With a strong economic recovery and pretty loose monetary and fiscal policies, the question of a return of inflation is back in the spotlight.
In the short run there are many reasons for tensions to persist: higher commodity prices, surging shipping costs, bottlenecks in some industries (for semi-conductors in particular), depleted inventories, but also price increases in the service sector due to the reopening of economies… All these factors have combined to push prices higher: producer prices as well as consumer prices have significantly accelerated in many countries in April. Moreover, PMI surveys are generally pointing to higher input prices, lengthening supplier delivery times, signalling inflationary pressures are likely to persist for some time.
This phase could however reasonably be regarded as temporary (i.e. lasting a couple of more months) as supply will adjust to the reopening and inventories will be rebuilt. This might take a bit more time than sometimes expected as global supply chains disruptions have been significant. But most central banks are likely to remain patient before removing accommodation, looking through the transitory surge of prices as activity is gathering momentum. Indeed, most economies are far from full employment. Despite the rebound in activity, around ten million jobs were still missing in the US in April 2021, and the euro area was even further away from its pre-crisis employment rate. While we continue to believe central banks will avoid premature tightening, the nervousness of market participants is understandable and inflation scares are likely to stay with us for some time… the more so since some central banks might see some merit in having a bit higher inflation than before the pandemic. Didn’t the Federal Reserve in particular vow to tolerate a period of above-target price rises? All those betting on a permanent surge in inflation however are likely to be disappointed: if the economy were to get too hot, central banks are not short of tools to calm down tensions!
Given our current expectations of mild inflation and higher but low real interest rates, we remain overall overweight equities. Contrary to bonds, equities tend to perform the best in a (mild) inflationary scenario. Even if equities P/E tends to deflate as long as rates increase, sensitivity to revisions in the growth momentum are even more important. Moreover, some corporates manage to pass on higher costs to consumers which limits the impact on earnings. On the opposite side, we keep a shorter duration and underweight bonds in such an environment. The returns offered by these long-dated securities become less attractive as they may no longer compensate for inflation.
Going one step further, cyclicals and value stocks should do best during the inflationary and rates appreciation period as they tend to be positively correlated to rising rates. This transition has already supported a sectorial rotation towards value and cyclical sectors, which is still at play. Hence, and our strategy is geared towards stocks leveraged to the recovery, a steepening of the yield curve and rising commodity prices. More specifically, we are buying small and mid-caps in the US, the UK and Latin America. Further, we have a positive stance on US and EMU banks, which benefit the most from the expected yield curve steepening.