Inflation now evident – and driving up volatility

Investment Policy, June 2021

Inflation now evident – and driving up volatility

As predicted by this column in recent months, the officially reported inflation rates of the leading economic nations are now rising sharply. At the same time, however, economic growth is also much stronger. Phases of consolidation after the gains of the past year are possible, but in the medium to long term equities looked to be more interesting than the historically low-yielding bonds.

In the first quarter of 2021, the US economy recorded one of its strongest growth rates for decades. Thanks to persistent economic stimulus from the government, economic growth over the remainder of the year too should be well above average in a historical comparison. Most notably, with households having saved almost twice as much as usual (i.e. compared to the long-term average) this year, there is plenty of “ammunition” for a spending spree. Consumer spending accounts for some 70% of economic output in the US. However, it is not just American companies that will gain a boost from the anticipated rise in consumer spending: European companies in particular should benefit. In Europe too, economic momentum is significantly stronger now than it has been over the last year. The manufacturing sector is unveiling particularly strong growth figures from a historical standpoint. By contrast, the Chinese government will be putting the brakes on growth as it seeks to scale down credit risks and prevent the economy from overheating. Other key emerging market economies (India, Brazil) are currently fighting another wave of the coronavirus pandemic.

The quarterly reports of US and European companies reveal a number of very pleasing business trends in 2021. In the US, the positive surprise was earnings growth: it was twice the level expected by the analyst community. In Europe too, the signs point to both sales and earnings developing positively. Earnings margins are actually increasing once again in the US, which is an impressive development in view of rising input costs. This will have repercussions for adjustments to earnings forecasts for the whole of 2021. Whereas the historical pattern is for analysts to put on their optimistic hats at the start of the year and then have to revise their forecasts downwards, this time the reverse is true: Earnings forecasts are having to be revised upwards. This applies in particular to economically sensitive sectors from the “value” segment, in which we have long had an overweight positioning. Should the global economic recovery continue, therefore, value stocks with their historically attractive valuations could outperform more highly valued growth stocks, as the latter generate a high proportion of their expected revenues in the more distant future. This would especially be the case if US capital market rates continue to rise, as the discounting factor of higher interest rates has a greater impact on these so-called “long duration” equities.

Bonds are less appealing than equities in the medium term.

Gérard Piasko, Chief Investment Officer

It is reasonable to assume that the trend of higher inflation will remain with us over the coming months. This makes bonds with long durations and low yields particularly susceptible to price corrections. Corporate/government bond credit spreads have narrowed dramatically in recent months in both the “investment grade” and “high yield” segments. From a valuation perspective, this makes bonds look relatively expensive, i.e. unattractive from a historical standpoint. The susceptibility of this asset class to rising inflation numbers is a strong argument for underweighting bonds in favour of equities.

Over the last few months, the rise in currency volatility predicted in many quarters has indeed happened. In other words, both EUR/USD and USD/CHF (as well as GBP generally) have oscillated erratically, though without any clear long-term trend establishing itself. As capital market interest rates are rising again on both sides of the Atlantic and economic developments are positive, exchange rate fluctuations in the major currencies of around 5% would come as no surprise over the next few weeks – and possibly even months. We are therefore retaining a neutral positioning in the major currencies.

What are the main trends in the commodity markets? Last year was positive for gold and negative for energy commodities. This year we have seen crude oil recover against gold – which has been strong for many years – in the light of the economic recovery. However, the question is how long the oil-producing nations can continue to suppress supply in view of the improving global demand situation. Agricultural commodities and industrial metals have also recovered so impressively from the lows of last year that consolidation would appear a distinct possibility, as healthy profits appear ripe for the taking. On the other hand, the global economic trend remains clearly upwards. Overall, our stance towards commodities remains unchanged, namely that a rise in commodity volatility too would come as no surprise following the recent gains. 

Conclusion: The pick-up in inflation, which is now clearly apparent in recently published official data, may persist in the months to come. Against this backdrop, bonds remain less attractive than equities for as long as the economic recovery continues. Equities, particularly those with a long duration or a high proportion of revenues expected at a far-off point in the future (e.g. US technology stocks) could suffer intermittent corrections in the event of rising capital market rates, or at least pause for breath after many years of strong performance. In the medium to long term, companies’ improved earnings make equities look more interesting than the low or even negatively yielding bonds.

Gérard Piasko

Gérard Piasko

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

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Editorial deadline: 19 May 2021

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