Portfolio Management

Market Thoughts: Should you worry about inflation?

Nov 16, 2021

Although global growth is decelerating, it’s resilient. We’re seeing the growth we expected and the slowing we foresaw.

Why are you bullish despite reasons to be bearish?

KEY TAKEAWAYS

  • Central banks, for the most part, continue to do and say the right thing. Their words and policy actions are under greater scrutiny. The same can be said for corporate earnings and management outlook commentary.
  • It’s too early to have an informed opinion on whether this cycle ends with inflation running fast ahead of policy makers. The data won’t be able to signal where we are likely to land for another few quarters.
  • Slower revenue and earnings growth will eventually weigh on market returns, just as higher interest rates will weigh on valuations. There is nothing negative in those observations.
  • Our focus is on risk. I want to anticipate what might impact a more dramatic shift, not only in confidence but market direction. The path ahead is going to be far less ‘one-way-up’ and more challenging

We are getting the markets and economic environment we anticipated and have positioned portfolios for this year, with upside. Right now it may be hard to be a bull, but it’s even harder to be a bear.

From a macro perspective, we’re seeing the growth we expected and the slowing we foresaw. Global growth is decelerating, but remains resilient – even if it’s uneven across economies (Figure 1). I expect we’ll see the same from market returns as we focus on the year ahead – positive, but less hardy. 

Figure 1: Economies still growing, but past the peak

Line chart of Global, Euro Area and U.S. Composite Purchasing Managers Index time series with monthly data points that are displayed on the y-axis and since 2019 on the x-axis. A horizontal dashed line shown across 50 separates economic expansion or contraction with above that value representing the former and below it the latter. For the better part of 2019, all economies were hovering not too far above 50, and in early 2020 a marked drawdown occurred across the board, with Euro Area declining the most. However, by mid 2020 all regained expansion but continued on an uneven trajectory coming into 2021, with Europe dipping below 50 again. 2021 saw Composite Purchasing Managers Index across economies remain firmly in expansion, though it has decelerated in recent months.

The simple math for anyone adding to risk assets is that stocks over the next year should outperform bonds, just not at the same pace. We expect U.S. equity market exceptionalism to remain intact, along with a well-supported dollar. European earnings growth may again surprise to the upside. Broadly speaking, we see emerging equity markets as challenged versus developed markets.

Fed tapering and market tantrums. Starting with the Federal Reserve (Fed), developed market central banks continue to do and say the right thing. However, their words and policy actions are under greater scrutiny. As the expression goes, the ‘easy money’ has been made and risks have risen. Valuations don’t offer the same degree of upside and if you look down from where markets have climbed, there is greater downside from where we stand today.

The Fed is reflecting improved visibility about a better economy. There is less uncertainty about growth. Inflation is a concern, but what gets lost in the discussion is the starting point. Interest rates have a long way to go before they become destabilizing. As a leading indicator, I’m watching credit markets. Relative stability across investment grade and extended credit is going to be key. It signals that investors remain, in general, constructive about the outlook.

It’s too early to have an informed opinion on whether this cycle ends with inflation running fast ahead of policy makers or we gradually revert back to where we were pre-COVID: slow and steady growth with controlled inflation. The reality is the data won’t be able to signal where we are likely to land for another few quarters.

Markets ‘get the joke’ about the current stagflation headline wars. Risk assets are well supported. That said, central banks are beginning to pivot in tone. The message Fed Chair Powell wants to resonate most with investors is that the Fed learned from prior mistakes of tightening before it was clear that inflation was in fact something to be concerned about. The same can be said for European Central Bank President Christine Lagarde.

Even as the Fed begins to taper its purchases of U.S. Treasuries and mortgages, it’s not reducing the size of its balance sheet (Figure 2). Both the ability for the Fed to purchase bonds and maintain a large balance sheet are part of its expanded policy toolkit. Neither is going away. Each will continue to be used to emphasize the Fed’s outlook and be put into action as needed. Those observations have somehow been lost in the clatter. They’re important to remember.

Figure 2: Central bank balance sheets continue to grow

Line chart of U.S., Euro Area and Japan local currency central bank balance sheet growth time series with quarterly data points displayed on the y-axis as indexed to 100 in Q1 2010 and shown since then through Q3 2021 on the x-axis. While divergent in the first few years shown, all regions show significant growth in total over the last decade and an accelerating pace of growth since around the start of 2020. Japan shows the largest relative increase over the time horizon at almost 600, followed by Europe and then the U.S. respectively above and below 400. The U.S. shows a particularly sharp increase in balance sheet growth in 2020, rising by almost 150 in that calendar year.

The Fed’s goal in quickly wrapping up bond purchases next year is to build in the optionality of being able to raise policy rates if they need to. It gives them the flexibility to move swiftly, should inflation remain high. So far, the bond market is taking all of this in stride. That said, we expect government bond markets to remain volatile as yields press higher.

Peak economic and earnings growth. Regardless of what you read, the ‘death of the reflation trade’ seems greatly exaggerated. The pace of global growth is slowing, as should the pace of inflation. Labor markets continue to open as consumption normalizes, in particular across the service sector.

We are seeing mixed data as we move through peak economic growth. Moving past peak growth doesn’t mean contraction, it means that the rate of growth is slowing. We expect above trend growth next year across developed economies and a weaker environment across emerging markets. We’ve seen consumer sentiment sour as the Delta variant spread. Hopefully, we’ve seen the worst, but COVID remains a known unknown, and investors loathe uncertainty.

Corporate earnings continue to press higher. That’s good news. But like central bank policy action and rhetoric, earnings and management commentary are going to be under far greater scrutiny over the coming quarters. We’ll be paying close attention to any hints of increasing pressure on margins (Figure 3).  So far, operating leverage remains robust both in the U.S. and in Europe. Those markets remain our largest regional equity overweights.

Figure 3: Profit margins are strong, but may be a risk

Line chart of MSCI USA, MSCI Europe and MSCI Japan last twelve month net income margins time series shown in percentage terms on the y-axis and displayed on a quarterly basis since 2002 through Q3 2021 on the x-axis. While divergent in level terms with the U.S. being highest at around 12% and Japan lowest at around 6%, all regions show significant margin growth in 2021, most notably in Europe which increased by over 3% to almost 9%. The chart denotes that past performance is not indicative of future returns, and that it is not possible to invest in an index.

My general sense is there is a little upside left to squeeze out of analyst earnings forecasts for next year. That’s good news for equity markets as earnings continue to support valuations. It’s also positive for corporate balance sheets and, by extension, credit markets as we continue to see strong new bond issuance.

Slower revenue and earnings growth will eventually weigh on market returns, just as higher interest rates will weigh on valuations. There is nothing negative in those observations. Gravity works. However, once it happens, the narrative will quickly pivot from high confidence strong earnings can continue to grow into multiples to refocusing on the fact that valuations are high, with less of an earnings cushion to lean into for reassurance.

Low yields, not to mention a still attractive equity risk premium, are supportive. The fact that credit markets are strong, upgrades are outpacing downgrades, cash holdings remain robust and the cost of capital is ‘cheap’ make for a robust backdrop. But at some point, we will begin to talk about the ‘late’ part of this market cycle. It’s by no means fast approaching, but it’s on the horizon.

There is nothing surprising about a regime change. As the last cycle showed, a late cycle environment can run for years. But it implies shifts to how we are investing. I don’t expect we’ll be leaning anytime soon into late cycle positioning, but we are having those discussions. I want a clear picture of where we think markets are heading before we get there.

Risks are higher. My focus is on the risks ahead. Investors aren’t irrational, but there is a creeping sense that markets only go up. They can until they don’t. I want to anticipate what might cause a dramatic shift in confidence.

Inflation remains the obvious risk to point to. If higher inflation proves persistent, we’re going to see a pullback in sentiment and risk positioning. At the moment, investors have been willing to give the Fed the benefit of the doubt. If by the middle of next year we’re still seeing the pace of inflation we are seeing today, buckle up.

I believe we have at least another few quarters of strong revenue and earnings growth ahead of us. That is going to help keep valuations in check and risk appetite hungry to buy pullbacks. The thing about sell-offs is that you don’t recognize the difference between buying a dip and something worse until you’ve bought one too many.

I’ve been asked if it makes sense to start pulling back our pro-cyclical positioning. I feel comfortable with the amount of risk we hold across portfolios. I say that because should we get a market correction, I’m still a better buyer of risk assets. We continue to have active discussions on the team about positioning, in particular as equity markets move higher. The path ahead may be bumpier than it has been, but we are staying on it.

Where do we go from here? We’ve seen the best of the economic and market recovery. Markets will be far less ‘one-way-up’ and more challenging. I am obsessed with asking what we’re missing and how we might be wrong in our outlook. I’m not worried about a pullback or correction; they happen. I want us focused on what might structurally derail the current cycle and market direction. What aren’t we focusing on and should be?

We expect to see the Bank of England (BoE) begin to raise policy rates shortly. Brexit has brought a unique set of challenges both to growth as well as inflation in the U.K that seem more structural. We’re paying close attention to what the BoE does as interest rates are, both on an absolute and relative basis, important to global markets. Higher rates in the U.K. are likely to nudge both European and U.S. interest rates higher as well.

The Fed isn’t raising policy rates quite yet (Figure 4). The same holds true for the ECB. Both central banks will continue to add stimulus to their economies, just at a slower pace. Our base case is that ‘lift off’ for the Fed – when they begin to raise policy rates – shouldn’t start before late 2022. The market is signaling it expects the Fed will begin to raise rates by the middle of next year. They may have to, we’ll see. We believe the ECB is even further away from raising policy rates than the Fed. A lot is going to happen between now and then. 

Figure 4: Central bank policy rates remain low

Line chart of U.S., Euro Area and U.K. central bank policy rates time series shown in percentage terms on the y-axis and displayed with monthly data points since 2010 through Q3 2021 on the x-axis. While divergent in both level and trajectory over the better part of the period shown, since 2020 they have all converged at around 0%.

Bond markets have lagged pricing in the above trend global growth we expect next year. That is particularly the case in the U.S. and Europe. As the Fed and ECB pull back on their amount of bond purchases, investors may start to pay more attention. We are underweight core bonds and duration because we expect interest rates will push higher.

Activity indicators for the most part continue to advance as does the global recovery, though at a more moderate pace. In round numbers, U.S. household wealth has increased by about $25 trillion from pre-pandemic levels. Cumulative excess consumer savings are now around $2.5 trillion since then as well. Wage growth looks durable and likely to press higher. All of that is good news for spending and investment.

Am I worried about inflation? The short answer is yes, but not to the extent that I want to change portfolio positioning. Profit margins and operating leverage are the ‘wild cards’ to watch over the next 12 months. Supply-chain disruptions remain in the headlines for a reason. They’ve run far longer than expected. I would say the same broadly speaking about labor shortages along with the squeeze we’re seeing in energy prices and housing. Companies continue to feel they have pricing power. That’s a theme we are going to be watching closely over the next few quarters.

I believe a lot of what is pushing prices higher will gradually decelerate. But inflationary pressure remains the biggest risk to disrupting investor confidence, not to mention derailing market strength. In the interim, expect investor behavior to rhyme with what we’ve seen over the past few months…markets are going to be bouncy.

I’m constructive on the outlook and our pro-cyclical portfolio positioning reflects that. Stocks should continue to outperform core bonds. I believe the same about credit markets and alternatives. The ride is going to get bumpier, which creates tactical opportunities for us to lean into or out of positions we hold across markets. I expect we’ll see more air pockets ahead, but if pressed, I believe risks to the outlook skew modestly to the upside.

If we were to see a market correction, we are better buyers of risk assets, predicated on what causes the selloff. I expect returns will be lower than they have been over the past year. But think about the number of times over the past few years where we’ve been in the same position. Markets run hard, fall and then quickly pick themselves back up again.

Past performance is no guarantee of future returns. That said, if you are investing through a cycle, bouts of volatility are less relevant than staying invested and compounding returns. The proof statement is in the numbers.

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