Taking stock of stagflation risk in multi-asset

In the latest instalment of Simply Put, we look back on the first quarter and consider the rapidly changing geopolitical and macroeconomic situations and the implications of this on multi-asset portfolio positioning. 

As 2022’s first quarter comes to a close, a bird’s eye view of all that has transpired is in order.

Geopolitics

The Russian invasion of Ukraine has created considerable uncertainty. In and of themselves, geopolitical events do not tend to have a strong market impact over the long-term but do lead to short-term sell offs. What is particularly worrying this time is the supply shock in the commodities complex that has accompanied the invasion. Indeed, Ukrainian crops are in jeopardy and international sanctions on Russia have ruptured the oil and gas supply chain. These are factors that cannot be managed by monetary policy but rather through diplomacy and trade treaties. Sharp energy rises (usually 50% over fair valuations) have historically led to recessions. But today it is not just energy prices that are higher but over 70% of commodity market components, including food, which is especially worrisome in terms of social cohesion. Among all constituents of the BCOM index, the median year-over-year price progression is 122%, the highest it’s ever been in 30 years and over 70% have increased over the past six months, resembling 2008 levels. In Chart 1, we can clearly see the extent of these increases. Comparing the average quarterly performance of various commodities during inflation shocks between 1990 and 2021 and their performance in Q1 2022, the situation can be qualified as truly exceptional. For example, energy prices have increased by almost seven times their average and agricultural commodities by about three times. Aside from creating a cost of living crisis for many people, such a sustained rise in energy prices can be destructive for growth and company profits.

Chart 1. Average quarterly performance: Q1 2022 vs inflation shocks between 1990-2021

Source: LOIM. Bloomberg. as at March 2022’

Macroeconomics

Growth conditions are supportive (albeit lower than three months ago) thanks to tailwinds from monetary and fiscal stimulus in the wake of the Covid outbreak. However, these stimuli caused a demand shock which then triggered a surge in Inflation. Currently, the combination of this demand shock and the aforementioned commodity supply shock is turning central bank focus towards the price stability part of their mandate. Through a hawkish policy path, central banks will aim to tame demand. However, they risk stifling growth in the process, increasing the risk of stagflation in the next year or two. Chart 2 depicts our proprietary monetary policy surprise nowcaster and the evolution of the Federal Reserve’s (Fed) own scenario for interest rates between mid-February to end of March. The nowcaster is clearly on an upward trend suggesting an increase in the probability of a monetary policy surprise. Furthermore, looking at the Fed’s dot plot it has become increasingly hawkish since mid-February. To summarise, inflation remains today’s challenge, but it opens the door for monetary policy mistakes that may trigger a slowdown and thus create the perfect storm for stagflation.

Chart 2. Monetary policy nowcaster’s recent evolution (left) and change in the Fed’s dot plot scenario (right)

Source: LOIM. Bloomberg. as at March 2022

Portfolio positioning

If a stagflation regime was to materialise, cash has historically been one of the best portfolio hedges. In addition, we believe maintaining exposure to commodities (inflation risk) as well as sovereign bonds (recession risk) could help hedge a barbell scenario. Finally, should central banks succeed in managing this conundrum, equities should benefit from a soft landing. The risk now is that the medicine kills both the disease and the patient.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

The macro data keeps pointing in the same direction: growth has been strong in Q1 while inflation is accelerating its upswing. This is naturally to be taken with a pinch of salt, given the fact that it does not yet capture much of the impact that the surge in commodity prices will have on growth. However, in order to better assess the potential impact of this hit on consumption it remains essential to understand how strong economic activity has been ahead of the commodity shock.

In the US, the CFNAI and Richmond Fed indicators added to the strong message from the Kansas Fed’s leading indicator last week: the US economy is roaring and is well positioned to sustain a $20 surge in oil prices and a couple of rate hikes. Its housing market is also showing signs of strength: last week’s building permits were echoed in this week’s new home sales. The rise in rates is not impacting the housing market in the US for now.

In Europe, the German IFO and the European Commission consumer confidence surveys showed a decline in confidence across Europe – a stark contrast to the US situation. Consumer confidence notably plunged towards levels last seen during the pandemic and the global financial crisis. Meanwhile, the producer price index surged by nearly 26% in Germany, opening a +20% gap with Germany’s CPI growth rate. This cost-related inflationary environment is likely to have an impact on the upcoming earnings season and markets will have to naïvely estimate the strength of this impact until then – little wonder that volatility has been so high of late.

Factoring in these new data points, our nowcasting indicators currently point to:

• Solid growth worldwide, with stronger momentum in the Eurozone, while China lags. US data are rising while European data are retreating progressively.
• Inflation surprises should remain positive. Recent inflation reports and commodity volatility feeds into a higher world indicator.
• Monetary policy is set to remain on the hawkish side. Even the Chinese indicator has risen slightly recently, pushing this indicator higher by the day.

 
World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)
   
World monetary policy nowcaster: long-term (left) and recent evolution (right)
Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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