The Anti-Goldilocks Portfolio

Global inflation surprises remain strong, while economic data is deteriorating. Consequently, the market is debating whether 2022 will be characterized by stagflation. Yet that may be too strong: data suggests we are not in stagnation. US and European growth remains strong – with the UK the only exceptional candidate for stagflation due to self-imposed bottlenecks. However, markets will likely withdraw from the past decades’ goldilocks environment, comprising strong growth and low inflation. Such a stagflation-lite environment would be bad for bonds and stocks, making asset allocation difficult.

From Reflation to Stagflation

2021 started with big hopes for economic reopening and growth-led reflation. As the global economy bounced back from the worst recession in three decades, real growth accelerated strongly. With massive fiscal and monetary policies supporting incomes, inflation bounced back too. In 2021, global growth will hover around +6%, the highest in 20 years. 10-year inflation breakevens in the US moved from 1.6% to 2.7% in the past 12 months, reaching a two-decade record. In fact, most countries displayed both growth and inflation substantially above their 20-year averages, led by the US.

In summer, though, clouds appeared on the horizon. Covid variants hindered the reopening process, the China property crackdown opened risks for global growth, and supply/commodity bottlenecks darkened the outlook for consumers: economic surprises turned negative, together with a slowdown in ISM/PMI surveys, indicating a loss of momentum.

Despite these economic bumps, inflation remains strong. US CPI spent the past six months above 5%, and Europe hovers around 3%. Emerging markets see peaks of 7-10%, with less credible – or more proactive – central banks forced into hikes. Global inflation breakevens are higher than in summer despite growth forecasts being much lower. In 2022, most countries will likely see persistent inflation and slightly lower growth than this year.

Away From Goldilocks

Are stagflation fears exaggerated? True, we are far from a 1970s-like context, both structurally and cyclically. 2022 should still see global growth above 4%, a newly approved $1.2tn infrastructure stimulus in the US, and still above 5% growth in China.

That said, some headwinds are on the horizon. As fiscal stimulus gradually fades, consumer demand must step up. This is starting to happen in the US, as recent ISM data shows. One major risk remains China’s crackdown on credit and property – now spreading well beyond the Evergrande group. So far, Chinese policymakers have moved from hawkish to tentative support measures, but we expect more easing next year given the upcoming National People’s Congress.

The result is slower growth momentum but persistent inflation. This context poses a dilemma for both central bankers – which we will discuss below – and investors.

The Anti-Goldilocks Portfolio

Asset allocation during stagflation is harder than usual. When growth and inflation slow, investors should focus on bonds. When the economy reflates, equities tend to outperform. In stagflation, no right choice exists. In an anti-goldilocks environment, investors are better off withdrawing from traditional asset allocation blocks and focusing on more specific investments or ad-hoc solutions.

The past century’s stagflationary periods have been concentrated between 1960 and 1980. During them, supply limitations hit commodity markets in various waves, which in turn hit growth. In those instances, real estate, commodities and volatility were among the few places to hide. Equities tend to be rangebound, with value typically outperforming growth. Among the losers, bonds are in a worse position than equities due to less favourable initial conditions: surprisingly, the level of initial yields remains the major long-term driver of returns in bond markets.

Commodities and Real Assets

In the 1970s, political noise over the Suez Canal turned into a massive supply squeeze in energy markets. The picture is relatively similar today, with the squeeze coming from supply disruptions related to the pandemic.

Supply limitations took a decent toll on gas and energy prices in past months. And they may persist for longer than expected, with OPEC+ leaning against output increases. Production bottlenecks in Asia take time to resolve, and the backlog of 2020-21 orders affects time to market. In energy markets, Russian gas may flow back to Europe only slowly, as politics adds up to physical limitations. OPEC+ is also in no rush to ease market pressure, as larger producers benefit from higher oil prices.

So, the commodity rally may not sustain recent momentum, but supply squeezes will support high levels in coming months. Energy and commodities assets will therefore keep performing and remain relatively cheap. 

Energy stocks in Europe are up 25% YTD, vs oil and natural gas, respectively at 70% and 140%. The energy index is one of the few still below pre-Covid highs, despite energy commodities being all through the highs. In credit, high-yield energy names have been lagging and offer 5-9% yields (depending on jurisdictions/subsector) despite improving balance sheets. Commodity-linked currencies, such as the Norway krona or the Russian ruble, are performing but still cheap to what their oil beta would imply.

Misery Means Volatility

Stagflation tends to raise market volatility, as higher inflation and low growth compound. The ‘misery index’ combines unemployment and inflation. It shows a tight correlation with cross-asset volatility during the 15 years between 1970 and 1984, a time characterized by high inflation, growth concerns and rallying commodities. The index was subdued during the 1990s and 2000s but is coming back up sharply in 2021.

After 10 years of quantitative easing (QE), markets are unused to volatility. Since 2010, rates and equity volatility has remained subdued, with only occasional spikes. Volatility has been concentrated in a few ‘bad days’, which soon turned into an opportunity to buy risk, especially in credit. A high volatility regime naturally favours flexibility and less reliance on market direction, at the expense of market beta.  

Alpha Is Back

High volatility means high dispersion, which raises the value of alpha or asset picking within asset classes. This is especially true in an environment where both equities and rates suffer, and so the value of beta is limited. With stagflation, energy, consumer and healthcare tend to deliver positive equity returns, while tech, industrials and materials suffer. Financials and utilities are more mixed as slow growth offsets high rates. At a country level, energy importers and countries heavily reliant on borrowing abroad, like Turkey, tend to suffer. Meanwhile, energy exporters with a solid external picture, like Russia or South Africa, fare better. Thorough country and sector selection is consequently more important than usual.

Stay Defensive on Paper Assets, Buy Upside on Real Assets

The recovery is solid, particularly in the US and Continental Europe. We expect China to turn towards bottom-up stimulus, with policymakers positioning for a long-term game. This will likely come not as large-scale rate cuts and QE, but topical policy decisions to support the housing market and services.

Against this backdrop, we expect inflation to stay elevated (as we have argued since earlier in the year). This is due to persistent supply bottlenecks and a pick-up in demand, combined with economic reopening and new measures to combat Covid.

If this view is correct, many Western central banks remain behind the curve – the Fed, for one, as well as the Bank of England and the European Central Bank. The dilemma is that these institutions have trapped themselves in an asset bubble of their own creation. Whether it is stock valuations in the US, property in the UK or BTP yields in the euro area, central banks will be unable to accept a prolonged negative price action.

For investors, this means interest rates will remain persistently below inflation. Meanwhile, the structural drivers of low inflation over the past decades – globalization, geopolitical stability, and the ability to consume planetary resources without caring for the environmental cost – are changing rapidly.

Consequently, we are positioned defensively in paper assets. Our longs in government bonds and credit are selective and with limited duration, yet still yielding substantially more than inflation. Also, we are positioned for upside convexity in instruments backed by real assets: convertible debt, equities, and commodities.

A more complete version of this report can be found here.