The rebound continues, Sébastien Galy, Sr. Macro Strategist
After the global shock hit the world economy in 2020, we are in the midst of a global rebound which is spreading steadily amongst developed markets to slowly reach some emerging markets. The fight against Covid-19 is far from over, but optimism abounds so much that the global economy is temporarily overheating as a consequence. Supply chains are overloaded, commodity prices have increased sharply and wage expectations have risen, at least in the United States. The question is whether this inflation is transitory or more permanent. We are of the view that it is partially transitory, though we expect wage pressures to stay elevated on the back of pent-up demand. This suggests a preference for low duration solutions and cyclical/value stocks.
Inflation is positive for earnings
In a demand rebound, the cyclical part of inflation has a positive effect on earnings as companies can easily pass on the rising costs (e.g. ESG internalization costs). That assumes gains in real wages or expectations of such gains in the medium term. Firms faced with low productivity gains are also forced to pass on the increased costs to their consumers, particularly where profit margins are low and demand is strong. Net net, we expect this inflation to translate into better earnings supporting equities and we favor value/cyclical stocks.
A transient spike in inflation
Supply chain issues could last for several months, while last year’s base effect on prices fades away. Faced with an expansive monetary policy and consequently rising costs, companies are raising prices and the fear is that inflation feeds on itself. Companies will start to anticipate rising inflation and mark up prices even higher creating an inflationary spiral. Some of this is already happening in the United States. On the other hand, some workers have suffered from low real wage growth, often for decades. It seems that their wage expectations have shifted upwards supported by a better labor market. We think that those inflationary pressures are transitory and only wage pressure will remain somewhat elevated on pent-up demand.
To which the Federal Reserve & ECB will only belatedly respond, which supports equities
Faced with an economy teetering on the edges of elevated inflation, the Fed has held the view that these inflationary pressures are transitory. Eventually though, it will be faced with the fact that wage pressure is somewhat elevated and persistent and has hence taken on a more prudent stance projecting two rate hikes in 2023 and we expect this less hawkish tilt to continue in Q3.
The ECB is mostly faced with transitory inflationary effects and can therefore afford to “print money” for longer than the Federal Reserve, which will drive EUR/USD lower. Having said this, we expect the ECB to slow down its accelerated Covid-19 bond purchases in September.
Investment implications
1. We prefer Global Value stocks. 2. European equities which are value/cyclical oriented. 3. If the economy overheats global listed infrastructure should still benefit from government spending in Europe and the United States. This is a defensive asset class, trading at historical discounts with high exposure to secular trends like ageing assets, de-carbonization and data growth, which will further drive growth potential of this asset class. 4. Expectations of tightening leads us to prefer the alpha capabilities in short-dated Covered Bonds. 5. We are cautious on High Yield in the US as it is priced to perfection.
Conclusion
The environment in Q3 should still be broadly supportive for risky assets, though fear of bouts of persistent elevated inflation could alter this scenario. We expect to see bouts of volatility from this, as well as periods of lower growth expectations. This continues to suggest holding flexible solutions that can quickly adapt to new circumstances among other solutions.
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