Riding a new inflation regime
The military conflict in Ukraine has been fuelling even more uncertainty around inflation. Year-on-year comparisons of consumer prices have been hitting multi-decade highs of late. Thus, inflation remains the key source of concern for investors. The drivers of inflation look more broad-based than usual. Nevertheless, we expect inflation to peak in the coming months, but the speed of normalisation is quite unpredictable. This is mainly due to sustained high energy prices and supply-chain bottlenecks. We are also looking for a temporary acceleration in wage growth. However, we do not expect a “price-wage loop” (higher inflation driving higher wages, in turn driving prices even higher) as seen during the stagflation period in the 1970s. Yet the risks remain biased to the upside and investors should consider solutions offering protection against unexpected inflation or even those that benefit from it.
A cross-asset theme: bonds, equities, real estate, infrastructure and commodities.
- Focus on generating income and bonds with attractive yields, such as financial credit and emerging market bonds. We also like floating-rate notes, absolute return/flexible bond funds, long/short credit, inflation-linked products with interest rate risk hedging (or short duration) and convertible bonds.
- Favour companies with pricing power and capital-light business models.
- Real assets (commodities, real estate, infrastructure) provide a reasonable long-term inflation hedge. We particularly favour life sciences and warehouse commercial real estate.
- Commodities have traditionally performed best in a higher-inflation context. They will also remain a source of inflation due to the structural shifts towards renewable energies and energy security. We expect strong demand for fossil energy commodities in the coming quarters (substitution for Russian supply) and battery and renewable energy-related commodities over the coming years.
- The main risk is inflation falling faster than expected. This could occur if energy prices were to decrease and/or reduce bottlenecks in supply chains and job markets.
- A sharper-than-expected rise in interest rates could trigger a recession, which would, in turn, reduce inflation risks.
Commodities and the super cycle
Historically, commodities have provided an excellent hedge against inflation and currency depreciation. This is, however, an imperfect hedge because commodities can often be volatile in the short term. In the present context, they are characterised by rising demand and supply constraints due to the lack of investment since 2012. We thus see the downside risks as limited.
The rush towards energy independence from Russia: the military conflict in the Ukraine has been a wake-up call for European countries, including Germany of late. This is not only true for natural gas but also oil. In the short term we expect a sharp rise in infrastructure spending in fossil energies like LNG port infrastructure in Europe and US shale oil & gas drilling. Renewable energies and storage technologies will also benefit from this new environment, as investments will be accelerated.
The path towards a low carbon economy with renewable energy: building out renewable energy generation. Requires huge quantities of base metals. Developing new mines is a long process – often a decade or more - while the potential to ramp up production of existing mines is limited. Supply growth is thus limited in the medium term. The most attractive metals are copper, aluminium, tin, and of course battery metals: nickel, lithium, cobalt, manganese and graphite. Platinum should also be considered for its essential role as a catalyst in hydrogen fuel cells.
Opportunities in equities and real estate
Focus on pricing power: all companies are facing cost pressures (plus ongoing supply chain issues) which are particularly affecting industrials, utilities, some materials, tech hardware sectors which are less able to pass through cost increases to end clients. We prefer companies that are not highly valued, and are capable of maintaining or even increasing their operating margins in this environment.
Energy and commodity-related stocks remain a very good hedge: they are backed by tangible assets with rising valuations, their balance sheets are stronger than ever and they tend to show very high free cash flow yields, allowing for new investments, dividends and share buybacks. These sectors are still cheap, particularly in Europe.
Turning to real estate, it is now time to become more selective. US real estate looks fairly priced today, whereas European REITs have lagged during the recovery phase. Real estate is a good diversifier and hedge against inflation, especially when real yields are so low. We favour exposure to the growth real estate sectors of warehouses (industrial logistics, e-commerce) and life sciences/healthcare.
In contrast, highly-valued growth companies tend to struggle when inflation picks up. We continue to avoid companies that announce poor results/forecasts, are very expensive, or show low profitability, because they remain very vulnerable in the current environment.
Use bonds as an inflation hedge
Inflation-linked bonds can be a good way to hedge against inflation. That said, they can suffer when real yields rise faster than expected. This is particularly true for longer-dated bonds. Hence, favour inflation-linked products with interest rate risk hedging (for short duration).
Floating-rate notes are better suited to the current environment of rising interest rates due to high inflation, as their coupons adjust quarterly to a short-term benchmark rate, namely the 3-month Libor or, more recently, the Secured Overnight Financing Rate (SOFR) in the US.