Feb 23, 2021
For the first time in years, there is a material risk of higher inflation in the years ahead. Now is the time that investors should think through the portfolio implications of a more inflationary environment.
The causes are many. As governments are trying to deal with the immense economic and social challenges of the pandemic, we have witnessed monetary expansion and shifts in government and central-bank policy that have been supportive of consumer spending. These measures will likely continue to play an important role, given the heightened focus on inequality during the pandemic. Additionally, in many countries the deflationary impulse from demographics is weaker than it was in the mid-2010s. A modest retreat from globalisation, which for many years has held down prices by shifting production to low-cost locations, may also underpin price rises. However, our base case is that regionalisation of supply chains, in line with current patterns, will largely restrain significant price increases in the goods sector.
All this comes against a very different structural backdrop, particularly in the US, where private sector balance sheets are less impaired than they were in the late 2000s. Combined, these factors could finally unleash the inflationary consequences of the money-supply expansion following the Global Financial Crisis and the coronavirus pandemic. None of this suggests that we expect the soaraway prices of the 1970s – those were the product of multiple and repeated monetary policy errors accumulated over a decade. But there is a greater chance than before that inflation will persistently overshoot its target. In our view, inflation looks more likely in the US than in other major economies, given the stronger deflationary headwinds in Japan and the eurozone, and China’s more balanced inflationary outlook.
A softer US dollar has helped to support emerging market currencies, and emerging market assets more generally. Dollar depreciation has been predicated on a continued decline in real US interest rates as the Federal Reserve (the Fed) keeps rates locked down and inflation rebounds. However, this has become a strongly consensus view going into 2021, which implies some caution towards strategies that are heavily dependent on this outcome.
Nevertheless, the Fed’s balance-sheet expansion is unlikely to be tapered any time soon – reducing, for now, the risk of a repeat of the “taper tantrum” of 2013, which severely affected emerging market currencies and debt. Meanwhile, the Fed policy review, which converged on average inflation targeting, is also likely to underpin real rates at the short end of the curve. This should ensure the continued flow of liquidity into emerging markets, even if the US dollar is not notably weaker.
Developed government bond markets are set to remain heavily distorted, offering poor long-term real rates of return. With short rates pinned down and yield curves still relatively flat, there is scope for yield curves to steepen as the recovery becomes more firmly embedded. Low interest rates mean that even modest yield rises threaten to wipe out carry. However, a move higher is likely to be punctuated by sharp rallies, given investors’ ongoing propensity to reach for yield, while supply pressure will continue to be offset by quantitative easing.
Figure 1: Developed government bonds offer poor real rates of return
Source: Bloomberg and Ninety One, December 2020.
Inflation across emerging economies should continue to converge with that in developed markets as a result of the emerging market currency strength already witnessed over the last few months. This is against the structural backdrop of somewhat worsening demographics and higher debt levels, but also the increasing credibility of emerging market central banks and institutions. On the whole, however, real interest rates in emerging markets are likely to remain at a premium to those in developed markets. There are still opportunities, particularly in areas priced for interest-rate normalisation, where fundamentals are strong. Selectivity will remain critical, given that average yields in emerging market local-currency bonds are already at record lows.
After an initial hesitation, industrial commodities have enjoyed a classic v-shaped recovery since the middle of last year. This has been underpinned by the recovery in China, the principal source of demand, and augmented by strategic stock-building by the Chinese government, which took advantage of low prices and the chance to diversify away from US dollars. Metals balances tightened rapidly towards the end of 2020, reflecting the recovery in demand for durable goods and lower inventory levels due to COVID-related supply disruptions.
Although the momentum of the global recovery can be expected to moderate in the first half of 2021, this will not signal a change in direction for industrial-commodities markets. Risks to prices will continue to be to the upside as the recovery broadens and policy support remains intensive. Consolidation has been a key trend in the mining industry in the aftermath of the secular bull market of the 2000s. This, coupled with an ongoing commitment to increased financial discipline, is underpinning the bullish outlook for prices. Supply in key metals should remain tight. Moreover, the energy transition that is now underway is resource intensive in the short run and will likely support secular demand for key materials.
The outlook for oil is more nuanced. We expect a further demand-driven recovery for oil from the current levels, which should provide a cyclical lift for energy stocks. But structural uncertainties are unlikely to fully dissipate amid an accelerating energy transition.
As coronavirus fears have eased, gold has corrected – an unusual phenomenon at a time of US dollar weakness. We consider this adjustment to be largely due to technical factors such as shorter-term momentum investors calling time on their gold holdings and a heavily overbought position being unwound, rather than fundamental ones. Real interest rates are set to remain low and will likely decline as inflation pressures build, supporting gold. After a further period of consolidation, gold should revert to its medium-term uptrend.
Gold equities have retraced over the past few months as the precious metal has retreated, but gold companies’ third quarter results were the best we have seen for many years. Margins and free cash flows are the highest for the sector since 1980 in real terms and net debt levels are the lowest on average for any sector, meaning that shareholder returns are growing rapidly. Gold companies are following the lead of the gold majors in focusing on disciplined capital allocation and earnings per share, rather than volume growth. Industry consolidation is also helping to cut costs.
Although we may see modest growth reversals in the first half of 2021 due to further coronavirus “waves”, there remains every prospect of a more broad-based recovery as the year progresses. This is already being signalled by steepening yield curves, marking the beginning of a rotation away from the stocks that had led the market recovery, and into some of the cyclical laggards and “COVID-victim” stocks such as airlines and tourism. Market breadth – lacking hitherto – is now set to increase as confidence in the recovery builds.
Outside the US, we continue to favour Chinese and Asian equities that have attractive valuations and strong secular-growth prospects. Ex-China Asia and broader emerging market equities are particularly well placed to continue enjoying a cyclical bounce in the coming months, and to potentially benefit from the constructive backdrop of helpful financial conditions, positive flows driven by improved investor risk appetite and, for some, stronger commodity prices.