest level since 2014, pricing in higher inflation expectations. We are also seeing pricing pressure on the food and energy side. Despite this rising trend, absolute inflation levels remain subdued. Some inflationary pressure is more than expected this year on base effects. However, the problem is not this short-term rebound of inflation, but the change in the paradigm ahead. The hot questions today are how much inflation surprise can we envisage for 2021 and how temporary will this inflation pick-up be? Or are we heading towards a prolonged period of higher inflation? The return of inflation narrative is gaining traction, propelled by the expected large US fiscal package and the recovery in demand that should come as the vaccination campaign progresses. The proposed package of $1.9tn has led some economists (Summers, Blanchard) to warn that inflation will be the end game of this huge fiscal push. However, others argue that there is room for this package, as the job market is still weak and it should not lead to a permanent rise in inflation as wage growth should remain limited.
Importantly, the starting point out of this recession is very different from that of 2008. First, this is a huge temporary shock that will be followed by a sharp reversal with less permanent consequences than a financial crisis. Second, the high levels of liquidity in the system, higher personal income and savings and the strong wealth effect will likely unleash pent-up demand: a cocktail that could further fuel inflation. Third, there is a risk that CBs will be trapped in their mantra of low interest rates and accommodative policies to restore economic conditions and tackle strategic social themes.
The big fiscal stimulus could make the case for a strong economic rebound which could not only drive some inflation pressure but also further increase divergences between the US and the rest of the DM world. This will make the case for being short the dollar quite challenging and increase the appeal of US fixed income in the desert of yield. China (and more broadly Asia) is maintaining a solid recovery pace and this was reflected in buoyant equity markets at the start of the year. The Asian region continues to be attractive to investors: it remained very resilient last year in terms of foreign direct investments (FDI) in an overall weak environment, and China for the first time surpassed the US in FDI flows. Signs of deceleration are emerging here as well, but if we look at the change in PMI over the last three months, China and India are among the best performers, together with the US. India’s new pro-growth budget is likely to see investors return to the country. Against this backdrop, our key convictions are:
- As the reflation trade continues, investors should still prefer equities to bonds, keeping a tilt towards more cyclical markets (Japan and EM Asia) and start to build in some laggards/value markets (Russia). But, investors should monitor the impact of inflation on earnings through input prices, which is emerging as a topic for discussion. As there is a rising consensus on cyclical trade with the reopening of the economy, selection in equities is increasingly relevant. The focus should be on sound businesses with a preference for value vs. growth as a multi-year rebalancing trend. In the short term, any sign of deceleration in economic activity may pause the rotation, but we believe this will be temporary and further reinforced by a steepening of the yield curve and an interest rate rebound.
- Stay risk-on in credit markets to benefit from central banks’ umbrellas, and start to increase the tilt towards SRI in bonds (green and social), as CBs may start to adjust their purchasing programmes in this direction. For example, in Europe, the ECB’s Villeroy has recently proposed starting to decarbonise the ECB’s balance sheet, while President Lagarde also made clear the ECB’s willingness to take steps towards taking a more active role in fighting climate change. This is just the beginning of a trend that we think will continue as CBs’ mandates start to adapt to the new post-Covid paradigm (huge fiscal push to fight the pandemic and move towards a more green economy and inclusive growth model).
- Start building hedges against inflation risk with breakeven and more generally with an investment approach that tests each investment case against a possible rise in inflation. This will affect sector allocation with a preference for sectors linked to real assets (commodities, energy, infrastructure) and single name selection with a preference for businesses with manageable debt levels, realistic valuations and pricing power.