CIO views: are inflation concerns over-inflated?

Asia fixed income: sell-off dislocations create opportunities

Inflation rates have risen since late 2020 due to demand-side stimulus, supply-side disruptions and surging commodity prices that were exacerbated by Russia’s invasion of Ukraine. In the US, the Federal Reserve (Fed) is likely embarking on an aggressive rate hiking cycle to lean against the highest US inflation readings in 40 years. As a consequence, markets have priced in 10 US hikes by end of 2022 or early 2023.

In response to rising inflation, 10-year US Treasury yields moved from 1.5% at the start of 2022 to close to 3%, representing the largest and sharpest sell-off since 1999. At the same time, longer term trend growth in the US is expected to be in the range of approximately 2% in the absence of any material productivity improvements.

As such, a dislocation has opened up between high inflation and the trajectory of growth from here, which is a result of over-easing by the Fed since the onset of the pandemic and likely over-tightening going forward. From here, as inflation starts peaking and with moderate GDP growth, we believe yields have overshot their long-term fair values and will start reversing over the coming quarters.

Overall, we believe that the worst of the spread widening and US Treasury yield increases are behind us, as higher Treasury yields have already pushed all-in yields to the higher end of the historical trading ranges in recent years. After this unprecedented sell-off, Asia and emerging market investment-grade yields in USD are as high as 5% at a diversified portfolio level, while high yield yields are at high single digits¹ even for defensive borrowers rated BB and B.

As such, we believe this dislocation has opened up a rare opportunity for investors to start averaging into the market, since the bottom for credit or peak in Treasury yields will be almost impossible to catch.  

We delve deeper into fixed income investing in in our feature viewpoint.

 

[1] Yields are subject to change and can vary over time. Past performance is not indicative of future returns.

Equities: seek low-beta quality stocks

As US monetary policy normalisation marches on, how should equity investors adapt?

“A very strong and extremely tight” labour market is a key concern for Jerome Powell, Chair of the Federal Reserve, accompanied by the prospect of wage inflation becoming a structural inflationary driver. Indeed, at 7%, US job openings as a percentage of the labour force has not been so high for more than 20 years.

There are only two ways to loosen a tight employment market: increase the participation rate of the working-age population, which is a long-term process, or weaken the job market by cooling aggregate demand.  In equity markets, strong sector and style rotations indicate that investors believe rapid and high interest-rates hikes are needed to combat inflation.

Could this result in recession, and if so, how can investors prepare?

 

History points to quality

We have analysed market returns before, during and after three bear markets: the 1990 downturn, dotcom bubble and global financial crisis. For each episode, we assessed style dynamics throughout distinct periods beginning with the inversion of the US yield curve, as indicated by the spread between 10- and two-year Treasuries, the subsequent recession and first six months of the recovery (see figure 1).

Given the inversion of the US yield curve in late March, what can this analysis tell us about the current environment? Our key conclusion is that portfolios should currently favour quality, low-beta stocks. In addition, focusing on companies with strong competitive advantages is essential: they can diffuse cost pressures among customers, thanks to pricing power and low price elasticity, and across suppliers, due to their bargaining power. Cost-saving measures and an ability to self-fund growth without needing to access to capital markets are also beneficial.

 

FIG. 1: Equity style performance before, during and after downturns vs global equity market

Period start

Period end

Growth

Value

Quality

Low beta

Inversion begins	Inversion ends	-2.2%	2.3%	1.6%	6.7%
Inversion ends	Recession begins	2.5%	-2.5%	3.5%	1.0%
Recession begins	Mid-recession	0.1%	-0.1%	3.7%	2.6%
Mid-recession	Recession ends	1.4%	-1.5%	2.2%	-4.0%
Recession ends	6 months after recession	0.7%	-0.7%	1.1%	-0.9%

 

Source: LOIM analysis as at April 2022.

Multi-asset: inflation fears might be inflated but inflation is here to stay

The main reason for the rise in long-term break-evens well above their 2% long-term level is that current inflation is proving more persistent than originally anticipated. Outside of the Eurozone, however, our proprietary inflation surprise nowcasters are no longer pointing to an inflation acceleration.

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

Reading note: LOIM’s nowcasting indicator gathers 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).

To understand why, recall that in the US, for example, four forces combined into a stronger inflation signal last year: strength of the housing and job markets, pressure on costs and strong overall economic activity. Of these four, only two remain: employment and costs. The former is a lagging consequence of strong economic activity, the latter the consequence of the Ukraine conflict. With the Federal Reserve’s focus now having resolutely turned to fighting inflation, the economic slowdown that should logically ensue should lead to an inflation moderation.

However, that is not to say we will see long-term rates back at 2% any time soon. The regionalisation of the world currently underway should prove long-lasting. The necessary ecological transition that the world is embarking on will raise energy costs and hence production costs across the board. Also, demographics and taxes should contribute to a higher inflation picture over the next decade. In short, inflation should be higher than it has been over the past decade for longer than investors expect, in our view.

Commodities and inflation-linked instruments should remain part of a core asset allocation at this time, we believe. On the other hand, nominal sovereign debt would be well positioned to protect portfolios to an extent in case of a recessionary shock. In addition, we maintain our positions aiming to diversify the diversifiers, such as long volatility or trend-following strategies, or just the philosophical open-mindedness to embrace cash as a simple shock absorber in case of a bout of stagflation, which would be detrimental to pretty much all asset classes.

Convertible bonds: a cycle of structurally higher inflation?

Predicting the path of inflation has been a significant challenge since early 2021. Initially the markets were simply relieved that the worst of the pandemic was over. However, it soon became clear that the inflation genie was out of the bottle. Global central banks were caught by surprise. Policymakers rapidly understood the need to support the nascent recovery whilst preparing the markets for higher rates. The resurgence of Covid in China led to lockdowns in the important manufacturing regions around Shanghai and Beijing. The Ukraine conflict provided a second exogenous shock. Supply chain bottlenecks persist and the penury of semiconductors is severely affecting production and delivery times for many sectors. Prices may not yet have peaked for some industries and we could be entering a cycle of structurally higher inflation.

Balance sheets are leaner and cleaner than at the onset of the global financial crisis, many companies are better placed to weather the storm, and those able to pass through price increases will thrive. The danger is not only the speed of price rises, but the cumulative effect on consumption. Savings built up in confinement could decrease rapidly as fiscal stimulus fades. The labour market is strong but as participation rates rise, it is unclear if wage increases will be sufficient to offset the loss of purchasing power.

The test for central banks in 2022 will be how to preserve credibility, anchor inflation at a manageable level, solve the supply-demand imbalance and raise rates without causing a recession. Will it be possible to engineer a soft landing when the price trajectories of many basic inputs – such as energy – are highly unpredictable? We expect the Federal Reserve to act quickly and decisively but are mindful of the negative effect on equities. Defaults are not predicted to rise significantly this year, and underlying volatility and dispersion have risen. Convertible bonds could provide a safe haven from volatility and the negative effects of duration in 2022, offering investors risk-adjusted performance in a ‘different’ environment for returns.  We believe that defensive positioning is the most effective way of both protecting² and generating returns in 2022.

[2] Capital protection is a portfolio construction goal that cannot be guaranteed.

Alternatives: a way to gain protection

Inflation metrics have reached levels not seen since the 1980s, and short-term inflation expectations are high. However, the longer term expectations (measured by the 5Y-5Y inflation gauge) remain relatively contained. They have increased recently, but still remain below the 2009-2013 level despite a prolonged period of accommodative monetary policy.

While temporary inflation is manageable, an extended period poses a real threat to investors’ portfolios. This is why we believe it is beneficial that central banks seem willing to maintain a hawkish stance to curtail long-term inflationary pressure (though that can potentially increase pressure in the short term).

Protecting portfolios³ against inflation is complex. Alternative investments offer compelling solutions that can support investors, such as:

• Commodities are strongly correlated to inflation and can provide an interesting hedge.
• Equity long/short strategies can position a portfolio to benefit from inflation (by being long companies with strong pricing power and short companies with excessive input costs). At the same time, they can shield investors from a potential beta reversal induced by an inflationary shock.
• Relative-value strategies can identify market dislocations due to inflation concerns that distort certain parts of the yield, credit or volatility curves, and build trades that potentially benefit from these.

Overall, inflation creates uncertainty and volatility, which generally offer a compelling environment for alternative strategies.

[3] Capital protection is a portfolio construction goal that cannot be guaranteed.