Macro Monthly From peak inflation to higher trend inflation

Macroeconomic uncertainty is high – and for good reason. It’s been over four decades since the Federal Reserve was faced with inflation running this hot, and engineering a soft landing as monetary stimulus is aggressively curtailed will be challenging. Russia’s invasion of Ukraine is leaving ripple effects, and perhaps scars, on the economic and geopolitical landscapes. COVID-19 flare-ups in China are being met with stringent mobility restrictions, dampening production and threatening to increase supply chain snarls and weigh on domestic consumption. And commodity price shocks are causing hits to real income that dampen the outlook for consumer spending.

Elevated inflation is the cause or product of these various macroeconomic flash points, and the proximate cause of elevated volatility in bond markets. This stands in stark contrast to last cycle, when low and stable inflation meant that market participants could focus on the ebbs and flows of growth alone. We believe we are migrating from an environment of “peak inflation” to “higher trend inflation,” and that market participants are likely to entertain a wide range of outcomes for both inflation and growth during this transition period.

Seasoned mountaineers are no doubt aware that the descent can be even more treacherous than the climb. So too is this the case with inflation, which we believe will have staying power as a catalyst for cross-asset performance based on how fast, how much, and the reasons why price pressures recede. In our view, stocks are unattractive at the headline level. The global equity risk premium is near its tightest level over the past decade, suggesting that investors are not being adequately compensated for the risk of surprisingly negative scenarios for growth or inflation. We believe that it is not prudent to aggressively pre-judge the eventual macro outcome or overweight risk assets during this time of heightened uncertainty, but rather to prioritize diversification and allocate to relative value positions that offer the best risk-reward in different scenarios: an inflationary boom, stagflation, a growth scare, and a moderation of both activity and inflation to levels relatively similar to the previous cycle. For some, valuations are sufficiently inexpensive that there is limited downside even if macroeconomic outcomes turn out to be in the least favorable quadrant for that trade. Other positions may not be cheap, but have positive momentum and return potential is asymmetrically skewed to the upside, in our view, particularly in the stagflation or growth scare scenarios.

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Evidence that China is able to reopen and deliver sufficient stimulus to stabilize the domestic economy would be an important catalyst to get investors to take a more favorable view on the strength and durability of this expansion.

Broadly speaking, price pressures could stay elevated because they are indicative of robust demand growth that gives the supply side a reason to continue playing catch-up – a virtuous cycle. Wage growth staying strong in the US and continuing to accelerate in Europe would likely help increase the longevity of the capex cycle, which may well also be bolstered by more structural trends like investment in national defense and energy security. All else equal, a higher level of resource mobilization means higher price pressures.

In this scenario, we believe European banks would be particularly well-positioned to outperform given the group has discounted a substantial amount of recession risk in light of the negative spillovers to growth on the continent from the energy price shock. This backdrop would likely be generally positive for risk assets, and therefore also benefit higher beta EM currencies, the Australian dollar/stocks, and US equal weight equities.

Negative supply shocks from geopolitical developments, the persistence of the pandemic and associated production interruptions, or severe weather events could intensify. An acute increase in the cost of necessities like food, energy, and shelter would leave households with less spending power on discretionary items. And because of how hot realized inflation has been, central banks will be unlikely to look though such sources of upward pressure on prices even if they are unrelated to excess demand. Tightening monetary policy would also weigh on the forward outlook, adding to the squeeze on real incomes.

In our view, commodities would be likely to play a key role in creating a stagflationary environment of growth slowing to below trend and inflation remaining stubbornly above target. We believe broad commodities as well as energy and agriculture stocks would be among the few beneficiaries if such a macroeconomic backdrop comes to pass, and are also attractive if the inflationary boom scenario plays out.

As we expect growth and inflation will moderate, it is also within the realm of possibility that market participants extrapolate that deceleration becomes an outright deterioration. This would particularly be the case if the current rotation of economic growth from goods to services sectors becomes more a story of the nascent softness in goods spreading to services.

Long positions in the US dollar vs. cyclical Asian currencies and the euro – the regions we believe would be most likely to be on the leading edge of a global economic downturn – are attractive on a fundamental basis and should display strong momentum. Within equities, we also prefer health care, the defensive sector with both the cheapest valuations and the strongest forward earnings revisions over the past six months.

If improving public health outcomes reduce supply chain risks, core goods prices normalize as demand shifts to services, and there is an end to Russia’s war on Ukraine, some upward pressure on prices would likely abate without any dent to the growth outlook.

But we believe the odds of the market pricing a migration to such a “Goldilocks” regime in the near term is relatively low, for two reasons. First, because inflation has broadened, surprised to the upside, and run above target for an extended period, so it will take time for investors to become convinced that this threat has diminished substantially. Second, two of the world’s biggest economic regions – the European Union and China – face different and significant downside risks that are clouding the economic outlook, and the magnitude of the lasting effects is uncertain.

Accordingly, our trade set has the least weighting towards this scenario at present. We retain some exposure to quality stocks that typically perform well as growth becomes more sluggish but remains positive, and also have some defensive characteristics should perceived recession risk rise materially. It is very important to monitor for indications that both inflation and growth risks are sustainably receding, as this would likely be a signal to increase gross exposure to financial assets.

Over the coming weeks, we expect the market will be whipsawed by these inflation cross-currents and competing narratives. For the time being, we remain cautious on risk at the headline level, with an underweight stance on global equities, neutral positions in credit and government bonds and an overweight to commodities. Expensive valuations suggest that the market is ruling out the potential for a growth scare or a stagflationary outcome, a stance we believe is too sanguine. In this environment of high cross-asset volatility, we believe it is prudent to select relative value trades that give us the opportunity to weather different macroeconomic outcomes rather than aggressively betting on the ultimate destination.

We expect to have more clarity on important macroeconomic milestones we are monitoring late in the second quarter or in the second half of 2022. These include the magnitude of Chinese policy support as well as the wherewithal to deliver it, the extent of the sequential moderation in inflation to shed light on how restrictive monetary policy becomes (if at all), and an end game or steady state for relations between Russia and the rest of the world. We plan to be nimble in reacting to new information and increasing risk judiciously as the inflation- induced fog over markets begins to dissipate.

Exhibit 5: Forward earnings yield for MSCI ACWI less the 10-year Treasury yield

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness, as well as the relative attractiveness within equities, fixed income and currencies, as of 29 April 2022.