Riding a new inflation regime
We have forgotten what inflation is like! We do not expect stagflation (low economic growth with high inflation), but inflation rates could remain higher for longer.
Nominal Sovereign and Corporate bond markets are vulnerable to a repricing of inflation expectations and higher risk premiums.
In the non-equity space, focus on generating income and bonds with attractive yields, in addition to absolute return/flexible bond funds, long/short credit, inflation-linked products with low interest rate risks and convertible bonds.
Higher inflation for longer, but not stagflation
The combination of the business cycle and commodities predicts inflation well: a relatively flat yield curve (indicating a low cost of long-term borrowing), tight High Yield spreads, plus Commodity index and Gold prices trending higher are relatively reliable market-based signals of rising inflation, particularly when combined. Therefore, today’s combination bodes well for higher inflation, rather than the “lowflation” observed since 2009.
Stagflation is not our central scenario, but remains a key risk for investors’ portfolios: although the combination of sharply slowing growth and demand-destroying inflation rates is not our base-case scenario, it cannot be ruled out. Investment portfolios comprising Equities, Sovereign bonds and Corporate credit would not perform well in a stagflationary environment, as all these asset classes risk negative returns.
Commodities & labour market tightness are key inflation drivers: supply chain disruptions coupled with a strong rebound in final demand are powering a sharp rebound in the demand for commodities, logistics and labour, and in turn, are pushing up global inflation rates.
Above-average nominal growth (real growth + inflation) is the best outcome for governments: faster nominal growth generates higher tax revenues for governments even without raising tax rates, while savers continue to be penalised by negative real rates.
Bonds and credit offer low expected long-term returns: Bond yields have been rising on the back of inflation concerns and earlier-than-expected rate hikes by some major central banks. While Government bonds are under pressure, Corporate credit has been fairing better in the current mid-cycle environment. Yet, credit spreads are tight, which is limiting expected returns.
Inflation-protected bonds are an obvious alternative, but are already expensive: breakeven rates (i.e. market-implied expectations of future inflation) are testing historical elevated levels, but should fail to move substantially higher without a wage-price spiral. Besides, real yields are close to all-time lows and are likely to move up as the Fed tapers its bond-buying programme, which would hurt the returns of inflation-linked bonds.
Fixed Income implementations: focus on generating income and bonds with attractive yields, such as financial credit and Emerging Market bonds. We also favour absolute return/flexible bond funds, long/short credit, inflation-linked products with interest rate risk hedging (or short duration) and convertible bonds.
Main risk to this theme: central banks change their view and no longer consider inflation as “transitory”, hike policy rates harder, hurting growth and hampering the economic recovery.
Favour Real Assets, with a capital-light approach
- Favour companies with pricing power and capital-light business models
- Commodities have traditionally performed best in a higher-inflation scenario
- The current steep slope of energy and metals commodity future curves (“backwardation”) adds to the current attraction of commodity roll yield products
- Real assets (commodities, real estate, infrastructure) provide a reasonable long-term inflation hedge
A smart equity-based solution to hedging inflation
Equities generally perform well during inflationary periods. Rising inflation is usually accompanied by robust economic growth. Unless inflation hits sustained elevated levels of 5%+, businesses tend to benefit from better pricing. That said, it may be dangerous to conclude that inflation is a “tide that is lifting all boats”. History shows that ultra-long duration growth companies tend to struggle when inflation picks up. But companies with pricing power and/or capital-light business models often yield superior results vs broader equity markets.
We define a “Real Asset company” as one that earns revenues primarily related to a tangible, finite asset base. Such company may benefit from i) the value of its assets being positively correlated with inflation, and/or ii) the price of the offered resource rising. A hard asset company has a similar tangible asset exposure, but through a capital-light business model. The capital-light business model requires less working capital and debt, and earns higher returns on capital. This facilitates higher compounding of capital during full business cycles, this being a key characteristic of a true quality stock.
The golden shine of inflation: gold is probably the world’s most well-established safe-haven store of value. Thus, a period of higher inflation should support this precious metal. Beyond that, concerns about government debt loads and the medium-term effects of unconventional monetary policies on fiat currencies should provide additional demand.
Commodities also tend to benefit from the pick-up in inflation. The world is entering an energy transition phase, during which our economies are moving from fossil fuel dependence to electrification. We believe that this transition will fuel medium-term inflation pressure. Consider the increase in demand in related metals: huge amounts of copper, lithium and rare earth metals are needed to build the infrastructure for a zero-carbon economy.
Examples of inflation beneficiary business models: stock exchanges are a perfect example of capital-light businesses with high pricing power and strong operating leverage. Due to extremely low marginal costs, higher volumes will immediately boost earnings. Within financials, we like banks owing to their high correlation with rising long-term interest rates.
We include infrastructure companies, funds and Real Estate Investment Trusts (REITs) in the realm of Real Assets. These types of asset all provide a cushion during periods of higher inflation given their natural inflation hedges via tariff and rent increases.
In the more commodity-related sectors, we see value in the European Energy sector due to the recent rise in energy prices and the attractive relative valuation vs their US peers. Basic Resources and Oil & Gas companies appear attractive due to their high correlation to commodity prices, as do certain commodities such as Gold or the aforementioned metals.