Some topics we thought were so last century are back in the news. Market observers are discussing the prospect of stagflation - defined as persistently high inflation, high unemployment and stagnant demand, all at the same time - which dogged markets in the 1970s.
It does share something similar – sky-high commodity prices, a disappointing unemployment rate, and cooling economic growth, which is a mix of current energy crunch and the carbon-neutral transition.
Inflation rose to a 13-year high of 5.4% in September in the United States, and 10-year Treasury yields reached 1.67% on Wednesday, the highest since mid-May.
But global stock markets have cheered up this week as traders weighed robust corporate earnings against inflationary or even stagflationary concerns. The S&P 500 has rallied for six days since Oct 13, gaining 4.3% and almost hitting a record high to close at 4,536 points on Wednesday.
Though there is no consensus about whether the market is approaching stagflation, or it is pointing to a healthy recovery, real assets are generally preferred amid price surges, while opinions vary on equities and bonds.
AsianInvestor asked asset owners and investment managers this week which assets they think will outperform in a stagflationary environment.
The following responses have been edited for brevity and clarity.
Matthew Peter, chief economist
Queensland Investment Corporation
Reflecting the current inflation uncertainty, we have modelled two possible scenarios – benign inflation and stagflation – against a "Goldilocks" base case to consider possible central bank responses and asset class impacts. The model forecasts real and nominal five-year annualised returns under each scenario to assess variations from the goldilocks base case.
Portfolios weighted to real assets are expected to be resilient even under stagflation because of the non-discretionary nature of cashflows, the linkage of income streams to inflation, and longer-term debt financing which is either fixed or hedged.
Under our stagflation scenario, central banks are forced to increase interest rates much more sharply than under the benign inflation outcome, pushing the global economy into recession. Increased uncertainty about the inflation outlook leads to temporarily higher bond term premiums as well as a spike in credit spreads and equity risk premiums.
Higher bond yields can be expected to force governments to deliver additional fiscal tightening. However, we believe central banks would succeed in re-anchoring inflation expectations, but at 1 percentage point higher than the goldilocks base case forecast.
Equities are likely to underperform in a stagflation environment, with lower growth leading to lower expected earnings, higher interest rates and a spike in the equity risk premium negatively impacting equity valuations.
Subash Pillai, regional head of client investment solutions APAC
We consider much of the inflation acceleration across developed markets as transitory. We believe the pace of inflation is at its peak presently and expect inflation to abate in 2022 also aided by liquidity growth tapering in coming quarters. Stagflation is not our central expectation. We do however envisage slightly greater medium-term inflationary risks considering the extent of monetary and fiscal stimulus in place across the Western world.
If we did move into a stagflation environment, there are challenges for both bond and equity investments, but greater opportunities within alternatives. We would favour higher allocations to inflation-linked bonds and assets with inflation protection including infrastructure and commodities. Within equities, we would favour defensive equities with stable cash flows and upstream producers with greater pricing power, at the expense of cyclical or downstream equities.
Regionally, Europe and Japan would be better placed as higher inflationary pressures are less likely vis-à-vis the US, Canada and the UK. Within emerging markets, we would suggest being especially tactical and selective. We don’t see meaningful inflation risk in countries like China Korea and Taiwan, but an environment of rising US interest rates can impact EM sentiment.
Paul Jackson, global head of asset allocation research
The assets most likely to mitigate the effects of higher inflation would be commodities and commodity-related equities, with gold reverting to its old habit of rising when inflation increases. I suspect that real estate would also perform well and that inflation-protected bonds would outperform other fixed income assets. Finally, if commodity prices are strong, I suspect that would be good for commodity-producing emerging market countries.
However, that is not a scenario I expect. I think inflation may prove stickier than previously thought, with an increasing number of “transitory” factors adding up to something more permanent, but I don’t think it will be serious enough to provoke recession. I suspect inflation will remain above central bank targets in many developed countries over the coming 12-24 months but that the peak will be seen in the next six months or so. I believe we will simply see economies transition from abnormally high growth rates to something more sustainable.
Market participants may worry about the effect of central bank tightening and perhaps mistake economic deceleration for recession during a transition phase, but I believe it will eventually be a good environment for cyclical assets.
My favoured assets are real estate and equities (non-US), with the former offering higher yields and lagging the rebound in equities. I prefer cash to bonds because I fear that tighter central bank policies will push bond yields higher. I also expect many commodity-related emerging markets to benefit from the rise in commodity prices seen in the last year, though I am not sure those prices will go much higher. I expect gold to struggle in an environment where bond yields are rising. In any case, I expect returns to be modest across even in my favoured asset classes.
Ben Luk, senior multi asset strategist
State Street Global Markets
While markets are increasingly worried over stagflation, we continue to believe in the transitory narrative as we see a minimal spillover to the second-round effects of inflation being sustainable in the medium term. The biggest threat to our base case is if supply chain disruption becomes more permanent as we approach the year-end.
We remain cautiously optimistic despite ongoing noise over stagflation. Our asset allocation framework moved back to pro-stock in October, giving us two neutral readings and 13 pro-stock calls in the past 15 months, which speaks volumes about the resilience of our risk-on trade.
Equity markets might be faced with slower growth, rising costs and even higher interest rate expectations, but corporate earnings have more than offset these worries despite much lower multiples. Our preferred strategy remains in cyclicals (energy, materials and IT), small caps and commodity-sensitive sectors and countries. We expect expectations for peak earnings to further improve in 2022.
Paul O’Connor, head of multi-asset
Janus Henderson Investors
Mitigating the effects of higher inflation would be a key defensive strategy. This would favour real assets such as commodities, property, market-neutral hedge fund strategies and some alternative assets over mainstream financial assets.
In fixed income, index-linked bonds would be a relative winner but returns would probably be negative in real terms across bond markets, given the upward pressure on yields and the low-yield starting point.
Defensive strategies in equities would focus on tilting exposures to sectors where valuations would come under less pressure from higher bond yields and to sectors where income can get an uplift from inflation. That would argue for a rotation towards value stocks in general and financials and commodity plays in particular. The high duration growth stocks that have outperformed everything in recent decades would probably struggle if the global economy was to move decisively towards stagflation. Such a big change in the economic environment would naturally demand a big change in equity market leadership.