Investment Strategy Insights: Inflation, Yes; Stagflation, Not Quite

Stance: Since downgrading our Global Macro score last month below neutral into marginally bearish territory, data flows seem to confirm a more rapid slowdown in the global recovery. If we are close to peak inflation, monetary policy tightening expectations probably have overshot their target, yet tightening is only beginning, and its impact on the global economy will mostly play out next year. That’s why we are likely to downgrade our score further in the coming months. An upgrade of the CS is not likely until we near the end of the tightening cycle.

Backdrop: Purchasing managers’ indices (PMIs) have been holding up fairly well through the end of the first quarter, indicating that global growth continued despite the Ukraine war and surging inflation. The latter remains the greatest threat to the recovery, since, if not addressed, it will continue to erode household purchasing power and push real GDP into recession territory. The recent broad-based decline in consumer confidence suggests that those forces are already in play. The Fed has finally started hiking rates, which may bring about a turn in the inflation cycle, but at the cost of adding to the forces that are slowing growth. Fine-tuning these factors will be a huge challenge and is raising the risk of localized short-run recessions.

Outlook: Our base case has been a gradual glidepath from extremely strong growth in 2021 back toward longer-term average growth rates this year, with a test of those thresholds some time in 2024. The latest International Monetary Fund (IMF) global growth forecasts indicate that we’re approaching those longer-term averages much faster than expected just a few months ago. Our forecasts also are moving in that direction. Growth in China held up surprisingly well in the first quarter, in contrast to most higher-frequency indicators, including PMIs, which suggest significant downside risk for the second quarter. Finally, Sri Lanka’s economic crisis may be just the start of what we will see in emerging markets, with fragile economic and political structures struggling with surging food and energy prices.

Risks: The key risks we see are 1) a Ukraine military escalation; 2) a financial market crisis resulting from excessive monetary-tightening expectations; and 3) the inability of the housing market to stabilize without sharp price declines.

In less than four months, rates have bolted higher across the globe due to central bank actions, led by the Fed, having decided that inflation is a problem and vowing to fight it. Ten-year rates are up across the globe. Among developed markets, the average increase year-to-date is 121 basis points (bps), with Greece, Portugal, and the US leading the pack with gains of 162 bps, 145 bps, and 142 bps, respectively. Japan saw the lowest gain, at 17 bps. Yield curve control seems to be working, and other central banks are taking note. The countdown until the economy slows has begun. When the tide turns, the rally in rates will be massive.

Typically, our score is driven by spread valuations in relation to risk levels. Currently, however, outcomes are primarily a result of rate sensitivity and the Fed. Credit spreads have been narrowly range-bound near more bullish risk sentiment levels despite heightened geopolitical risks, energy and inflation spikes, and aggressive Fed tightening. Therefore, we maintain our more defensive bias despite continuing to forecast ultra-low default rates and still-positive earnings trends. While valuations have been highly volatile, at current spread differentials we would prefer a more defensive investment grade (IG) exposure relative to high yield (HY) in the US. Fundamentals in Europe have declined due to the Ukraine war, but valuations are creating more total-return opportunities. We’ve also seen increased volatility in China credit, adding to risk concerns.

The second-order effects of the Ukraine conflict have become increasingly apparent and are now key drivers of foreign exchange (FX) returns. Currencies that enjoy positive yields and improving terms of trade (TOT) are outperforming those with a deteriorating TOT position and negative yields. Winners include the US dollar, the Australian dollar, and Latin American currencies. Losers include the euro, the Swiss franc, and the Japanese yen, where worsening TOT and the Bank of Japan’s continued use of yield curve control and aggressive action in the bond market have led to weakness, which is likely to continue. We have increased our 12-month US dollar/Japan yen target to 135 ± 2.5. We believe the ECB’s hawkishness is unrealistic relative to the Fed’s, which is why we prefer the US dollar to the euro.

We have increased our bear-on-a-leash scenario to 30% from 10% given tremendous uncertainty in both the global macro outlook and financial markets, which justifies an extension of the defensive “quality and creditworthiness” approach we initiated at the end of last year. While we expect oil prices to revert to $85-$95 per barrel over the next 12 months, prices will likely remain elevated for some time. We also expect surging inflation, an aggressive Fed, a yield curve inversion, and stagflation starting in Europe. As a result, we believe higher cash levels and short duration are warranted for the second quarter and are seeking opportunities in uncorrelated or less US Treasury sensitive assets.

Anticipating continued weakness and increased tail risks, we have taken our score a bit further off neutral, from 3.15 to a more bearish 3.5. Risks are rising, and the market’s long tailwind from monetary accommodation is about to turn into a headwind at the same time that fundamentals, though still very healthy, are starting to erode. This backdrop is not great for risk assets, yet it also has been challenging for safety assets, such as government bonds. We are increasingly shifting our risk budget toward idiosyncratic opportunities and away from the core financial assets that benefited the most from the prior backdrop. European Union carbon credits look attractive on the growth side, while commodity carry is compelling on the capital appreciation side.

The focus on ESG has intensified over the past six to 12 months. While environmental issues have long been a concern, as property and construction sectors account for about 40% of all carbon dioxide emissions globally, the industry is grappling with how to measure social and governance factors, which had been largely neglected. Currently, changing use patterns are exacerbating dramatic undersupply issues in logistics, institutional rented residential, senior living, and student housing, sectors that are attracting capital. While recent supply-chain bottlenecks, primarily in steel and timber, are easing, risks include funding gaps due to hesitancy from traditional banks to finance development, profit erosion due to rising costs, and inflation-related interest rate increases, which would cause substantial value erosion.

Recent management meetings and earnings reports suggest global business activity remains solid. Sentiment surveys convey caution, but there are few signs of slowing demand. That said, it remains to be seen if the market will credit companies for current strength during upcoming first-quarter earnings reports. Though the Fed has telegraphed its rate-hike plans, uncertainty about monetary policy, inflation, Putin, and supply chains is causing volatility. Signs that inflation is peaking would comfort the market and allay concerns about stagflation. We expect volatility to persist as macro debates play out, underscoring the continued importance of portfolio balance.

We are keeping our score at 2.25, which indicates high conviction over the long term. In the near term, geopolitical and macro concerns remain a headwind. Fiscal and monetary policy support is expected in China, with consumer companies anticipating a better second half after lockdown-related weakness in the first half. Companies are planning price hikes because of cost inflation. In India, global supply shortages are being reflected in the paper, chemicals, building materials, and automobile sectors. In Central and Eastern Europe (CEE), war is clouding the business outlook, but fiscal and monetary support is likely. High commodity prices are boosting economic activity and broadly improving estimates in the Middle East, North Africa, and Latin America, where investors are benefiting from a redirection of allocations from China and the CEE. We consider long-term opportunities in emerging markets to be some of the best in years.

Our US Market Cycle Indicator (MCI) went deeper into the cautious zone, driven by a flatter curve (down 35 bps), which dominated tighter BBB spreads (down 11 bps). The long end in IG and HY spreads looked cheap. Our model favors energy, natural gas, electric, and insurance and dislikes brokerages, consumer cyclicals, financials, and technology. Our global rates model continues to forecast lower yield and a flatter curve. The rates view expressed in our G10 model portfolio is overweight global duration, being neutral in North America (underweight US and overweight Canada), slightly overweight Europe (overweight in peripheral countries and underweight the core), and overweight Australia/New Zealand in Asia while underweight Japan. Along the curve, we are still positioned for flattening and are overweight the long end.