The five-year market perspective

Our inflation estimates have moved up slightly, though not as dramatically as changes in breakeven rates imply. Although we see short-run inflationary pressures, we expect central banks to be successful in controlling inflation. We tend to side with the Fed that this is a temporary spike in inflation and that the deflationary forces of technology and a high degree of substitution will keep sustained inflation in check.

The global 60/40 approach continued to have solid returns. A 60% MSCI ACWI unhedged and 40% Bloomberg Barclays Global Aggregate hedged return 31.2% in the past year and 9.8% over last five years.¹ However, on a forward looking basis, we have lowered our return expectations.

We expect the stock-bond correlation to continue to be negative, though the relationship has weakened a bit and is vulnerable to a reversal with a breakout of inflation and possible Fed interest rate hikes.

We view China as unique: neither a developed nor an emerging market, it continues to offer unique diversification benefits for global investors. China continues to have a different business and market cycle than the rest of the world. The correlation of Chinese equities with the S&P 500 (local to local currency) was 0.03 over the past year. In fixed income, Chinese government bonds continue to have a low correlation with other government bond markets, despite the recent deceleration in Chinese credit growth.²

With equities rallying 14.2%³ from November through April, valuations have become even more stretched and will require extraordinary earnings growth and continued low rates to be justified.

Although cash rates barely budged, government bond yields in developed markets moved up anywhere from 8 bps (Japan) to 89 bps (Canada). The emerging markets also saw a substantial increase in yields. China is one outlier, with their benchmark 10-year government bond yield declining by 9 bps.⁴

In general, with the US dollar getting closer to fair value, we see limited gains from currency exposure for unhedged non-USD assets in USD terms. Conversely, we see smaller losses for foreign investors investing in USD-denominated assets.

¹ Data from Macrobond, calculation by UBS Asset Management. Data as of 30 April 2021.
² Data from Morningstar, calculation by UBS Asset Management. Data as of 30 April 2021.
³ MSCI AWCI in USD from 30 Nov 2020 to 30 April 2021 (five months).
⁴ Data from Morningstar, Macrobond, calculation by UBS Asset Management.

Short term measures of inflation have risen sharply in the past few months. Back in November breakeven rates were around the average inflation rate for the last dozen years (1.7%). But in 2021 inflation has shot up 70 to 90 basis points to hover around 2.6% for the US. (One interesting recent development is that shorter-term measures of expected inflation are higher than longer-term measures. For example, the 5-year breakeven inflation rate, the difference between nominal Treasury and inflation-adjusted (real) Treasury yields as measured in the TIPS market, is 2.6% while the 10-year is 2.4%. And the 1-3 TIPS sector compared with the 1-3 Treasury sector indicates a 2.8% inflation rate.)

Source: Macrobond, UBS Asset Management. Data as of 30 April 2021.

We explore four different inflation scenarios. In each of these scenarios we are assuming a continuation of growth and above-average inflation in the second half of 2021. Thus, the negative and positive effects begin to show themselves in early 2022.

⁵ For example, since 2009, the Fed has targeted 2.0% inflation on a Core PCE basis. However, Core PCE has averaged about 1.6% over this period. The 'headline' inflation figure (CPI-U All Items) has been a bit higher at 1.8%.

1. Growth inflation: Strong growth and high inflation.
2. Baseline: Moderate growth and moderate inflation.
3. Stagflation scenario: Low growth and high inflation.
   
4. Stagnation: Recession in late 2022 followed by low growth and low inflation.

When analyzing scenarios, we combine growth and inflation to produce nominal growth rates. We project that nominal growth could be as high as 6.3% and as low as 3.0%. However, we ultimately want to judge returns in real terms and significant differences in inflation can cause a notable difference between the nominal and real results.

Our expected returns for equities—especially US equities--are the lowest in years. Pockets of equities outside the US offer more compelling returns. Offsetting this is an increase in government bond yields, though this has stabilized in the last couple of months.

When it comes to asset returns and inflation, we see that the market is little prepared for a big breakout. In the short run there is no place to hide from negative real returns.

We expect alternatives to suffer the least as commodities, gold and real estate gain relative to other asset classes. Again, the backdrop to the type of inflation is important. Growth inflation should benefit real estate, while a Stagflation outcome would probably be very positive for gold. Commodities would probably be one of the drivers in inflation and clearly should do better in an inflationary growth environment. In short, the market opportunities to truly profit from inflation are few.