investment viewpoints
CIO views: inflation offence and defence
Higher inflation figures and central bank communication have ignited discussion about the character, and future, of price pressures in the global economy. A complex array of factors is driving inflation: will they prove temporary or more persistent? Central banks have generally insisted that current inflationary forces are transitory, but their messaging has been mixed: the Federal Reserve’s outlook at its last meeting was more hawkish than expected, only for policymakers to reaffirm their accommodative stance in the days after.
So what do we talk about when we talk about inflation?
In the sections below, our CIOs present their views and how to best navigate a quickly changing setting in order to optimise the benefits of their asset classes.
Fixed income: favouring spread returns backed by fundamental analysis
One of the most widely debated topics in financial markets currently is inflation, and more specifically, to what extent recent price increases will prove transitory rather than persistent. We tend to favour the former as we find that most of the spikes in the data are related to a reopening of the economy. Last week, the FOMC increased its outlook and inflation projections, suggesting that the transitory timeframe might be a question of quarters rather than months and that it could be opportune to start tightening financial conditions at some point in the medium-term.
We think such a backdrop favours spread over duration risk, and have shortened our duration position where possible. However, we stress the need for thorough fundamental credit analysis, which goes beyond traditional financial model analysis to include the assessment of sustainable business practices and business models.
Vulnerable companies with impaired business models are still benefitting from this exceptionally accommodative environment and could have a hard time if financial conditions were to tighten in the short- to medium-term. We prefer to avoid such names despite their sometimes attractive valuations.
Uncertainty about the trajectory of financial conditions remains elevated, but the price of volatility has remained at relatively low levels. We therefore like to hedge for tail-risk events. Lastly, we believe in the benefit of portfolios designed to be flexible in order to adapt to changing market environments. This is primarily achieved by adding a layer of uncorrelated alpha, which can further benefit from diversification across portfolio managers in a multi-manager setup, and/or through portfolios that can re-position across fixed income segments, such as dynamic bond funds.
Swiss fixed income: credit for yield pick-up and diversification
The tale of rising inflation has yet to reach the Swiss economy. While travel-related components of the Swiss Consumer Price Index (CPI) have reflected the first steps towards normality, a large part of overall inflation stems from imported products – this is not domestically generated and hence is largely independent of Swiss economic performance.
Additionally, price levels remain subdued and far away from the Swiss National Bank (SNB) target of “less than 2%”. This is the case out to the SNB’s own longest forecast horizon, which sits at a bare 0.8% in 2024, raising doubts about the credibility of its target level, and making it difficult to judge the future trajectory of the Swiss policy rate in the medium-term.
With a policy rate at or close to the lower bound, firmly in negative territory and expected to remain at low levels for quite a while, investors are struggling to find positive yield. Recognising this, and in line with our global fixed income CIO’s viewpoint, we favour credit over rates risk in Swiss fixed income.
With such a large part of the sovereign curve in negative territory, we see little value in duration generally. We also highlight the highly asymmetric risks from extending duration when only very marginally compensated for such exposure, as some correlation with global rates markets can’t be ruled out and this could potentially lead to significant mark-to-market portfolio impacts.
We favour both the yield pick-up and the diversification benefits that credit offers for its much shorter duration and like to take measured default risk by moving gently down the risk spectrum. Additionally, we particularly like the high-quality profile of the Swiss fixed income market and the access it allows to less common issuers compared to the global fixed income universe. We generally believe that this market offers interesting investment opportunities due to its liquidity profile and the size and segmentation of its investors.
Asia fixed income: flexible duration positioning to avoid policy drag
It is very rare to witness such a synchronised global recovery, and especially one from a base of rising consumer and home prices rather than falling ones, as in other crises or recessions. The US is spearheading this recovery with expected GDP growth of 7% in 2021 and up to 5% in 2022. In Asia, vaccination drives have finally gone into full force: China has already administered 1.05 billion doses and India is currently vaccinating 8 million people per day.
With these powerful tailwinds, we believe fixed income investors should position for growth trends and avoid the potential drag caused by global monetary policy normalisation anticipated in the coming quarters. Prizing flexibility, we have positioned our portfolios to be overweight credit-spread duration and underweight interest-rate duration. This exposure is expected to benefit from an environment where longer-dated spreads continue to compress while US Treasury yield curves gradually flatten into 2022 and beyond.
In our view, cyclical names in the refining, gaming, chemicals and industrials sectors offer greater potential for spread compression, as earnings and cashflows appear progressively strong. For structural trends, we believe sovereigns and corporates exposed to commodities offer a unique opportunity to benefit from what we think is a new super-cycle, but without the associated volatility that arises from instruments in other asset classes.
Where possible, we choose to implement our underweight to rates duration through short positions in the US Treasury futures market. This is a not a no-brainer, unfortunately, as these positions reduce carry for our bond strategies and cause opportunity costs if long-dated bond yields rally from current levels. Still, on balance, we think this is a prudent approach as we seek to capture growth opportunities in credit markets in an environment where the Federal Reserve’s quantitative tapering could begin sooner rather than later.
For our views on how global inflationary forces could prove more persistent, please see: Eight reasons why inflation could persist | Lombard Odier.
Equities: selection based on quality, pricing power and trends
The Federal Reserve’s hawkish surprise, in the context of the strong cyclical rebound in which rising valuations were driven more by recovery expectations than earnings, signals to us that equity markets are now transitioning to a secular growth phase. In this environment, weighing exposures to factors such as growth or value becomes less important and stock selection comes to the fore.
Our stock-picking focus remains on quality companies that tick two boxes: they can exercise pricing power in order to benefit from increased demand while protecting margins from higher input costs, and they are exposed to powerful trends – particularly sustainability, digitalisation and the rise of north Asia.
But we are watching a number of potential catalysts for a structural rise in inflation. They are:
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Stimulus - The magnitude of US and EU stimulus is likely to overcompensate for the negative output gaps in these economies, and could create strong growth and very tight labour markets.
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China - China suppresses the renminbi through a range of measures, including: purchasing USD or EUR assets, financing offshore Belt and Road projects overseas and encouraging domestic savers to invest abroad. Should any of these means become exhausted, the renminbi could rapidly appreciate and transmit price inflation. Another risk is that Chinese exporters pass on higher production costs to international buyers.
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Deglobalisation - Further trade friction, such as the EU’s aim to tax the carbon emissions of imports, supply-chain disruption or higher labour costs (given the end of the demographic dividend and lack of new, cheap pools like the China or Eastern Europe of recent decades) could prompt pressure on prices.
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Uberconsumption - Baby boomers and middle-class Chinese, who are exiting workforces and unleashing retirement savings, and the increasing popularity of redistributive social policies in the West, could underpin increased consumer spending.
Convertibles: bridging benefits between fixed income and equities
Whether transitory or persistent, both schools of thought on inflation bring valid arguments to the table. Our view is that inflation will be transient, but we also acknowledge that the renewed focus on inflationary pressures is clouding the ‘rosy’ economic recovery scenario. In addition, both the rise in raw material prices and higher corporate taxes to finance stimulus plans could build pressure on margins, limiting upside. This suggests caution is necessary.
Since convertible bonds are a bridge between fixed income and equities, inflation has a direct impact on the performance of the asset class. While the expectation of an interest rate increase negatively affects the bond component of convertibles, the indirect effect of sector rotation out of growth names (which are more sensitive to interest rate moves) impacted the performance of the asset class more in recent weeks, due to the natural exposure of the investable universe to this subset of issuers.
Nevertheless, convertible bonds benefit from the following advantages:
- The asset class tends to perform well during periods of inflation because it is less sensitive to interest rates than traditional fixed income instruments. Also, its exposure to global equity markets is typically boosted by broader growth momentum at present.
- The convertible bond primary market, which was particularly active in 2021, has substantially diversified. It now provides access to a broader range of companies likely to benefit directly from a strong reopening of the economy, such as the transportation, hospitality or entertainment sectors. The universe also offers increasing exposure to companies linked to climate transition, which, in our view, will represent a long-term investment opportunity (beyond the initial inflation infuriation).
- In the long run, many growth companies in the convertible bond universe have sustainable businesses, a growing addressable market and access to disruptive technologies. Beyond the Covid-19 crisis, we believe many of them are here to stay and will flourish. In addition to upside equity participation, convertible bonds could also offer solid downside protection as the balance sheets, and consequently the credit quality, of many growth names improve
Multi asset: protecting1 portfolios against inflation surprises
Is higher inflation sustainable? The debate on inflation risks continues to occupy the front of market participants’ minds. The recent spike has brought back to the fore questions surrounding the impact high inflation can have on asset classes and how best to position multi-asset portfolios in this scenario.
As systematic investors, we adopt an agnostic approach to portfolio construction, aiming to build portfolios that can respond to whichever phase of the economic cycle we are presented with. In this context, inflationary scenarios are part of the set of possible outcomes that needs to be considered at all times. In our view, a structural allocation to inflation-sensitive assets, providing a risk exposure commensurate with a 20% probability (according to our analysis), should be core to all portfolios.
We consider three key ways to position a multi-asset portfolio for an inflation scenario:
- Commodities is the first asset class that comes to mind, since commodity prices typically rise when inflation is accelerating. So far in 2021, an exposure to commodities has proved beneficial, especially if supplemented by tactical components such as trend-following or carry strategies. Some investors have limitations around commodities and can only invest in gold. This can have a material impact, however, as gold has underperformed other commodities this year: for instance, the Bloomberg Commodity index was up +18.8% in 2021 at the time of writing, while gold prices were down -6% year-to-date. As such, investing only in gold means investors would not have benefitted from the reflation trade in their portfolio.
- Inflation-linked bonds also offer simple diversification from traditional bonds, which can be badly affected by a bout of inflation. Higher inflation often comes with higher rates in time – which can be negative for nominal debt. But with higher rates often comes higher volatility, enabling a long exposure to rates volatility as an interesting form of diversification.
- Finally, cash remains a simple yet underused asset, in our view. Aside from being the ultimate safe haven and essential for an efficient risk management process, it can offer protection against inflation – if short-term rates do not move in perfect sync with inflation rates, they tend to remain correlated.
1 Capital protection/preservation remain a portfolio construction goal and cannot be guaranteed.
Alternatives: the wealth effect of inflation
With massive liquidity injections likely to result in higher inflation, we believe hedge fund strategies that can pinpoint dislocated valuations can thrive.
While consumer price inflation has remained low over the last decade, wealthy investors have benefitted from asset price inflation in their equity, bond and real estate portfolios. This rising buying power of the wealthy is likely to fuel consumer price index (CPI) inflation as they spend and drive prices up. Workers are likely to demand wages increases, which companies will then pass on to consumers, resulting in further CPI inflation and subsequent central bank responses.
The key question has now shifted from whether there will be inflation, to how strong will it be? Contained inflation could be positive for a portfolio dominated by equity risk, but a high inflationary environment would be dreaded by investors – even those with well-balanced portfolios.
In this uncertain environment, hedge fund strategies can offer an attractive source of diversification to equities and bonds. While complacency in the market has been strong, our managers are finding attractive dislocations and opportunities to build in trades with a lot of asymmetry. This is reflected in our convexity strategies where we are ‘long change’, which means we could benefit from a shift to a more volatile environment. Exposure to commodities can also perform well in periods of inflation, and we are prefer diversified solutions that optimise futures contracts selection to minimise the cost of carry.
Sustainability: the shape and pace of the climate transition
Inflation, like most macroeconomic variables, is not immune to climate change. Central banks are increasingly looking to monitor the effects of physical risks (such as floods, wildfires, and hurricanes) and transition risks on the formation of inflation expectations. Because both physical and transition risks are relatively novel phenomena, there still is little empirical evidence on the exact nature and scale of their relationship with inflation. There are, however, several channels through which these links are likely to materialise in the near future.
For instance, extreme weather events are known to increase food prices. As the frequency and intensity of these events increase with global warming, so will the volatility of food prices, which could, in turn, result in lasting inflation expectations. When it comes to transition risks, the pace and shape of carbon pricing policy will further trigger structural changes in the energy mix, which could also feed into inflation expectations. Equally, large-scale shifts to renewable energies could likewise inform deflation expectations. Renewable energy sources such as wind and solar are benefiting from falling investment costs as well as a marginal cost of production of zero. For instance, the average cost of utility-scale solar energy installations has dropped by a whopping 80% between 2010 and 2019.
To navigate this new reality, investors need to be able to anticipate the shape and pace of the climate transition. Similarly, investors need to be able to anticipate the materialisation of extreme weather events and their impact on prices. Both analyses require particular attention to geographical and industrial context and call for deep expertise in environmental science and environmental economics. To this end, Lombard Odier has developed, and continues to refine, unique methodologies to assess both transition and physical risks on a forward-looking basis.
