Like it or not, the alignment of the planets regarding inflation will last for a while. October saw the recognition of a more permanent than expected inflation, with the IMF officially stating that we are entering a phase of inflationary risk and CBs partially admitting that inflation is proving stickier than anticipated. In our view, this adds an extra dimension to the idea that markets are moving in quicksand and the permanent inflation narrative is getting a boost. The mismatch between supply and demand is widening, with shortages all over the world and full economic reopenings in the main markets fuelling demand. Supply bottlenecks are intensifying and the astonishing rise in energy and food prices is further driving inflation dynamics in a vicious circle. The additional factor that could trigger further inflation rises is the wage component. Persistent rises in prices will, in our view, push workers to ask for wage increases.
Given the known risks regarding the I (inflation) part of the equation, the market’s focus will return to the G (growth) side. Are we heading towards a deceleration around potential or below, therefore feeding stagflation fears? On growth, all economic areas (US, Europe, China) face some challenges.
Our base case is for a controlled deceleration entering 2022, while further fiscal support to address the different open issues should kick in next year and help reinvigorate growth throughout 2022. Longer term, the energy transition is the key priority that might once again fuel an additional global fiscal push. COP26 will be a key milestone to watch to assess the future path of policy actions. Market reactions will depend on CBs and there is no room for mistakes on their side. We think any action by CBs will be incredibly gradual because there is little that CBs can do to address supply-side inflationary forces.
This scenario confirms our current stance:
- Real rates are the key variable to watch. In this phase of growth reassessment, we expect nominal rates to drift marginally higher but stay capped, while real rates trend lower. This phase will still favour equities over bonds. Later in the sequence there will likely be a catch-up, with nominal rates trending higher and real rates staying flat (at some point in 2022). This phase may trigger volatility in both equities and bonds and will require investors to add additional sources of diversification. The third sequence is about real and nominal rates both trending up. This could be a more challenging development, but we do not think this is around the corner.
- Overall duration stance remains short, but we do not expect much of a rise in rates for now. Credit remains favoured as fundamentals have been improving, but at current spread levels selection is vital to prepare for the next sequence, when liquidity risks will rise. China local government bonds remain in demand in the hunt for yield and more generally, so do EM bonds with a short-maturity bias.
- Stay neutral on equity and search for possible entry points at better levels, but be aware of risks and keep hedges amid phases of higher volatility, should growth deteriorate further and/or central bank communications be weak. In equity, each business case should be tested against rising inflation and rising rates. Value remains a good hunting ground for companies that can show real inflation-proof business models. This reporting season should be one of the toughest in terms of visibility. Expectations are already discounting headwinds, so the earnings season should not be a bad one, but uncertainty is very high and some of the energy pressure is not yet priced in and therefore it will be important to assess its impact in terms of forward guidance. The growth part of the market remains more vulnerable to rising rates. While at the moment the rise is capped, the next sequence will be more challenging and investors should prepare to embrace a very cautious stance in areas where valuations are excessive.
- In EM, which may now join the reopening narrative thanks to an improvement in the virus cycle, discrimination is increasingly relevant. Countries that can benefit from rising energy prices, such as Russia/Indonesia, are favoured, while those most exposed to the China slowdown look weakest.
Overall, the backdrop for investors is becoming more uncertain and riskier, with little upside potential in the short term. Markets are stuck in the middle. Rising inflation fears push long-term yields higher, but only to a certain extent because when growth is under threat, CBs are reluctant to tighten policy significantly. Equities is the place to remain given the low yields from bonds, but in an already stretched valuation environment in absolute terms, any rise in inflation and long-term yields should result in a reassessment of each business case.
CB = central bank, HC = hard currency, FI = fixed income, EM = emerging market, DM = developed markets, YTD = year to date, HY = high yield.