10 Jun 2021
07/06/2021 | Romain Boscher, Global CIO Equities
Inflation concerns are building and feeding into uncertainty over the outlook for financial markets. Romain Boscher, Global CIO Equities, outlines how equity investors should approach this environment and highlights why it makes sense to favour more economically-sensitive areas in the short-term, albeit with a keen focus on earnings and profitability.
The US Federal Reserve’s preferred inflation measure - core personal consumption expenditure (PCE) - rose 3.1% year-on-year for the month of April. This represented a substantial increase on March’s 1.9% figure, well above the Fed’s 2% target rate and the highest reading since 1992.
The spike in inflation has been driven by businesses reopening and a surge in consumer activity while disruptions to supply chains as a result of the pandemic are ongoing. On the ground, our analysts have started to note cost increases across most regions and sectors. At the moment, these appear limited in time and space with the United States and China under more pressure than the rest of the world.
However, this ‘champagne bottle’ effect of a pop in inflation as we exit from lockdowns is most likely transitory. Supply issues are showing signs of gradually resolving, employment support policies will lapse through the year - helping the labour market find a more natural equilibrium - while it is also notable that the strength of the housing market seen in many inflation calculations forms a relatively smaller component of core PCE.
Only a self-reinforcing rise in prices underpinned by an increase in costs, especially wages, perpetuates inflation. The core PCE reading also has had little effect on yields, which are still very low and negative in real terms.
Spike in inflation but real yields negative
Source: Fidelity International, Refinitiv, FRED, May 2021. Note: US PCE monthly, yoy, seasonally adj. Real yield calculated using breakeven rate.
However, while the current inflation trends appear to be transitory this is not to say that they may not become more persistent later. It is also enough to justify some caution of securities that derive much of their valuation from earnings far into the future given their sensitivity to inflation expectations. Companies with pricing power, able to withstand rising costs and sustain their margins will provide added protection to portfolios. This means that the profit outlook at a granular level is crucial.
Over the past year, we have increased our exposure to cyclical stocks, particularly in technology and industrials, due to high expected growth in profits in 2021. But rather than compare earnings forecasts with last year where base effects are extremely flattering given the shutdown of economies, we have used 2019 numbers. Globally, we expect earnings growth to be around 15% higher than 2019, with Asia responsible for the biggest share and Europe only marginally up.
Significant public spending supports growth prospects on a global scale with investment diffusing across sectors and geographies. With that in mind, even within growth sectors we prefer cyclical components. One exception in banks where we remain cautious about the upside potential particularly if inflation is transitory and real yields remain negative.
Overall, consumer strength, fiscal stimulus and accommodative monetary policy remain key pillars of support in developed markets. But the celebratory mood amid the uncorking of the champagne bottle as we emerge from the crisis will subside. It is then that demographic pressures and higher tax burdens will come back into view and act as brakes on earnings growth and the economy. Excessive levels of debt will also be a source of volatility. For those reasons investors may be better served by being more cautious in the medium and longer-terms than they are in the shorter-term.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Investments in emerging markets can be more volatile than in other more developed markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.