Inflation remains a dominant factor in the capital markets
The US Federal Reserve has reiterated that bringing down inflation is its top priority and that one of its objectives is to cool the labour market. In Europe, inflation will remain at heightened levels for some time to come due to high energy prices. This will result in further increases in interest rates on both sides of the Atlantic. What does this mean for the different asset classes?
The leading central banks are relying on further interest-rate hikes to tackle persistently high inflation. In September, for example, the European Central Bank (ECB) raised the deposit rate by the historically high amount of 75 basis points and announced that it would be making further moves on interest rates. And at its September meeting, the US Federal Reserve (Fed) increased interest rates by 75 basis points for the third time in succession. Given the rise in the core inflation rate in the US, the Fed is not expected to veer from its course of monetary policy tightening any time soon. Union Investment’s economists anticipate that the federal funds rate will increase to a range of 4.25 to 4.5 per cent by the end of 2022 and that the now restrictive impact of monetary policy will result in a slight recession in the US in 2023.
Inflation is a global phenomenon
Change in consumer prices in 17 developed markets
In Europe, inflationary pressure is likely to persist for longer than in the US due to the difficult energy situation and elevated energy prices. This means that a recession in the eurozone, and specifically in Germany, is unavoidable. The ECB will probably continue to push the pace of interest-rate hikes in the short term. The question of how high the terminal rate will be will depend heavily on inflation rates and thus energy prices, so it is subject to significant uncertainty.
In the medium to long term too, investors should be prepared for permanently elevated inflation rates. Union Investment believes that the capital markets are heading for a new equilibrium. There is likely to be more growth, for example due to the restructuring of supply chains and the transition to a green economy. Inflation is expected to be higher than before the start of the coronavirus pandemic in 2020 as reduced international division of labour and higher commodity prices will result in stronger upward pressure on prices. Demand for investment, coupled with an unchanged or slightly declining level of savings, tends to increase the price of capital, which means that interest rates are also likely to rise.
What impact is this expected to have on the individual asset classes in the short to medium term?
- The equities asset class is under pressure as a result of increased inflation expectations and bond yields. For the Fed, its goal of stabilising prices clearly takes priority over the situation in the US labour market. Monetary policy will act as a drag on the US economy. Other central banks, such as the ECB, will follow suit, resulting in similar damping effects on other parts of the global economy. In this environment, risk assets such as equities should be underweighted in the first instance. However, Union Investment’s experts anticipate that the annual inflation rate will fall sharply next year. As this should ease the rise in yields in the bond markets, drops in price will offer opportunities for active stock-picking. Looking at past data, history shows that the best environment for equities is when inflation rates are between 1 and 3 per cent.
Significant correction for long-term valuations
At 6%, US equities above the long-term average
Significant correction for long-term valuations
European equities 18% below median p/e ratio
The better macroeconomic conditions mean that US equities are currently more interesting because Congress has given the go-ahead for planned government investment of around US$ 1,260 billion in infrastructure and in sectors such as semiconductors and energy. This raises the prospect of higher growth for the US economy, which in turn should benefit US equities.
In the face of elevated inflation, targeted security selection is recommended. Companies that may be of interest are those with strong pricing power that can pass on higher costs for base products and energy and can offset narrowing gross margins with higher revenue.
A particularly cautious approach is needed in Europe owing to the tangible risks created by high energy prices for energy-intensive industries, such as automotive and chemicals.
Given the economic risks and the expectation that interest rates will remain elevated for some time, the prospects for companies with relatively low valuations – value stocks – look quite good. These include companies from sectors with a defensive business model, such as pharmaceuticals and telecommunications. Infrastructure stocks can also offer a buffer against inflation as their business models incorporate fees that are pegged to inflation, for example.
For the time being, the bond markets will continue to be affected by uncertain expectations concerning inflation and interest rates and will therefore be susceptible to volatility. Consequently, bonds are still underweighted in a multi-asset context. Given that monetary policy is now more restrictive, with the US seeing quantitative tightening, Union Investment predicts a further rise in yields on German and US government bonds.
In the fixed-income segment, the preference is for government bonds from the US and core eurozone countries, although the interest-rate duration should not be maintained at too high a level owing to the trend in key interest rates. The jump in market interest rates means that bonds are generally regaining their appeal because the higher coupons are starting to offer a buffer against interest-rate changes, and thus price falls, once again.
Caution is required when it comes to government bonds from eurozone periphery countries due to the ending of the ECB’s purchase programmes. In 2023, there will be a risk of heightened volatility in Italy if a right-wing coalition in Rome comes into conflict with Brussels with regard to reforms. However, spillover effects seem unlikely.
Spreads maintain their upward trend
Corporates: spreads have stopped widening (for now?)
Spreads maintain their upward trend
Government bonds in consolidation mode
- The picture for corporate bonds is dominated by the risk of recession. In the year to date, they have underperformed relative to governments bonds with similar maturities due to the widening of asset swap spreads. However, the rating agencies do not yet see any significant pressure on the creditworthiness of investment-grade companies in the eurozone.
- The banking sector looks relatively interesting. By contrast, investors should be cautious when it comes to cyclically sensitive sectors, such as consumer discretionary (clothing, entertainment, automotive), and European issuers that are heavily reliant on Russian gas supplies.
- Inflation-indexed bonds offer diversification and protection against any further rises in inflation, as long as current inflation expectations in the markets are too low. Conversely, there is a downside risk if inflation expectations are too high.
- Increased economic risk and slower growth in China – the world’s biggest consumer of commodities – are taking their toll on the commodities asset class. In view of the prospect of an economic downturn, commodities will probably be the final asset class to be affected, which is why there is currently a risk of price falls.
- This means that, at present, the cyclical softening of demand is putting downward pressure on commodity prices, whereas they had previously been buoyed by post-pandemic momentum and by the war-related distortion of supply. This trend is set to continue in the coming months. Looking beyond 2023, the transition to a green economy and the need to invest in boosting the supply of commodities provide a positive outlook for this asset class.
- Overall, commodities are a suitable way of diversifying a multi-asset portfolio in an environment of heightened inflation. They can reduce the portfolio’s volatility range as they have relatively little correlation with equities or with the fixed-income asset class. From a historical perspective at least, this then improves the risk/return profile.
As at 22 September 2022.