After a brief correction in September on the back of inflationary fears, the markets quickly recovered, reassured by solid quarterly results, and above all still supported by the abundant liquidity poured by central bankers but also the boosted fiscal stimulus measures. The acronyms TINA « There Is No Alternative » and FOMO « Fear Of Missing Out » are back on investors’ lips… But is it right to forget so quickly about this inflation topic?
For the ordinary people confronted with rising gasoline prices at the pump, this topic is far from being trivial. The same is true for pensioners who must also face an erosion of their purchasing power, confronted as they are with the decline in nominal and real rates affecting fixed income portfolios. The most pessimistic investors are also raising the prospect of stagflation, an economic feature experienced in the 1970s and characterized by stagnant growth and a double-digit inflation rate.
Despite the claims made by the proponents of stagflation, it is tough to consider economic growth as stagnating when it has never been that strong since the end of the 1990s and should remain above potential in 2022. Admittedly, with the Q2 base effects dissipating, growth is slowing down, but in Q3 GDP growth is still averaging 4.9% YoY in the US and 3.7% in the Eurozone.
We have seen worse… With 4.9% annual growth in Q3, China has not escaped the trend, but let’s not forget that:
- having barely used the budgetary and monetary levers in 2020, it has a greater leeway to stimulate its economy;
- that the economic activity has undoubtedly been penalized in Q3 by energy shortages and an extremely strict quarantine and COVID-containment policies;
- that China’s GDP today weighs close to CNY 28 trillion, i.e. almost 3 times the value it has at the time GDP was growing at a double-digit rate with little consideration for social and environmental issues.
It is also worth remembering that this inflation issue is one that is affecting primarily the United States and is closely linked to rising commodity prices. Structural deflationary factors such as technological changes and ageing demographics, as well as in Europe the 5 million jobs destroyed during the COVID crisis and not recovered since then, are clearly limiting factors when it comes to inflationary pressures in Europe, China and Japan.
As for rising commodity prices, although very noticeable this year, they are often put aside by central banks as they are considered to be unpredictable, or to have a limited aggregate input and to be cyclical in nature. However, this time around, they seem to result from both cyclical factors – a globally synchronized recovery of economic activity in the post-COVID world, supply chain disruption – and structural ones – commodity supply constrained by decades of underinvestment and a decarbonisation process that appears to be inflationary.
« It is tough to consider economic growth as stagnating when it has never been that strong since the end of the 1990s and should remain above potential in 2022. »
In the end, central bankers may be partially right when arguing for “transitory” inflation. Transitory first of all, because the consumer price index excluding energy and food prices, a measure closer to the one watched by the FED and other central banks is already showing signs of stabilization in a post-COVID world. Transitory secondly, the sharp rise seen in recent months seems to be due to limited components and outsized contributions that are expected to normalize over time.
On this point (see chart 1 below), two factors have made a disproportionate contribution to the recent drastic increase in consumer prices: the increase in “shelter costs” – housing and renting costs – that reflects the underinvestment in housing since the 2008 crisis, and rising used-cars’ prices, particularly in a context where the components’ shortage has drastically affected the production of new vehicles. Transitory at last, as to be considered as more structural and sustainable, a price wage loop would have to appear. While the risk to seeing such a loop happening in the US is real, there are nevertheless a number of important safeguards to prevent such a risk: One is the still precarious job market – an indicator also closely watched by the FED – with nearly 5.5 million jobs lost compared to the pre-COVID situation, or the significant productivity gains that have so far counterbalance wage growth.
Chart 1: Core US inflation and its various components
Source: BLS, Banque Eric Sturdza.
Therefore, we remain in the camp of those expecting inflation to be slightly higher than expected but the acceleration phase to be transitory. The post-COVID bottlenecks and the recent evolution of commodity prices could nevertheless translate into a slightly longer than anticipated plateau phase. This rationale is driving our thought process on the topic and is accompanied by a heightened degree of caution with regards to this inflation issue and by an opportunistic positioning on themes that offer protection or indexation to inflation without distorting our allocations or overplaying this risk.
Fixed-Income: « Transitory » Pressure on Long-Term Interest Rates
Four factors pushing up interest rates
US long-term interest rates (and the Bund is in the same boat) have had to cope with four rather gloomy pieces of news this month. The WTI crude oil price rose above $80 a barrel, reviving concerns about commodity-driven inflation. Second, the retail sales statistics came out higher than expected, pushed up by the recent rise in prices, of commodities in particular. Third, the corporate earnings season has got underway and all that was needed was a first few solid earnings reports to reassure Wall Street. Lastly, US and European long-term interest rates did not appreciate the attitude of the Bank of England (the BoE), which will probably raise its key intervention rate in the near future. There is really only a single subject of concern, inflation, with markets fretting that the major central banks (except the BoE) are doing nothing and are taking the risk of finding themselves behind the curve.
There is really only a single subject of concern, inflation, with markets fretting that the major central banks are doing nothing and are taking the risk of finding themselves behind the curve.
Growth: is there cause for worry?
Is the current inflation transitory? What definition should be given to the term transitory? On 3 November, we shall at least know the Fed’s official position regarding the phenomenon. Nearly all investors analyse the impact of these shocks solely under the prism of inflationary pressure, without considering the damage caused to growth. At present, what worries us most is not the duration of the transitory inflationary regime but the possible risk of China’s slowdown spreading throughout the Western world.
This complicated environment for central bankers offers us a scenario of a possible monetary policy error in the coming months. Markets are expecting a “hard” tapering ending by the end of June, followed immediately by a Fed Funds rate hike. Is this reasonable? We have always considered QE as a global QE, observing, on a global scale, the total amount of the purchasing programmes of the major central banks. With the huge amounts that the PBoC may have to prop up to reinvigorate the Chinese economic growth, the Fed’s tapering could soon become insignificant, and 2022 could be another year characterised by global QE on an exceptional scale.
The US 10-year rate at 1.80%?
In all this hubbub, long-term interest rates are as yet relatively calm. We are no longer very far from the 1.7742% of 30 March last, but can rates reasonably climb much higher? We do not believe in a sudden surge in long-term interest rates and we are waiting for possible coming stress to increase the duration of our portfolios. In the very near term, US long-term interest rates could rise again if inflationary pressures – and fears – persist and if the Fed gives the impression of being no longer in control: this would be an investment opportunity to seize before the US yield curve begins a flattening trend in 2022.
Equities: Continued strength in corporate earnings support rebounding equity values.
After a minor retreat of -5.5% for the MSCI world net returns index between September 6th and October 4th catalyzed by a deteriorating newsflow out of China and uneasiness around the Federal Reserve’s attitude towards spiking headline inflation numbers, the market has once again bounced back to reach a new historical high.
With around 40% of the MSCI World members having reported their quarterly earnings, the first takeaways are that the positive earnings surprises continue to be strong by historical standards but are slowly normalizing when compared to the post-COVID period. In fact, at current levels, the current 12% aggregated surprise would register as the smallest since the second quarter of 2020.
In broad terms, revenue surprises are following the same trend, converging towards the levels seen in Q2 2020, leaving ammunition for both bulls, touting the absolute level, and the bears focused on the second derivative. Naturally, the market’s heavy reliance on the large technology firms implies that Tesla’s strong deliveries and associated stock performance provided a jolt to capitalization-weighted indices, and also explains the recent rebound in performances.
All in all, we remain in the camp of the cautious optimists, underscoring these overall positive results against the back of continuously increased expectations, a demonstration of underlying strength in our view.
Chart 2: MSCI World – EPS and Revenue Surprises
Source: BES, Bloomberg.
The topic of supply chain stress and energy shortages remained top of mind during conference calls, with many companies attributing sales shortfalls to procurement issues, from everyday consumer goods to high-tech components, sparking short-term investors’ nervousness.
The topic of supply chain stress and energy shortages remained top of mind during conference calls, sparking short term investors’ nervousness.
Governments are increasingly looking to address the issue, from extended operating hours in California ports to talks of increased gas production in Russia and a return to a more market-friendly tone in the Spanish electricity market, all positive news in our view. Further, we see the first signs of normalization in a few categories such as specific semiconductors, where lead times have roughly stopped increasing. While this phenomenon has contributed to market share shifts and real economic headwinds in certain cases, we continue to view the vast majority of these phenomena as transitory and supportive of more investment spending, a positive for real GDP growth down the line.
While China’s real-estate sector remains under stress and many questions linger, local investors seem much more inclined to focus on the long-term opportunity provided by China’s economic trajectory than their international counterparts. The Chinese Renminbi progressed 1.3% this month, in stark contrast to past economic jitters, and equity benchmarks stabilized or rebounded. Our assessment of the macroeconomic picture remains broadly supportive for equity markets on the back of strong corporate earnings and our view of benign monetary policy adjustments, in part due to a normalizing global economy and a temporary economic slowdown in China.
The normalisation of economic activity, fiscal stimulus packages and easy financial conditions should continue to act as powerful supports for companies and stock markets. The recent earnings season further reinforces this reading. We maintain our positive view on the asset class but remain cautious to take into account the expected logical slowdown after normalization of base effects, inflationary pressures in the United States and regulatory developments in China and the risks they entail. At this stage, we maintain a constructive view of the Chinese markets: the economic slowdown induced by China’s very tough anti-COVID policies, energy shortages and tightening regulations in certain sectors such as real estate could prompt the authorities to loosen the monetary and fiscal stranglehold, particularly for households. While the recent publications of the US tech behemoths underline the strength and the interest of staying selectively invested in a pool of secular growth stories, the recent outperformance of cyclical and value stocks – oil and banking ones in particular – also underlines the interest of a so-called Barbell strategy.
We continue to maintain a cautious and selective positioning in this asset class. The government bonds’ markets continue to be largely administered by central banks and are penalized by the gradual upward adjustment of long-term rates. In this context, we continue to favour exposure through specific strategies and themes: rate and curve arbitrage, corporate hybrids, selective exposure to short-duration EUR High Yield, Chinese Investment Grade bonds issued in local currency, and mixed convertible bonds.
The normalisation of economic growth, as well as decades of underinvestment, are propping up the prices of industrial and energy commodities. The discipline shown by OPEC+ members and the wait and- see attitude of American producers in anticipation of tighter environmental regulations are also factors supporting energy prices. However, the volatility of these commodities and the contango effect make them difficult for private investors to invest indirectly. Precious metals are also stabilizing. In a context where real interest rates are still expected to be largely negative, the interest of gold as a diversification asset remains. In this context, option writing strategies are proving to be an interesting way to monetize gold positions through the capture of option premiums.
Despite lacklustre performances in 2020, alternative investments still offer interesting diversification potential in a context of low or negative interest rates. With these strategies, selectivity also remains essential. We also favour liquid strategies.
In an environment where long rates remain largely administered, the USD is positioned as the main adjustment value. As a result, we had positioned our portfolios to take advantage of a marginal appreciation of the USD against the EUR, and we maintain this view for the time being. The JPY seems to have broken through important technical points against the USD and could weaken further. As such, we have started to partially hedge some of our positions. Finally, the Chinese currency continues to be very resilient confirming its position as an alternative reserve currency and its interest from a diversification point of view.
As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolio.
+44 1481 742380
The views and statements contained herein are those of Banque Eric Sturdza SA as of 05/11/2021 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.