Positioning for reflation
History shows commodities have outperformed during periods of high inflation compared to stocks, writes Anthony Fensom.
Inflation is in retreat across the developed world, with record low interest rates fuelling a continued bull market for equities. Yet with a vaccine for COVID-19 on the horizon and the world economy expected to recover in 2021, is it time investors started positioning for reflation?
“Inflation is undoubtedly very, very low at the moment, probably at the low point in the cycle,” said Morningstar’s Ross MacMillan, senior analyst, manager research.
“And if we look at what the RBA [Reserve Bank of Australia] is saying, next year they anticipate inflation of below 1 per cent and in 2022 around 1.5 per cent. So we’re talking about inflation levels that in the economic history of Australia post the Second World War are very low and likely to remain at low levels for at least the next two to three years.”
Adding to the soft inflation outlook is a high jobless rate and sluggish wages growth due to the coronavirus-caused recession. The RBA expects the unemployment rate to peak at just below 8 per cent and remain above pre-pandemic levels to at least the end of 2022, while wages growth is expected to stay below 2 per cent over the next few years.
“In this environment, it’s difficult to see a rapid pick-up in inflation,” MacMillan said.
Yet not all analysts are bearish on inflation.
“The fallout from COVID-19 will probably keep inflation subdued in the near term. But there is a risk of significantly higher inflation further ahead if earlier policy stimulus starts to push prices up sharply and central banks either fail to nip it in the bud, or perhaps choose not to,” said Oliver Allen, markets economist at Capital Economics.
History shows commodities have outperformed during periods of high inflation compared to stocks.
According to Allen, gains in commodity prices exceeded US equities considerably during the three episodes of high inflation in the US over the past 60 years, comprising the second half of the 1960s, the 1970s and the late 1980s.
In each of these periods, the US Federal Reserve eventually tightened monetary policy to counter rising inflation, which together with ensuing recessions caused US stocks to lag.
Yet while commodities could outperform again should high inflation re-emerge, there are some headwinds.
“We expect energy commodities and oil and coal in particular, to be held back by the ongoing transition towards green energy … that transition should, in our view, benefit certain industrial metals. But we think this will be set against a structural slowdown in China’s economy.”
Nikko Asset Management also sees coordinated fiscal and monetary stimulus driving global demand and reflation in coming years, “opening up broader growth opportunities and ultimately better scope for portfolio diversification.”
These reflationary forces are expected to weigh on the US dollar, with a shift in capital flows to other markets such as Europe and North Asia, according to Robert Samson, senior portfolio manager, multi-asset at the Tokyo-based fund manager.
“While technology has delivered exceptional performance over several decades, part of its outperformance is attributable to very low interest rates that tend to support higher valuation multiples. As reflation lifts rates, the technology sector will look increasingly expensive,” he said in a 21 October report.
Reflation should force bond prices lower and yields higher, with gold expected to find favour as a hedge against rising inflation.
Just as low interest rates have boosted stock prices, Morningstar’s MacMillan warns the reverse could occur, with investors expected to prefer bonds instead of equities in a higher inflation environment.
Among stocks, sectors that could benefit from rising inflation include gold and oil, consumer staples, utilities and healthcare as well as resources.
Other beneficiaries as the world recovers from COVID-19 could include airlines, casinos and companies exposed to the tourism industry.
“You’d be looking for sectors where companies can increase prices above inflation and it won’t impact demand for their product or service. Back in the 70s and 80s, gold and gold stocks did well … but trying to pick when inflation and interest rates will pick up is very difficult,” MacMillan said.
Conversely, if inflation fails to accelerate, technology stocks should continue to enjoy gains, “particularly those that are disrupting established players” such as in the fintech sector.
In its latest “World Economic Outlook”, the International Monetary Fund projected global growth of negative 4.4 per cent in 2020, with a rebound to positive growth of 5.2 per cent next year.
However, the cumulative loss in global output relative to the pre-pandemic situation is projected to reach US$28 trillion ($38.5 trillion) by 2025, amid the “worst crisis since the Great Depression.”
By the end of 2021, the loss in output relative to pre-pandemic levels for emerging and developing economies (excluding China) is expected to reach negative 8.1 per cent, with advanced economies suffering a 4.7 per cent decline.
“There’s going to be a slow grind out of recession which will keep a cap on employment … we’re probably looking at a relatively low level of interest rates and inflation out to the next five years,” MacMillan said.
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