The prospects of higher inflation have been reflected in higher US inflation breakeven rates and in a steeper yield curve, amid a quick and sharp rise of US Treasury yields.
In the short term, further upside pressure to US Treasury yields will be limited, as overseas demand may prove strong -- current US Treasury yields are attractive for global investors. However, any possible upside pressure from rising inflation -- coupled with the risk that the Fed might fall behind the curve -- will warrant a cautious duration exposure.
In bonds, rising bond yields will warrant a cautious and active approach to duration, while searching for income across the entire market spectrum with a global unconstrained approach. Indeed, ten-year US Treasury yields have risen back to their pre-pandemic levels amid yield-curve steepening due to strong fiscal stimulus, the economic recovery and accelerating inflation.
Moreover, investors should adopt a flexible approach and go beyond benchmarks to search for yield. Nowadays, traditional benchmarks hold significant duration risk, with low implicit yields. For such reason, it will be paramount for investors to get exposure to different sources of return, with an unconstrained approach that may help limit the duration risk, and consider increasing their allocation to inflation-linked bonds, floating-rate notes and securitised assets, as well as exploiting relative-value opportunities. In such an environment, absolute return approaches, that can reinforce portfolios with a number of uncorrelated strategies (FX, curves, sector), may prove beneficial to protect investors from higher fixed income volatility and higher inflation.
In equities, higher inflation may dent valuations, especially those at highly expensive levels. As the Fed is now targeting average inflation over a time horizon, the subsequent acceleration of inflation may prove persistent, denting equity valuations. In turn, this may favour a multi-year rotation from growth into value stocks both in the United States and Europe. This rotation is already underway and we believe could be a long-term trend.
From a cross-asset perspective, it is important to monitor the different inflationary regimes to assess the asset classes that can perform better. Our Inflation Phazer identifies five different inflation regimes from 1960, analysing historical trends of the most relevant US inflation indicators, namely CPI, PPI, core PCE deflator and unit labour costs.
The Phazer gives each regime a probability based on our expectations for different inflation indicators. According to our model, there is a 60-70% chance of being on a normal inflation regime in 2021, 2022 and 2023. The other two regimes, deflationary and inflationary have similar probabilities, slightly skewed towards the inflationary one.
Asset classes tend to behave differently under various inflation regimes. In the 1970s, equities delivered poorly, while commodities were the most remunerative assets. Historically, gold proved to be strongest under an inflationary regime, while delivering positive returns under all three scenarios (deflationary regime, normal regime and inflationary regime). It is among only a handful of assets which have recorded positive returns in every scenario. For 2021, under a likely normal inflation regime, alternative assets could be attractive. Under such a scenario, with some upside risk of inflation, investors should enhance diversification by incorporating assets that would be more resilient to higher inflation.
Credit indices have tended to perform at their best during periods of normal inflation (2-3%), as such a regime usually comes with economic growth and a risk-on appetite in financial markets. On the other hand, under an inflationary regime (3-6% range), monetary policy is usually in tightening mode, causing spreads to widen and credit to underperform. Unsurprisingly, inflation-linked bonds’ relative performance against credit is the most attractive under an inflationary regime.
Normal inflation has proved to be the best environment for equity as well. Equity returns have recorded their best performance throughout normal inflation regimes, as healthy economic growth and accommodative monetary policy support a risk-on stance in financial markets. As happened with credit markets, tighter monetary policy during periods of higher inflation (inflationary regime) weighs on risk asset returns, as higher interest rates result in single-digit returns for most equity indices.
Solutions that target real returns with a broad range of asset classes will be attractive in a normal inflationary regime with upside risks. This means including real assets, inflation-linked bonds, floating-rate notes, commodities and equity sectors linked to the real economy, which tend to outperform in a rising inflation environment.