Pictet’s Luca Paolini on why he believes inflation worries are overblown

by | Mar 3, 2021

“The economic recovery that will gather strength over the course of 2021 shouldn’t lead to a rapid pick-up in inflation”, says Luca Paolini, chief strategist at Pictet Asset Management.

“Any overshooting of central bank’s inflation objectives is likely to be only temporary, given large amounts of spare capacity in the economy. And we don’t see underlying inflation picking up for at least the coming year,  which leads us to maintain our overweight bias on equities and neutral stance on bonds.

“While there are warning signs in the shape of record levels of new equity issuance and frothy valuations, stocks have the potential to extend gains in the coming months. However, equity investors should expect to see cyclical and value stocks to lead the market higher.

“With strong growth and gradually rising bond yields, financial stocks should be able to increase their earnings. We see room for further gains as investors are yet to price in the substantial upgrades to banks’ earnings forecasts. Our stance is now overweight.

“We downgrade healthcare to underweight with the sector trading at an excessive premium among defensive peers on a cyclically-adjusted basis. Investors should also beware of potential regulatory risks in the US.

“Elsewhere, we remain overweight economically-sensitive materials and industrial stocks.

“When it comes to regions, while emerging market equities have rallied due to a strong economic recovery, valuations remain fair, especially in Asian markets, where effective management of the pandemic and structural reforms should help boost corporate earnings growth in the medium and long term.

“We also keep our overweight stance on Japanese stocks, which should benefit from a recovery in global trade. We expect Japan’s corporate earnings to grow an impressive 33 per cent this year, faster than emerging markets and the global average.

“We remain underweight US stocks, which trade at a rich valuation of 23 times forward earnings against the long-term average of 15. Particularly concerning is that the US market is overly exposed to technology stocks, vulnerable to a continued rise in bond yields.

“We remain neutral European stocks. Valuations are unattractive at a time when the region’s economy is making only a slow recovery.

Fixed income and currencies: emerging opportunity

“A stronger global economy and the spectre of rising inflation aren’t particularly welcome signals for bonds.

“However, we remain sanguine. Monetary stimulus, while fading, remains sufficiently strong to support certain parts of the fixed income market. Total public and private liquidity across US, China, the euro zone, Japan and UK stands at 14 per cent of GDP according to our models – down sharply from a peak of 28 percent in mid-2020, but still comfortably above its long-run average of 11per cent.

“The recent sell-off in bond markets has served to increase the appeal of US Treasuries and emerging market local currency bonds. We hold overweight positions in both.

“With 30-year nominal US bond yields having risen above 2 per cent, real yields on 30-year paper have turned positive for the first time since the start of the pandemic. Demand for longer-dated debt among pension funds should rise in response.

“We also continue to favour emerging market local currency bonds in general and Chinese renminbi debt in particular.”

“Emerging market debt attracted USD44 billion of capital in January, with over a fifth of that heading to China.”

“Despite growing investor interest, Chinese renminbi-denominated bonds remain the cheapest asset class in our scorecard. What’s more, a likely appreciation in the renminbi provides an additional source of return. The Chinese currency should continue its ascent against the greenback as the US’s money supply is expanding at a faster rate.

“Elsewhere, we are cautious on US high yield bonds, whose valuations look extremely stretched. With yield spreads having fallen to pre-pandemic levels, we believe the market is under-pricing default risks.

“Among currencies, we downgrade the Swiss franc to neutral from overweight – a tactical move after its 10 per cent rally versus the dollar over the past year. We remain negative on sterling as the UK economic recovery continues to lag.”


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