Reflation should allow equities to outshine bonds

Investment Policy, April 2021

Reflation should allow equities to outshine bonds

Reflation has emerged as a key topic of discussion in the financial markets. Past experience of reflationary phases shows that – in the great majority of cases – although market volatility rises, equities deliver a clearly superior overall return in the medium term compared to bonds. This is a common phenomenon in situations where inflation rises from a low level and is accompanied by strong economic growth that boosts corporate earnings. Given this scenario, it would come as no surprise if impressive medium-term global value stocks with relatively cheap valuations in a historical comparison were to perform impressively.

Global economic growth continues to accelerate, led by the US. The cheques sent out to the American people as part of last December’s economic stimulus package have clearly boosted US consumer spending. This much is clear from the very healthy recent data on US retail sales volumes (+6.3% year on year). In Europe, a number of leading indicators on the production side point to higher economic growth than in 2020. With shops reopening as winter recedes, Europe could make up some of the ground it has lost on the growth front, but should also benefit from the even greater acceleration in US and Chinese economic growth due to the boost that this will give to exports. As the global economy continues to strengthen, the other side of the coin is a rise in inflationary expectations. However, in contrast to the end of 2018 or 2013, below-average employment levels mean that central banks will continue to adopt a very expansionary monetary policy stance involving an abundant supply of liquidity – a situation that favours equities over bonds for the time being.
 
Equities
When inflation starts to pick up again from a very low level – so-called reflation – the result has historically often been greater volatility, initially in the currency market and then in the equity and fixed-income markets. The reason for this is an increase in trading activity because of profit-taking in securities that were previously among the “winners”, such as growth stocks from the technology area. At the same time, there is greater demand for cyclical stocks, so-called value stocks, which have relatively cheap valuations and have historically benefited most of all in an environment of rising bond yields. This market-internal rotation increases volatility, which can of course be quite unsettling. But investors should keep their cool and focus on the quality of individual companies. After all, quality can be found among both defensive and economy-dependent, cyclical stocks, as well as in the value area. The most important factor remains higher corporate earnings against a backdrop of a stronger global economy. In the most recent reporting season, earnings surprised on the positive side both in the US and in Europe.

When inflation rises from a low level, i.e. in the presence of reflation, value stocks can exhibit strong medium-term performance.

Gérard Piasko, Chief Investment Officer

Bonds
In the fixed-income markets, rising inflationary expectations are an obstacle to healthy returns, particularly for bonds with low yields and a long duration, i.e. great sensitivity to interest rate movements. Constructive comments on the part of central banks can provide some support. But even more effective than words would be actions – such as greater purchases of long-dated bonds in the context of quantitative easing programmes. This was the approach adopted by the Federal Reserve (Fed) a few years ago in what was termed “Operation Twist”. We currently anticipate an even steeper US yield curve against a backdrop of rises in inflation fuelled by higher oil prices. In the fixed-income area, we are sticking to our heavily diversified global positioning. We are overweight in corporate bonds at the expense of government bonds, albeit not as strongly as a few months ago. The reason for this preference is the lengthening duration in the investment grade area over the last 18 months.

Currencies
Our currency market view remains unchanged for the time being, namely that movements by major currencies in either direction would not come as a surprise. Two factors are likely to determine the development of the US dollar for quite some time: The key negative is the further rise in the US budget deficit combined with the high balance of payments deficit. By contrast, the stronger growth of the US economy than those of other countries is a positive, and this difference is becoming all the more apparent to the markets given the latest US economic stimulus package. As the Eurozone will also benefit from this phenomenon as a key trade partner, the euro has strengthened against the franc. The appointment of Mario Draghi as Italian Prime Minister has also increased the appeal of euro compared to the franc.

Commodities
With the exception of gold, commodity markets are benefiting from an accelerating global economy, as this is feeding through into demand. For many commodities, supply is not yet able to keep up with demand, hence rising prices and a boost to inflation. Oil – the most-traded commodity in the world – also reacted positively to the decision by OPEC and other countries at their most recent meeting to not increase production quotas, as this decision was not expected by the market. We are neutral with respect to gold, which has historically often served as a valuable diversification tool against any unexpected geopolitical surprises. We took profits in this key precious metal a few months ago when it was trading at around USD 2,000 per ounce – the gold price has undergone a significant correction since then. 

Conclusion: In phases where inflation rises from a low level, greater financial market volatility has been a historically common occurrence. In the case of equities this is explained by rotation between sectors, and in the case of bonds by steepening yield curves. When temporary rises in inflation are accompanied by continued expansionary monetary policy from central banks and rising corporate earnings, experience shows that equities can increase their advantage over bonds.

Gérard Piasko

Gérard Piasko

Gérard Piasko is CIO and head of the investment committee of private bank Maerki Baumann & Co. AG. Before he was for many years CIO of Julius Baer, Sal. Oppenheim and Deutsche Bank.

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This publication is intended for information and marketing purposes only, and is not geared to the conclusion of a contract. It only contains the market and investment commentaries of Maerki Baumann & Co. AG and an assessment of selected financial instruments. Consequently, this publication does not constitute investment advice or a specific individual investment recommendation, and is not an offer for the purchase or sale of investment instruments. Maerki Baumann & Co. AG does not provide legal or tax advice. In addition, Maerki Baumann & Co. AG accepts no liability whatsoever for the content of this document; in particular, it does not accept any liability for losses of any kind, whether direct, indirect or incidental, which may be incurred as a result of using the information contained in this document and/or arising from the risks inherent in the financial markets.

Editorial deadline: 17 March 2021

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