May saw a 6.1 percent increase in consumer prices in the EU compared to the previous year, the lowest level since February 2022 and slightly lower than economists’ predicted 6.3 percent. In the United States, inflation has now dropped below 5 percent, the lowest level in two years.
The declining inflation is good news for households and investors, but it also represents “the only silver lining” in the most recent market outlook from State Street Global Advisors (SSGA). The US asset manager is concerned about fluctuations in inflation in the medium term, and they are not alone.
Fabio Panetta, a member of the ECB’s board from Italy, expressed his concerns about inflation volatility during a presentation last month. He noted that the changing nature of globalisation could impact the “natural” interest rate - the rate in a balanced economy - and that geopolitical shocks could lead to persistent fluctuations in production and inflation.
Inflation still above two percent
The combination of the green transition and increasing geopolitical risks suggests an environment where economic shocks may occur more frequently, resulting in peaks and subsequent sharp declines in inflation, according to State Street’s chief economist, Simona Mocuta. “It is becoming increasingly difficult, if not impossible, to predict the timing of these fluctuations,” said Mocuta.
Nevertheless, State Street GA attempts to project the future: over the next decade, inflation will “slightly exceed the 2 percent target.” An inflation scenario with high volatility could pose more challenges than persistent but stable inflation at 3 percent, writes Mocuta. “Such an environment would require continuous and fairly significant adjustments in the allocation of investment portfolios to navigate successfully,” she said.
Fixed-income preferred
Navigating SSGA’s diversified investment portfolios is the domain of Chief Strategist Gaurav Mallik. In a conversation with Investment Officer, he shared his plan. “We prefer fixed-income securities over equities because we expect interest rates to decline. Tighter credit conditions are expected to accelerate the slowdown in growth and inflation. This is becoming increasingly visible.”
The strategist maintains a cautious stance on corporate bonds, especially high-yield and other high-beta bonds. While credit spreads are larger than they were in early 2021, the possibility of a hard landing and concerns about tight credit conditions can have significant consequences for companies with lower ratings seeking to attract capital. These consequences are exacerbated by high interest rates and recent events in the US banking sector. “An increase in defaults seems likely,” said Mallik.
The key cyclical trends that investors need to consider over the next six to twelve months, according to Mallik, are lower interest rates, steeper yield curves, and widening spreads.
Equities
Mallik does not believe that the upward trend in stocks will continue throughout the rest of 2023. The rise in the US stock market was led by a select group of mega-cap stocks that benefited more from declining interest rates than from earnings results.
For the rest of the year, Mallik expects earnings to further weaken. “I am concerned about deteriorating fundamentals, weaker demand due to tighter financial conditions, and increased margin pressure due to still-high inflation levels,” he said. He prefers value stocks, particularly those in the industrial, energy, and utilities sectors.
When asked for a recommendation for institutional investors, Mallik said, “Consider stocks with steady dividend growth and increasing free cash flow, and invest in assets not denominated in dollars.”
Dollar
State Street GA expects a prolonged decline in the value of the dollar. “So, it is wise to gradually manoeuvre away from dollar investments,” he said.
In 2022, the dollar received a boost from rising relative yields and its appeal as a safe haven amid declining stock markets, increasing recession risks, and high geopolitical tensions.
According to State Street GA’s estimates, the dollar reached its peak in September 2022, with an overvaluation of 29 percent compared to what investors consider the “fair value” - the correct value - measured based on a currency basket reflecting the MSCI World ex USA Index.
However, since April 2023, this overvaluation has been reduced to 20 percent. “There is still room for further decline as the factors justifying the high value of the dollar begin to reverse,” said Mallik.
The interest rate advantage of the United States is nearly at the level it was at the end of 2018, “but the dollar is now nearly twice as expensive compared to our estimate of fair value as it was in 2018.” This interest rate advantage of the United States is likely to decrease as the Federal Reserve lowers interest rates due to growth slowdown, while in Europe, where growth and core inflation have surprised positively, the European Central Bank and the Bank of England continue with tightening and subsequently maintain the interest rate unchanged.
This article originally was published on InvestmentOfficer.nl.