2Q 2021 Quarterly Investment Forum The Inflation Debate

Inflation’s influence on the macro outlook

Evan Brown, Head of Macro Asset Allocation Strategy

Inflation is the most talked-about subject during client conversations, with the media, and among business executives.

The two largest monthly increases in US inflation in nearly 40 years add another risk for investors to worry about. Inflation concerns are contributing to a less constructive backdrop, and we expect a choppy performance for equities at the index level.

The inflation outlook is important because it can separate relative winners from losers within different asset classes, provoke tightening by central banks that undermines economic growth and equity valuations, and can threaten the negative stock-bond correlation that underpins traditional portfolio structures.

We are closely watching for any signs of higher inflation feeding into higher inflation expectations and demands for pay increases, which could create a feedback loop that pushes prices up.

We believe that the bond market has largely digested the potential for upside price pressures in the very near term, but remains sanguine about medium- and longer-term inflation risks. Whether higher inflation is ultimately transitory or more persistent is a debate that’s far from over. What is important is that the outlook remains uncertain, and risks appear tilted to the upside. This means the evolution of inflation may contribute to bond market volatility that can have spillovers to other asset classes.

Fixed income: Inflation and positioning

Jonathan Gregory, Head of Fixed Income, UK
Kevin Zhao, Head of Global Sovereign and Currency, Fixed Income

If higher inflation occurs on a sustained basis, it will be because underlying structural drivers of disinflation over several decades have reversed. Demographics and technology are likely to continue to keep price pressures relatively subdued. However, for fiscal policy, monetary policy, labor’s share of income globalization, and corporate strategy, the outlook is more uncertain, and risks are more tilted to the upside than at any other time in the past 20 to 30 years.

Of particular note is how governments, regulators, and investors are forcing a rethink of corporate strategic priorities away from “cheapest to deliver” to “greenest to deliver.” This trend could result in profound, widespread changes that result in broad pressure on end user prices.

For the US, the risk of Japanification – a perpetual dearth of price pressures – is lower now because of the amount of fiscal stimulus deployed into the pandemic. This is likely to help the Federal Reserve achieve its targeted level of inflation, but without a 1970s-style upside scenario. Continued strong US growth and a falling unemployment rate are unlikely to spur an upward spiral in wage and inflation expectations in the short term.

In our view, Treasury Inflation Protected Securities are unattractive, as are most inflation-linked bonds across developed market economies, with the exception of New Zealand and Japan.

Whether persistent inflation is a negative for credit will depend on the Fed’s stance on higher price pressures. If tolerant, that is likely to be positive for spreads, whereas if the Fed shifts towards earlier tightening, its stance is likely to create a less positive environment.

Inexpensive equities for an inflation upturn

Max Anderl, Head of Concentrated Alpha Equity
Steve Magill, Head of European Equity Value

The probability of higher inflation has increased. There are natural hedges within the equity market if this comes to pass, which we believe happen to be undervalued at the moment.

At the current time, the inflation outlook would entail that equity investors should overweight mining and energy companies where share prices appear to discount a decline in commodity prices, while underweighting companies that have high labor and wage exposure.

Overall, equities are not the safest asset class if disruptive inflation is coming, but we believe that some areas of the market are better than others and that those segments are currently inexpensive.

Central banks will need to be careful in dampening inflation without sparking a downturn in asset prices. With a large share of the population in developed markets at or near retirement, and more sensitive to asset price fluctuations, a sustained bear market would both be a negative to economic activity and likely spur a more pronounced rollover in inflation than the central bank desires.

Additive alternatives: Real estate and infrastructure

Tiffany Gherlone, Head of Research and Strategy, REPM US
Declan O’Brien, Head of Infrastructure Research and Strategy

Statistically, real estate is a good inflation hedge – but not all segments within this asset class have that characteristic. Apartments and industrial have been able to, and are likely to continue to perform that function. Office and retail are not, as actual cash flows are low since a lot of funds are reinvested back into the property.

What helps to make real estate an inflation hedge is the active management of owning and operating properties, choosing capital investment programs that are more accretive and defensive, and managing lease terms and the tenant profiles. Appreciation in the underlying property is also important.

Within real estate, emerging/niche categories such as manufactured homes, self-storage, student housing, life sciences, data centers, single family rental, and cold storage are also likely to make the asset class a more robust inflation hedge over time.

In infrastructure, assets either have an explicit or implicit linkage to inflation. Core sectors such as utilities and transportation often have this relationship directly tied into revenue growth. Others, such as telecom and renewables, have implicit connections through changes in merchant power prices.

When US CPI inflation is above 3%, infrastructure tends to perform extremely well relative to equities. When inflation is between 2% and 3%, the asset class tends to have modest outperformance.

Inflation is positive for cash flows in infrastructure, but another consequence is that bond yields rise. The biggest factor in returns and valuations is real interest rates, since assets tend to be levered at 60%.

How hedge funds are reacting to inflation

Edoardo Rulli, Head of Europe Investments, Hedge Fund Solutions

Hedge funds are positioning for a regime shift and elevated inflation lingering. Short positions in bonds and long commodity positions have been very popular trades. Recently, funds have begun to embrace bear flatteners, believing the belly (or five-year tenor) of the yield curve will lead weakness. Interestingly, positioning does not suggest that gold or bitcoin are being utilized heavily as inflation hedges.

Short-term contributors to inflation include supply bottlenecks, including in the labor market, lasting longer, and the unprecedented fiscal stimulus. Longer-term, the rising cost of climate change and China’s shift to a more consumer-driven economy may fuel price pressures.

Our positioning tends to reflect reflationary views, with relatively elevated exposure to commodities, discretionary macro funds, and adding to value-centric managers while lessening exposure to those focused on long duration stocks.