Post-Covid, should investors worry about inflation?

Stefan Hofrichter June 29, 2021 10:46

The economic outlook is positive at the mid-year point, thanks in large part to the significant economic stimulus packages over the past year, but all this growth may come at a price. Investors need to think broadly to navigate an environment of uneven global growth and higher inflation expectations.

1. In the post-Covid boom, investors must navigate diverging economies, high valuations and higher inflation

The global economy continues to reaccelerate after last year’s severe slowdown. While the Covid-19 pandemic isn’t over, vaccines are helping some parts of the world turn the corner and the hope is that risks will decrease as the year progresses. Looking ahead, investors need to navigate uneven levels of economic growth across countries and sectors, and the diverging amounts of fiscal and monetary stimulus around the world. And they need to factor in higher inflation.

– The United States will power the global economy in 2021, largely thanks to its successful vaccine drive and massive stimulus packages. Some forecasts show upwards of 6% year-over-year US GDP growth. US equities – while quite expensive – have continued to enjoy a strong rebound since the market lows of early 2020.

– China already enjoyed its strongest post-coronavirus rebound, posting 18.3% year-over-year GDP growth in March 2021, before slowing to a more moderate rate. Equity markets have consolidated after a strong 2020. We consider the pullback a healthy development that sets a more solid foundation for the future.

– The European Union is having a slow economic recovery from the coronavirus-induced recession. Some EU countries are still struggling to contain the spread of the virus and vaccinate their populations. It may be some time until Europe turns around fully, but European equities are cheap. This may be a good time to consider increasing allocations.

– Emerging markets are suffering the most – particularly India and Brazil – with the coronavirus exposing long-running problems with economic inequality. Developed nations will need to make a concerted effort to help other countries with virus containment and vaccinations.

Investment implications

Overall, economic growth has returned forcefully, bringing a boost to capital markets, though growth will likely remain below the pre-Covid growth trend for years. This boom in the economy and markets also comes at a potential price, and we expect to see policymakers respond in a way that investors will want to factor into their strategies.

- A spike in inflation this year – and potentially beyond – makes it important to preserve purchasing power with additional sources of return.

- The US Federal Reserve plans to slightly raise rates in 2023 in response to stronger-than-expected economic data and rising inflation. Markets could become more volatile depending on how these moves are telegraphed and enacted.

- We still have a bias for risk assets – albeit with some caution. As such, we don’t think investors should “de-risk” their portfolios, but rather consider a more neutral position along the risk/return spectrum – at least for the short term.

2. In this “lower for even longer” environment, keep an eye on inflation

Economic stimulus will continue to be a major investment story in the second half of 2021. The overall level of global economic stimulus (in the form of fiscal and monetary policy measures) will be lower than the record-setting levels implemented last year. This is because recovering economies require less stimulus, and because governments don’t want to add to their debt levels unless it’s absolutely necessary. Indeed, some emerging markets will be reining in their fiscal spending and tightening their money policy by hiking rates.

But the picture is different in developed markets – particularly the US, where we expect to see some additional fiscal spending programmes and tax cuts this year. All this spending is raising concerns about “nanny capitalism”, with central banks effectively beholden to their governments by funding this spending. Major central bank balance sheets are at all-time highs and projected to push up further in the coming quarters.

One consequence of this massive policy stimulus, both fiscal and monetary, has been a notable spike in inflation that started in the second quarter following the swift economic recovery and shrinking global output gap (meaning there’s less spare capacity in the economy). Other contributing factors include the ongoing supply chain disruptions for companies around the world and the “base effect” of commodity prices, particularly energy costs, that have risen notably from last year.

There is also evidence that the rise in inflation is not purely transitory. For example, monetary aggregates – the amount of money circulating in an economy – have skyrocketed during the Covid-19 crisis in response to unprecedented monetary stimulus. Furthermore, a continuation of the deglobalisation trend – as countries seek to be self-sufficient with essential goods – would further drive inflationary pressures. There are also tentative signs of rising pressure on wages, which gets passed on in the form of higher prices.

Given all these factors, it’s possible that inflation may be even higher than expected beyond 2021 – or at least the markets may price in a rising probability of this outcome.

And if this scenario is on the cards for next year, we expect the markets would begin pricing it in much earlier. The financial markets will closely watch how central banks react to inflation and stronger-than-anticipated economic growth – particularly the US Federal Reserve. The Fed has been following an “average inflation targeting” approach, which means it will be comfortable with a temporary overshooting of its 2% goal. But the recent spike in inflation has already gotten the Fed’s attention, prompting officials to announce their plans for small rate hikes in 2023. The market has also been expecting the Fed to start “tapering” its bond-buying, probably in 2022. Both these moves could trigger some volatility depending on how they are managed by the Fed.

So with inflation going up, at least temporarily, and with central banks set to tighten monetary policy sooner or later, bond yields have risen since the beginning of the year. But we continue to believe that over the long term, real interest rates (which have been adjusted for inflation) will stay low compared with their long-term averages given that certain structural trends – including shifting demographics, low productivity growth and high debt levels – will keep economic growth low as well. And all else being equal, economic growth and interest rates historically track each other relatively closely.

Investment implications

– Fixed income: We have a bias for keeping durations short. Many bonds are expensive, and not just sovereign debt: investment-grade and high-yield debt is pricey. If bond markets get more nervous about inflation and central bank action, yields may rise (and prices fall). Investors will want to manage their positions actively in this environment, but lower prices may also present an attractive opportunity. Income replacement will continue to be a challenge in today’s low-yield environment.

– Equities: Central bank liquidity and a general “risk-on” attitude have pushed up the prices of equities. US stocks are expensive – perhaps they’re even in bubble territory – but they may “bubble up” further in the next six to 12 months. European and Asian equities are cheaper and moderately priced compared to historical levels. We favour the value style of investing over growth currently, but – in the long run – tech stocks also have an important role to play. Focusing on companies that emphasise sustainable business practices – including environmental, social and governance (ESG) issues – can help investors navigate a possibly bumpy road ahead.

– Risk management: Consider agile risk management strategies. In a low-yield environment, many investors acknowledge that they will need to take more risk to achieve their objectives. The key is to take this risk in a managed way.

3. Consider any setbacks in Chinese equities as an opportunity to re-establish a longer-term position

This year has been a case study in the exciting potential and stress-inducing volatility that have long characterised China’s capital markets. After China’s authorities successfully managed the country out of the Covid-19 crisis last year, and reported stellar year-over-year GDP numbers in early 2021, China’s equity markets sold off dramatically in February and March. The authorities’ clampdown on the internet sector earlier this year played a notable role, as did profit-taking among previous stock market winners. Since then, China’s equity markets have been relatively calm but moved mostly sideways.

Throughout it all, corporate China has been doing well, with most companies meeting or exceeding expectations and many companies reporting strong underlying demand.
The internet sector remains under a cloud, however. Anti-trust regulators have now met with all major internet platforms to warn them about illegal business practices. In the long term, we believe these companies will continue to deliver faster growth than the overall economy, but the growth will likely be achieved in a different way than was historically the case. Valuations are set to remain under some pressure for the time being.

China’s economic policies during the pandemic have been arguably the most orthodox of any major central bank around the world. Indeed, as the post-Covid recovery has taken hold, China alone among the major economies has acted to tighten fiscal and monetary policy. While the natural inclination of China’s policy makers is therefore to take proactive steps to prevent the build-up of inflationary pressures and asset bubbles, the extent of any policy tightening for the rest of the year will likely be constrained.
Investment implications

In the short term, we would not be surprised to see a further period of consolidation in China’s equity markets. Stocks have rallied strongly over the last year and some profit taking would be entirely natural. In addition, as China takes prudent steps to normalise monetary policy, the very strong liquidity environment may become more moderate. In fact, we think the recent pullback was a healthy development that helps to set a more solid foundation for the future. It remains extremely important to be selective and ESG factors can be a good lens through which to identify companies that will continue to thrive in this environment.

In the fixed-income space, ”onshore RMB” bonds (those traded in mainland China and denominated in CNY) offer an attractive opportunity to international investors. This is primarily thanks to their higher yields, compared with bonds from other major economies, and the diversification potential provided by their low correlations with other asset classes. Investors can also benefit from longer-term trends in China’s bond markets. For example, China is the second-largest bond market in the world, and Chinese bonds are steadily being added to international benchmark indices. Increased investor interest can give early entrants the potential to benefit from price appreciation.

Over the longer term, we continue to see compelling reasons to invest into China. It is, of course, a relatively volatile asset class, so it’s important for investors to have a long-term
perspective and consider their comfort level with drawdowns.

4. Sustainable investing is the new standard

In the past year, global ESG assets under management reached USD 1.7 trillion, according to Morningstar. Already, over a third of global AuM now applies ESG criteria, and this growth is set to continue. In fact, rather than diverting attention from sustainable investing, the Covid-19 pandemic – and its knock-on effects for society and economies – have accelerated this shift. Investors are increasingly convinced of the essential role that sustainable approaches play in driving investment performance and helping to manage risk. In particular, independent data shows the outperformance of actively managed ESG funds over their passive counterparts during the start of the pandemic, underscoring the value of an active approach to sustainable investing.

As we head into the second half of 2021, the case for sustainable investing will continue to strengthen. In the post-pandemic recovery, ESG factors will be critical for assessing a new array of risks and identifying previously unknown opportunities. This should make investors more comfortable taking a “risk-on” stance, but we also urge caution. Economic growth paths – and monetary policies – are diverging. And multiple factors are dampening real economic growth: global fiscal policy is becoming less uniform and accommodative, supply chain and trade disruptions are pushing up inflation, and the number of “zombie” firms (businesses with low productivity, high debt and a high risk of default) is rising.

Assessing companies across the spectrum of ESG factors – and actively engaging with them to influence change – will be critical to test their resilience against this backdrop. The key is to identify those factors that are most influential for each individual company – such as greenhouse gas emissions, workers’ rights and executive pay – and encourage
them to increase transparency.

What the substantial growth in ESG assets indicates is that the case for sustainable investing – in terms of balancing risk and reward – is proven in many investors’ minds. The priority now for investors is to see how these investments can create demonstrable, real-world change.

Investment implications

– Post-pandemic, many governments are pledging to “build back better” with a focus on areas such as green infrastructure and addressing social inequalities. Greater global cooperation on climate change and other key issues will also spark an array of projects that require funding.

– Incorporate ESG factors into everyday decision-making to test companies’ resilience in a challenging investment environment, and to drive change on urgent issues.

– Consider investments aligned with one or more of the United Nations sustainable development goals (SDGs). These 17 focus areas represent a call to action to address challenges facing society, representing potential market opportunities of USD 12 trillion. These may include investments that address the implications of climate change for our “planetary boundaries”, such as clean water and food security.

– Explore growing opportunities in green debt. The pandemic and green infrastructure spending likely provide scope for new issuance.

– Many institutional investors are using impact investing in the private-markets space, in areas such as renewable infrastructure and development finance. It’s a highly effective way to promote inclusive and sustainable growth in emerging and frontier markets.

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Stefan Hofrichter

Head of Global Economics and Strategy, Allianz Global Investors