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BNY Mellon IM: the inflation question

Q2 Investment Convictions

Equities

“Although our single most likely scenario remains ‘good recovery’, the probability has fallen making room for upside risks in inflation. Overall, equities remain the most attractive option in risk assets. We expect the remainder of 2021 to be characterised by sector and stock selection as markets transition to an economic reopening and stronger focus on valuations. The cyclical trade that favours sectors such as Industrials, Materials, Financials and Energy continues to have runway and could be the main driver of broad market gains this year.

“European economies suffered more severe lockdowns in Q4 2020 and Q1 2021, which delays the economic recovery, but we expect European equities to perform well Q2 and Q3. We foresee attractive returns for international developed equities, further reinforcing the importance of this asset class for diversified portfolios.

Fixed Income

“We expect central banks to remain cautious and diligent about maintaining expansionary policy, but the rise in inflation expectations globally is likely to put pressure on DM sovereign bond prices through the end of 2021 and into 2022. However, the movement in yields that has already occurred somewhat reduces downside risk in sovereigns that was present last quarter, and makes Treasury yields more attractive than most international sovereigns on a relative basis, albeit still unattractive compared to other fixed income asset classes.

“US investment grade credit has become slightly more attractive given the expected improvement in corporate fundamentals and the additional fiscal support that should keep spreads contained.

“Much of the spread compression that occurred in HY over the course of 2020 was due to unprecedented monetary and fiscal support and there is a chance for a widening of HY spreads as that support is withdrawn. However, it should be noted that investors using HY exposure for income generation may find buying opportunities in this space over the next 12-24 months, especially if yield volatility picks up.

EM focus  

“EM equities continue to benefit from global cyclical recovery, weakening USD bias, easy DM policy, and lower trade uncertainty under the new US administration. That said, the pandemic has changed the risk-reward balance, and there is significant
dispersion of region and country outcomes.

“Strategic allocation to Taiwan and Korea is advised, which have high beta to Chinese recovery and are helped by global demand for and shortage of semiconductors. We expect cyclical recovery to accelerate in India, where healthcare and tech offer attractive opportunities. For China, long-term investors are advised to tap into sectoral opportunities that will likely benefit from China’s high-quality consumption-focused growth mandate.

“A weaker USD view makes us slightly favour EM local currency to hard currency debt. Within local rates, we favour those countries where central banks tend towards easy policy bias and/or real rates are at attractive levels (countries such as Indonesia and Mexico).

Inflation

“To date we have been relatively sanguine about inflation – generally classed as an odds-against risk, at least in 2021. That remains the case in our single-most-likely scenario: a ‘good recovery’. In that world, we take a relatively optimistic view about the elasticity of aggregate supply. Many of the hardest-hit industries are in what we might call the ‘close-contact services’ sector and, by definition, services are products that are ‘consumed at the point of production’.

“In principle then, it should be possible to increase the supply of these services relatively quickly once economies open up, alleviating any upward pressure on the aggregate price level. However, much depends on how flexible labour markets are and whether fiscal support schemes have succeeded in keeping establishments viable.

“That said, we are more concerned about inflation than we were. Our inflationary scenario – ‘Overheating’ – gets a probability of 30%, up from 20% last quarter. In our latest outlook, we have two inflation scenarios, distinguished mainly by what central banks decide to do about it. Too much market conversation centres on whether inflation is coming and not on what the policy reaction to it will be – the latter is far more important to investment outcomes.

  • Inflation scenario one

“In our first inflation scenario, inflationary pressure starts to rise towards the end of this year, but crucially central banks decide to accommodate it, initially at least, by leaving monetary policy where it is. Specifically, the Fed waits until the trailing 2-year average of inflation reaches 3% before responding, which isn’t until late 2022. As a result, inflation starts to pick up next year and conventional bonds sell off further in the face of the inflation ‘surprise’. That could cause some short-term volatility in equity and credit markets, but ultimately this is a scenario in which real interest rates remain low or even fall – at least for a while. There is, however, an element of ‘policy error’ in this scenario, as central banks incorrectly interpret inflation running above 2% to be temporary and therefore maintain an accommodative policy stance.

  • Inflation scenario two

“Our second inflation scenario sees the Fed and other central banks react much sooner to a rise in inflationary pressure. Specifically, the Fed starts to taper and prepare the market for rate rise as soon as the trailing 2-year average reaches 2%, which is in late 2021. That is much sooner than the markets are currently pricing in. The upshot is that, unlike the first inflation scenario, real yields rise and that hits equity and other risky asset valuations. Conventional bonds, inflation-protected bonds and credit all sell off too.

  • Investment impact

“Despite the increased inflation risks, we remain optimistic that our ‘good recovery’ scenario will play out. Equities remain the most attractive option in risk assets, while emerging market equities continue to benefit from global cyclical recovery. Alternatives continue to be an integral part of an investor’s opportunity set as markets navigate the possibility of a stronger recovery that results in higher inflation.

 

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