April 13, 2022 Quarterly Investment Forum Macro update on the ascendance of Inflation

The investment implications of elevated inflation and a volatile geopolitical environment

Asset allocation 04 May 2022 3 min read
Authors
Barry GillEvan BrownBruce AmlickeJonathan DaviesGeoffrey Wong

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The Quarterly Investment Forum (QIF) is an ongoing cross-investment team discussion and debate about the most relevant active risks in major markets and across asset classes and funds.
Each QIF is a mix of 'top down' and 'bottom up' perspectives, beginning with a 'top down' discussion of the major macroeconomic themes identified by the Asset Allocation Team. Each quarter, a rotating roster of portfolio managers present a 'bottom up' view of major active risks in their portfolios.

We have a unique depth and breadth of investment expertise across traditional and alternative asset classes in all regions globally. The QIF leverages that expertise through regular, structured communication between investment teams. The ultimate goal is to improve client outcomes.

Quarterly Investment Forum highlights

Macro update on the ascendance of Inflation

Barry Gill, Head of Investments

We are at the beginning of an era of secularly higher inflation. Most of the key factors that drive the ebbs and flows of price pressures – demographics, politics, fiscal policy, monetary policy, supply chains, and geopolitics – have inflected in a pro-inflation direction. Technology may continue to be a countervailing force, but is unlikely to be a sufficient offset in the face of these myriad structural turns.

Dependency ratios across developed economies – and also in China – have shifted. There are more people dependent on fewer workers, driving up the bargaining power of labor. In the past, countries have managed to side-step this inflationary impulse by outsourcing labor and production to other regions, but that trend may have run its course. The probability of labor weakening relative to capital here is low, a dynamic which should weigh on profit margins somewhat over time.

Politics are also shifting. We are at the point where the median voter in the US could be a millennial, a cohort which self-reports as extremely or somewhat likely to vote for a leftist candidate. Such politicians tend to support redistributionist policies that are inflationary in nature.

On a similar note, fiscal policy is playing a much more robust role in stabilizing economic activity. The stimulus passed globally to mitigate the economic damage from the COVID-induced recession was two times larger than what transpired after the global financial crisis. This provides a playbook for more muscular government action in the future.

Central banks may need to accommodate higher price pressures on an ongoing basis, much as the Federal Reserve did in the wake of World War II. In this instance, monetary policymakers may need to keep real rates suppressed to help facilitate the trillions of investments needed to carry out the green transition. The greening of the economy promises to be a commodity-intensive, inflationary undertaking that requires both public and private capital.

For decades, supply chains had been optimized for businesses prioritizing low costs and low inventories. Reshoring and rebuilding inventories are likely to be multi-year processes that contribute to rising prices.

Geopolitics add another facet to this higher inflation thesis, particularly in the near term, as Russia’s invasion has resulted in much higher commodity prices, particularly for energy and agricultural products. Going forward, stockpiling of essential inputs is likely to become the norm.

In this higher inflation environment, the stock-bond correlation is likely to stay positive even in developed markets, though there may be a head-fake at the time of the next recession in which bonds rally as stocks decline. But as a general matter, the Sharpe ratio of portfolios will be more challenged as stocks and bonds move in tandem, and we will need to provide more innovative solutions to help clients reach their investment goals.

Panel discussion on investment implications and risks

Evan Brown, Head of Multi-Asset Strategy/Portfolio Manager
Bruce Amlicke, Chief Investment Officer - Head of Hedge Fund Solutions
Jonathan Davies, Portfolio Manager
Geoffrey Wong, Head of EM & APAC Equities

The movement towards populism and autocratic strongmen – politicians that have goals beyond spreading prosperity, but legacy-oriented, territorial ambitions – is contributing to an environment of higher geopolitical risks and economic decoupling. Peak globalization has likely passed, with countries more likely to optimize for economic security rather than efficiency. Broad-based curtailments to global trade may be unlikely, but countries not considered geopolitically aligned are unlikely to rely on one another for vital inputs in strategically important industries.

Prime contributors to inflation – shortages of labor, housing, and commodities – are likely to have staying power. A more prolonged phase of commodity price inflation is likely given the extended period of underinvestment and the demand needed to decarbonize economies. One counterpoint to this notion of a higher-inflation regime, however, is that the interests of central banks and politicians are aligned. Surveys of consumer sentiment are at low levels because of high price pressures, and inflation is well above central bank targets.

The prior era of low interest rates created pockets of excessive leverage that may be vulnerable given the pace of tightening cycle that monetary policymakers are telegraphing. In addition, investors may still be underestimating how high central bank policy rates will be on a structural basis. This is a negative environment for bonds and bond-like investments. In sovereign debt, there are more attractive opportunities at the front end of the curve than the long end.

Though some pockets within global equities are still attractive, particularly those with higher weightings to energy and financials, this dynamic is likely to exert downward pressure on stock valuations. Within foreign exchange, the impact of real interest rate influences is essential. There has been much more aggressive monetary policy tightening in a lot of emerging markets, particularly Latin American, than in G10 countries, which has benefitted those currencies.

Within the hedge fund space, we believe that allocations to commodity, macro, fixed income relative value, and equity hedged are particularly attractive. These areas offer exposure to a potential supercycle in commodities, opportunities to benefit from elevated uncertainty on economic outcomes, changing central bank reaction functions amid volatile inflation, and the fertile opportunity set on the short side for single stock selection.

Investors in emerging markets may benefit from sectors that are at the nexus of price inflation, as this is likely indicative of firm demand that limit the scope of any potential cyclical downside. On a regional basis, we believe that Indonesia’s orientation towards commodities makes it relatively attractive among EM Asia. In addition, there are inexpensive long-term themes in automation in EM and Japan. Since automation equipment sales tend to track capital expenditures broadly, this is a structural trend with a cyclical overlay. Select Chinese clean energy stocks, which are capital intensive but post high sales growth, are also preferred, in our view.

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