High inflation is on everyone’s mind, but perhaps growth should be more concerning when taking investment decisions.
It is true that to understand the present and face the future, we need to first understand the past. We have talked at length about the current inflation risks and, ultimately, stagflation scenarios and what this all means when building a portfolio. Stagflation happens when the inflation rate is elevated and economic growth is stagnating or slowing.
For asset allocators, following an economic cycle (expansion, slowdown/stagflation, recession/disinflation and recovery) and knowing where economies are in the cycle has always been important as it can help them determine the most appropriate mix of assets to own at different times.
Different asset classes (cyclical and defensive) respond with varying success according to what stage of the cycle we find ourselves in.
But does this mean investors should slavishly follow the rules of the past in investing during today’s environment?
Fundamentally, there is only one comparable example of prolonged stagflation over past decades, which is the one that occurred during the 1970s. Between 1973 and 1974 the oil price rose by 300% (by comparison, the price of crude oil price has risen 70% year-to-date), with subsequent rationing of supply, high unemployment and low productivity. This development coincided with years of large fiscal deficits that followed the conclusion of the war in Vietnam.
Finally, the relinquishment of the Bretton Wood agreements meant that several central banks around the world endorsed stimulative monetary policies right at the point where inflationary expectations were becoming de-anchored, meaning prices would become instable.
But today’s economic and market conditions are quite different from the ‘70s:
- Economic productivity is at much higher levels.
- Unemployment is lower and governments are gradually reversing part of the fiscal support that was created in the wake of the pandemic.
- Financial markets in the 1970s were less interlinked and investors had less access to markets.
Nevertheless, it may still be helpful to look at both past data and forward-looking indicators to understand where economies and markets might be heading next.
In particular, weighing the risks of inflation versus growth can help indicate if and when investors should position their portfolios for a recession.
The market narrative is shifting from inflation to growth
During the first quarter of 2022, many multi-asset investors (including ourselves) were heavily positioned in favour of those assets best placed to hedge (or somewhat protect) against inflationary pressures.
Commodities have been a core strategic position and the positive performance of this asset class year-to-date has been consistent with past periods of stagflation.
Equity styles also reflected the concerns of those seeking shelter from rising prices, with energy stocks and those sectors with cash flows explicitly linked to realised inflation (e.g. REITs or infrastructure) outperforming. This was also true for regional equities, with the UK FTSE 100’s sector mix (tilted towards raw materials and commodity producers) best suited to match the coincident rise in consumer prices.
Unsurprisingly, perhaps, assets with nominal payoffs like government bonds struggled to meet their safe heaven status. With inflation at decade-highs and still rising, investors hurried to capitalise on the rapid repricing of yields.
However, since the start of the second quarter of 2022, we have seen signs of a potential break to the inflation narrative. The chart below shows that two assets with perceived inflation-hedging abilities, real estate equities (REITs) and US treasury inflation-linked bonds (TIPS), witnessed an inflection point during April. At a superficial level, REITs can be considered a useful gauge of how much emphasis investors are placing on future risk of inflationary spirals.
While it is premature to draw formal conclusions from the last few weeks of price actions, we notice that market participants have become more balanced in their assessment of the tug of war between inflation and growth risks moving forward.
Is this a natural pause in what has been a very strong rally in inflation protecting assets? Or should this act as an initial sign that investor’s fears are now shifting towards growth downside? It’s hard to know with certainty, but certainly it’s a development to watch more carefully as we transition to the second half of the year.
Will bonds provide any diversification in this environment?
In the short-term, central bankers will be focused on taming inflation, even if that action may entail tightening of financial conditions and, consequently, a difficult path to thread for the real and the financial economy. The speed at which central banks navigate the difficult intersection of high consumer prices and slowing consumer demand, will likely determine the future direction of bond yields from here.
A very important question for asset allocators is whether bonds can continue to present themselves as a diversifier of equity risk in an environment where inflationary pressures remain elevated. What can the past (albeit somewhat limited in its depth) teach us, again?
History suggests that higher inflationary regimes have typically been associated with positive equity-bond correlations, as you can see in the chart below.
Looking at the 1960s and 1970s, the hedging properties of bonds were less attractive than what they have become during the ‘Great Moderation’ that ensued from the early 1980s. While we think it is very difficult to predict future correlations, we do expect the hedging properties of bonds to be more limited in a world where inflationary risks dominate over growth concerns.
Additionally, accommodative monetary policies have likely determined lower volatilities in fixed income markets; it is therefore plausible that the increase in volatility we have experienced this year (in response to tighter monetary conditions) may be illustrative of the future direction of travel. Higher interest rate volatility has been associated with higher equity-bond correlations, thereby reducing the overall diversification potential of government bonds.
With nominal bonds seemingly less helpful as a hedge against equity risk, trying to find other forms of protection will remain important for many investors.
At face value, inflation-linked bonds could be seen as a viable alternative, with their coupon payments directly linked to the change in prices. However, given our expectation that the central banks will likely raise rates above what is considered a ‘neutral’ interest rate (in order to gradually slow the economy and mitigate inflationary pressures), we struggle to yet justify buying TIPS today.
What about gold?
Gold, similarly perceived as a safe haven-hedge against stagflation, tends to perform well after the first rate hikes as recession fears begin to loom. The risk to this asset class, much like TIPS, is probably represented by rapidly rising real yields (a scenario when precious metals tend to perform less well). Bearing in mind this important caveat, we do, however, favour gold at this juncture because of its convex response to geopolitical risks, its typical under-representation within diversified portfolios, as well as its diversifying role in concentrated central banks’ reserves.
Finally, we believe that commodities should remain a core diversifier over the coming months. We expect the unequal balance of supply and demand to persist, barring extreme scenarios of upside supply shocks or major demand slowdowns (perhaps associated with prolonged lockdown policies in China).
A cash comeback?
Cash is resurfacing as a possible short-term diversifier of risks. Its purchasing power is clearly being eroded in a world where inflation remains elevated and short-term real yields continue to be negative. However, as savings rates gradually rise, the opportunity costs associated with holding cash should correspondingly decrease.
When should investors start to recession-proof their portfolios?
There are a number of indicators that tend to ‘predict’ when a recession will take place. These include inflationary measures (such as commodity prices and the output gap), with a lead time of around 15 months to 24 months. Also, monetary measures (such as the yield curve), with a typical lead time of 5 to 13 months. So too near-term macro and financial measures, with a lead time of less than 3 months. Consumer and market sentiment will also be important to monitor – measures of consumer confidence in the West have already fallen to levels not seen since the global financial crisis.
However, it would be impossible to isolate the precise tipping point when the economic cycle snaps from one particular stage to the next; the shift tends to be gradual in nature.
Determining when and how to change a particular asset mix is best left to a careful assessment of multiple inputs and to an attentive examination of the particular idiosyncrasies each cycle ultimately presents.
But what follows periods of high inflation when we descend more firmly into economic recession? Previous recessions tell us that assets that perform well at such times include equities (as their prices have typically fallen and markets begin to anticipate an economic recovery) and higher yielding bonds.
As investors rotate away from the defensive sectors, growth stocks (which are more positively correlated with lower real yields) are likely to re-emerge as the winners. Similarly, smaller companies typically stage a comeback during recessions as cost pressures ease.
The difficult balance between inflationary and recessionary forces will determine whether commodities can continue to outperform other asset classes once the economic momentum deteriorates.
In a nutshell
Inflation is likely to remain above target for the foreseeable future and the risks of transitioning to a stagflationary environment have meaningfully increased. That said, it is possible that central banks will eventually control the problem by slowing economic momentum and reducing aggregate demand.
On the other hand, slowing growth caused by both geopolitical tensions and supply-side restrictions is much harder for policymakers to control.
The war in Ukraine, the recent resurgence of Covid in China, and bottlenecks with global logistics have all converged to form a ‘perfect’ supply-side storm. That is, of increasing prices and slowing growth factors which have been so far difficult to tame.
Given the uncertainties that we face and the challenge of predicting what economic forces will drive investors’ perceptions, we believe that tilting a portfolio too aggressively towards a scenario of inflation or slowdown is possibly misguided.
We still believe that the best course of action for the months ahead is a diversified portfolio that incorporates two types of assets. On one side, those assets expected to hedge tail risk scenarios of sustained inflation, such as raw materials, precious metals and equity sectors more geared to real assets. On the other side, assets that can positively respond to a rapid fall in economic momentum (nominal and inflation linked bonds).
Source: Schroders, Bloomberg. Data to January 2022. Notes: equity are US large-cap equities, bonds are 10-year US Treasuries, inflation is US CPI. Past performance is not a guide to future performance and may not be repeated.
Originally published by Ugo Montrucchio, Multi-Asset Fund Manager, Schroders