30 Nov 2022
Central banks are facing strong and persistent inflation. So they have started putting rates up – a policy that impacts economic prospects. Could inflation go back to its pre-crisis levels? What effect could this have on the markets and asset classes? Read the answers given by our experts, who were interviewed by Brice Anger, Country Head France at M&G.
The value of a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. Whenever performance is mentioned, past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.
Thanks to globalisation and technological progress, ‘most of us have seen inflation fading away for many years’, points out Jim Leaviss, Chief Investment Officer Public Fixed Income. But globalisation is now under threat on different fronts, especially since the Covid pandemic, which disrupted global production lines by creating bottlenecks. And when you add job market tension and an energy price hike to the equation, you get a powerful driver of inflation.
To tackle this trend, central banks have taken the drastic step of quickly putting their base rates up. Yet for M&G’s experts, they believe the influence central banks actually have remains limited.
‘Central banks have taken credit for inflation falling over the past thirty years. But it would probably have fallen anyway – with or without them. So to fight inflation, it’s unlikely they’ll exert as much influence as they think they have’, explains Jim Leaviss, for whom the ECB’s rate hikes will not, for example, have ‘any impact on the prices of gas imported from Russia’.
For Steven Andrew, Sustainable and Income Multi-Asset Fund Manager, central bankers know their power is limited but they are using a ‘window of opportunity’ to break the deadlock of their ultra-dovish policies. He shares this view with Fabiana Fedeli, Chief Investment Officer Equities and Multi-Asset. She agrees that central banks only have ‘blunt tools’ with which to address inflation, but admits it is the only means they have. Fedeli thinks the rate hikes will likely prove more effective in the US than Europe, where inflation drivers are more ‘endogenous’ than those in Europe.
The three managers agree inflation is unlikely to go back to its pre-crisis level anytime soon. Fedeli thinks inflation could gradually wane over the next six months but staying at higher levels for longer.
Energy will likely be the dominant factor in how inflation behaves from here. Fedeli notes that the upward pressure on gas prices in Europe is already creating an inflationary problem, and energy security concerns necessitate the ‘move to clean energy’. While large scale public investments in renewables on both sides of the Atlantic may fuel further inflation in the near term, diversifying supply and building out renewables infrastructure could progressively bring down the price of renewable energy over the longer term, bolster energy security, and counteract the inflationary pressures we are seeing today.
Still, in the short term, the tightened monetary policy of central banks could slam the brakes on the economy. In Andrew’s opinion, ‘markets look vulnerable to the extent that the consensus expectation of a soft landing also seems to be the best-case scenario for the corporate earnings forecasts that underpin equity valuations. A hard landing would unseat these beliefs.’ So markets have perhaps not fully factored in the coming risk. Fedeli adds that it also depends on how you define a hard landing, ‘there are a lot of exogenous events’, not least the ‘energy crisis’ in Europe and also the prospects of a ‘credit crisis’ – although the latter is not a base case scenario. Comparing today’s situation with the 2008 financial crisis, she notes ‘banks are now better capitalised’ – so the potential for credit crisis scenario is less likely, and perhaps we only see a more pronounced slowdown from a demand standpoint.
Financial markets have not factored in the worst-case scenario but they have already fallen greatly since the year began. ‘Everything has got cheaper!’ says Steven Andrew. This environment potentially creates new opportunities, though investors as always should stay cautious. “The returns available on a certain number of markets are adequate based on the risk levels involved. For example, we are overweight Japanese equities and certain segments of the European and US markets, especially US banks, which we believe could be well positioned to take advantage of the increase in interest rates,” adds Steven Andrews.
Leaviss believes ‘you can get value from the bond markets for the first time in a long while. Before Covid, credit risk wouldn’t pay well. But now it offers considerable returns.’ For example, in the US high-yield bond market, yield spreads are once again reaching five hundred basis points in the face of sovereign bonds with yields that have themselves risen. Though yield spreads could carry on increasing, Leaviss likes a three-year buy-and-hold strategy in this segment. “These levels are pricing in an economic hard landing scenario, which is far from certain in our opinion,” says Jim Leaviss. “In addition, the returns on offer in certain emerging market regions seem very high despite the limited risks of default.” US inflation-linked could also be among the segments with potential for protection against some risks. . They’re now offering positive real returns, i.e., yields that are 1% or even 1.5% above inflation for 10-year or 30-year bonds.
In equity markets, Fedeli says ‘we don’t see this as a market to make big sector or style calls’. In the recent earnings season, even companies within the same sectors have had very different results due to factors such as varying exposures to particular end markets, levels of debt, or the nature of the management strategy. For her, it is important to look for stocks that ‘can weather the volatility we will likely experience over the next six months. ’
In the US, Fabiana comments that while equity markets in aggregate aren’t looking particularly attractive, we are finding interesting opportunities among technology names that are not exposed to consumer weakness but operate in growth areas like enterprise, cloud and data services. Andrew thinks US banks could be an advantageous sector as they usually benefit directly from an environment of higher rates.
The UK and Japanese markets also may offer attractive idiosyncratic opportunities, in Fedeli’s opinion but she warns ‘selectivity is key’. She also prefers long-term themes that are able to endure independence of the prevailing market backdrop, and will benefit from further investment. In particular, renewables (including suppliers and companies using low-carbon technologies to improve efficiency), along with infrastructure companies (many with inflation-linked revenues and offering higher and growing dividends).
For M&G experts, selectivity and diversification are still the watchwords for tackling today’s economic uncertainty.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.