Rising inflation could prompt rotation

Investment Policy, March 2021

Rising inflation could prompt rotation

A topic increasingly preoccupying financial markets right now is the rise in expectations of further US economic stimuli, which has in turn increased expectations not just of higher corporate earnings but also of higher inflation. As long as inflationary expectations are linked to economic growth and persistently loose monetary policy on the part of central banks, they represent more of a threat to low-yielding bonds than to equities. This could trigger a switching of capital from the fixed income to equity markets.

The growth of the global economy is being strengthened even more by the world’s two key economies – US and China. In the US, the production side of the economy is in particularly robust health; leading indicators of manufacturing orders have already surpassed the levels recorded before the coronavirus crisis. Thanks to massive state bailouts and high savings rates, it is likely that consumer spending in the US will strengthen even more over the coming months and become a significant additional prop for global economic growth. With Europe and China likewise set to enjoy stronger economic growth this year, corporate earnings should increasingly be revised upward all around the world. Similarly important will be the new economic stimulus planned by the US President, which – if Congress does give the green light to a package worth between USD 1.0 and 1.9 trillion – should lead to even more upward revisions in economic growth and earnings estimates, but also to higher inflationary expectations.
 
Equities
The interim consolidation of equity markets at the end of January was short-lived. Two reasons explain the fleeting nature of this weak phase: On the one hand, the new coronavirus support measures of the US government, together with the high savings rate of US households, are giving the Americans plenty of spare cash, and the stock market is an increasingly popular place to put it. On the other hand, both US and indeed many European companies reported much better earnings in the final quarter of last year than was predicted by the consensus of the equity analyst community. For the first time, it was also a case of better-than-expected results being delivered by the more cyclical sectors – rather than by just the “usual suspects”, i.e. technology, pharma, and communication companies. Improving corporate results are now crucial if the historically high current valuations of equity markets are to be brought down. Moreover, this is now becoming a more probable scenario, as analysts are starting to revise earnings estimates for 2021 and 2022 upwards.

Rising inflationary expectations could increasingly weigh on bonds going forward.

Gérard Piasko, Chief Investment Officer

Irrespective of the economic outlook, equities from the internet security (“cyber security”) area look interesting. The hacking attacks against US government entities and some 30,000 companies around the world in December confirms a trend that has been on the rise for some years now. As these attacks threaten reputations and customer security as well as business development generally, it is likely that investment in IT security will rise, particularly against a backdrop of the increasing digitization of leisure time and working practices. IT experts are expecting expenditure on cyber security to grow at above-average rates, and indeed more so than other technology expenditure, which implies that leading suppliers of cyber security solutions have attractive earnings growth potential.

Bonds
The threat of price losses for low-yielding bonds has become more real in view of the rise in inflation. Nor is it just government bonds that could come under selling pressure – the spreads of many corporate bonds have narrowed following recent price gains to the point where they are now very close to their historic lows. That makes these instruments more vulnerable too. This will remain the case for as long as economic growth continues to improve and inflationary expectations rise further. The low prior-year base for consumer prices and the sharp increase in commodity prices now make many bonds less attractive when compared to equities. By contrast, the still significantly higher returns available on high-yield bonds could serve as a buffer against rising inflationary expectations.

Currencies
In our February Market Comment (“Currency market dilemma?”), we suggested that the trend of US dollar weakness could tail off. This could be prompted not just by the expected new US economic stimulus package, but also by possible profit-taking after a prolonged period of moderate euro strength. Moreover, it is also conceivable – against a backdrop of rising US inflationary expectations – that the interest rate differential, which narrowed noticeably in 2020, will once again improve in favour of the US dollar. The difference in yields between US and European 10-year government bonds has already widened in favour of the greenback. Currency markets are not one-way streets either.

Commodities
With the exception of gold, the asset class of commodities has benefited since the start of the year from two factors that are likely to persist for quite a while: On the one hand, the Chinese economy is currently the strongest of any country; and on the other, US economic growth is turning out to be more powerful than expected and could accelerate even further thanks to the US President’s economic stimulus plans. As a result, global demand for cyclically sensitive commodities (ranging from oil through to industrial metals) is rising faster than the available supply, making many commodities the beneficiaries of economic growth and inflationary expectations.

Conclusion: The theme of rising inflationary expectations will be a constant companion as the year progresses. This in turn could trigger a rotation of capital flows of international (and above all US) investors from bonds to equities, and probably also to commodities. Led by the Fed, the world’s key central banks have repeatedly made it clear that they would rather accept the possibility of inflation rising rather than lingering at historically concerning lows. After all, higher inflation also provides one answer to the problem of historically high levels of government debt (see Market Comment “Underestimated inflation debate?” of September 2020).

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: 18 February 2021

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