Over the past month, we have been subject to a stagflation chill. The main equity market indices have corrected between 4% and 5%. Technology stocks retreated between 7% and 10%. A combination of jitters going into the next earnings season, uncertainty on the (global) growth impact of the spreading Chinese real estate crisis and a 25bp jump in US 10-year rates towards 1.46% has been enough to fan the stagflation fear. A fear encompassed by the lack of diversifying capacity offered along the bond-equity conundrum.
What are the odds that we are in the first innings of a 1970 style stagflation episode? My guestimate is about 20%. That essentially means that an extended stagflation dynamic belongs to the risk scenario category. The 80% base case scenario portends that inclusive growth will be supported by a collaborative fiscal-monetary entente.
Employment conditions are improving today…little evidence is present that stalling is around the corner. During the 1970’s stagflation episode, US labour markets worsened as unemployment drifted from 4% to 6% by end of the decade, reaching a high of around 9% mid-1975. Today, if anything, globalisation has put on the brakes on international labour arbitrage, resulting in a potential brightening of domestic employment prospects. Fiscal support towards infrastructure projects, strengthening of healthcare – social security fabric and measured normalisation of the corporate tax rate should keep US potential real growth rate around 1.8% and push unemployment towards 3.5% through 2023. The all-important Total Factor Productivity (TFP) parameter might be levelling out over the next decade. I think about the framework described by Peter Thiel in his book ‘Zero to One’. It mentions that technological, vertical breakthroughs take you from 0 to 1 compared to globalisation that takes you from 1 to n… reflecting horizontal progress by copying existing ideas into new applications. The remaining variable in this stagflation debate remains inflation. Is inflation unanchoring?
At the time of writing, market-based long-term inflation expectations remain anchored with 10-year US breakeven rates at 2.38%. The economic boom years between 2004 and early 2008 pushed US headline CPI in a similar 3%-5% bracket. US 10-year inflation expectations reached a high of 2.78% back then. Markets will become impatient as the debate on the transitory character of inflation will drag into 2022. Survey-based indicators (like the Michigan University 5 to 10-year Inflation Expectations measure printed at 3.00% last Friday) should be taken with a decent pinch of salt. I expect that supply bottleneck constraints become an instrument in the hands of companies, allowing them space and time to realise a lift in earnings, over 2022 but not beyond. As an example, we tracked a beaten-up energy sector over 2020 morphing into a winner over 2021. A short-term classic. As pent-up demand normalises, expect supply bottlenecks to deflate.
The question remains: ‘how does one cater to a 20% stagflation probability? A fashionable and profitable solution, as proven over the past 12 months, was a decent allocation within your overall bond allocation towards inflation-linked government bonds and a conviction allocation to high yield corporate credit. One should maintain this stance over 2022 to pull in an appropriate risk/return equation. Less appeal resides in exposure to investment grade credit that has little credit-risk-premium buffer left to withstand a rate increase that goes beyond levels priced through forward rates. A strategic exposure should always be considered over a minimum 5-year investment horizon. Tactically, IG corporate credit requires skill in order to crystallise the thin credit risk premium.
Within equity, under a stagflation ecosystem, financials are your preferred sector. Rising term premium or curve steepening momentum are friendly to actors in finance. Next to financials, commodity-exposed business models can also prosper. However, the top performers are monopolistic business models. Such business models thrive the very moment business models that survive under the perfect competition mantra fight to remain fit enough. Investors exposed to public equity exposed to high competition, trying to maintain thin margins over the ‘short-term’, might lag equity indices. Yes, technology companies that boasted innovative solutions, positive scale effects and strong branding outperformed during stagflation. Pricing power was on their side. Maybe, the technology sector will get substituted for biotechnology or sectors that thrive under climate adaptation and mitigation policies.
Just as a reminder and returning to a basic axioma when investing in bond markets: end of March 2021, 10-year US Treasury rates 5 years forward touched 2.90%. Today, you are ‘looking into the future’ with this key bond indicator sitting at 2.32%. So, when market commentators warn about higher US 10-year rates, you should interpret their predictions against the forward rates as priced today. I repeat, scaremongers predicting US 10-year rates to hit 3.00% are telling us that 10-year rates will be about 70bp higher 5-years out versus the 2.32% priced in today. Moreover, one should not only focus on nominal rate levels…the deeper truth is captured by 10-year real rate levels. Since the start of 2021, 10-year US real rates averaged -0.97%. Last Friday we closed at -0.90%. What has occurred over the past 20-odd years? Well, over the first decade of this century, 10-year real US rates averaged 1.96%. The average over 2010 to 2019 stood at +0.42%. Since January 2020, the pandemic and emergency central bank QE programs pushed this metric towards an average of around -0.72% on the US 10-year real rate. Key message: the pandemic pushed 10-year real rates from positive into negative territory. Expect this episode to have legs. Negative long-term real rates are here to stay.
I want to end with a sweetener and venture into advising readers with a 5 to 7-year investment horizon to hold onto an above-average allocation to local currency emerging market [EM] government debt. The sector yields between 5.25% and 5.50% depending on your risk profile. If stagflation comes through, it might be to the detriment of the USD. EM Local Currency debt will prevail. Gaining exposure to non-USD investment during the 70’s was an ingredient to achieve real capital preservation. These moments in financial markets call for a lot of studying and reflection in order to protect your capital. The performance path ahead goes uphill. Proper preparation will split the wheat from the chaff.
