Multi-Asset Solutions Monthly Strategy Report
Global markets and multi-asset portfolios
- The supply chain disruption and energy price appreciation, linked to the post-pandemic rebound in economic activity and demand, have stoked inflationary fears in some quarters.
- But despite a backdrop of rising energy prices, central banks are likely to look through current inflationary pressures that they see as mainly transitory. Rates will eventually rise, as the economy grows, but even then rates will likely remain negative in real terms.
- Fears that high energy prices will cause a widespread squeeze on corporate margins are overstated. Some specific sectors such as materials may be vulnerable, but these are not a large weight in most developed market indices.
- Ultimately, we expect supply chain issues to ease and inflation fears to moderate, allowing central banks to avoid a sharp, hawkish shift. The combination of solid economic growth, backed by strong demand, and easy monetary policy, supports a pro-risk tilt.
Ballooning natural gas prices in Europe, a lack of tanker drivers prompting panic buying of gasoline in the UK, semiconductor shortages affecting automakers, and spiking crude oil prices have all hit the media in recent weeks. All share one underlying driver: a supply chain crisis that may stoke inflation, just as momentum in global growth is moderating. More excitable commentators worry about stagflation and while we do not think this is likely, we acknowledge that navigating the supply chain issues presents challenges for policymakers and asset allocators alike.
Our central economic case sees above-trend economic growth in 2022, with policy rates tightening only slowly as current inflation risks moderate. We expect earnings growth to continue, albeit at a more moderate pace than in the last few quarters, and equity markets to perform well. Nevertheless, we cannot ignore current supply chain issues. Even if they prove to be temporary, they are causing investors to reassess the balance of risks and central banks’ likely policy reactions.
To best understand the tangle of supply chain and inflationary issues, we should first unpack some factors that have brought economies here. Next we can consider how these issues may resolve themselves and what, if any, policy response to expect. Finally we cover any effects on asset returns, at the margin, in coming months.
The pandemic’s disproportionate effects on commodities
During the pandemic, a large portion of global economic activity briefly ground to a halt. Disruption to the supply chain was in equal measure inevitable and unpredictable. The unprecedented, sharp drop in activity created a strong base effect that, 12 months later, contributed to an outsize jump in key economic indicators, including inflation. The disruptions in the commodities market in the depths of the pandemic ultimately caused the negative prices in the front crude oil contracts in April 2020, as storage capacity reached its limit. Once energy prices began to normalize, base effects there, too, created a significant impact on headline inflation.
The fiscal policy stimulus unleashed in response to the pandemic found its way disproportionately into goods rather than services, as lockdowns and travel bans remained in place. The surge in demand for goods, together with a supply chain that could not simply restart at full speed, led to rolling supply pinches in everything from timber to freight and shipping. Many of these issues are now well documented and for some time have been brushed off as transient. However, the more recent acceleration in energy prices has spooked some analysts and left media commentators pondering whether inflation might be “stickier” than assumed (Exhibit 2).
The ballooning prices of natural gas, coal and oil have captured attention
Exhibit 2: Key energy prices, rebased
The sharp increase in economic activity as the pandemic has eased has, to some degree, spurred the rise in energy prices but other factors are also in play. First, the supply response from OPEC and shale producers has been notably sluggish. That may be because oil producers are facing the eventual decline in fossil fuel demand as the world moves towards renewables, and financing constraints as environmental, social and governance (ESG) considerations increasingly play a major role in institutional investment decisions; it is possible that even today’s higher energy prices may simply not be attractive enough to spur additional supply. However, a structural decline in demand is probably still at least a decade away, so we do expect that the recent surge through USD80/bbl will begin to elicit a supply response – at current prices, shale producers can operate well above costs, and most major conventional producers are above their long-run fiscal breakeven levels.
Gas pricing in Europe and gasoline availability in the UK are more nuanced stories. European gas prices followed crude oil prices higher and were driven up further due to weather – a summer with little wind meant less output from wind turbines and more reliance on gas, following a severe winter that had left storage levels relatively low. Politics may also be playing a part, as discussions over the supply of gas from Russia via the Nord Stream 2 pipeline continue. Meanwhile, over time the twin disruptions of Brexit and COVID-19 created a shortage of transport workers in the UK and with that, a bottleneck in moving sufficient wholesale gasoline reserves to retail outlets. We expect supply response by oil and natural gas producers to arrest the rally in crude and to reverse the recent spike in gas. However, these issues in the UK arise much more from a structural labor shortage than from the energy supply chain. As such, the UK is one economy that may be facing a large and lasting negative productivity shock, and hence stagflation may be more than a low probability tail risk there.
Supply chain issues should wash through in coming quarters
In general, supply chain disruption in energy can be alarming to investors because first, it raises the spectre of the 1970s oil-linked recessions, when oil supply disruptions coincided with high inflation and second, a sustained rise in energy prices is effectively a tax on consumers that can hurt both sentiment and activity. This helps explain why, unlike supply chain disruptions in timber and semiconductors, those in natural gas and crude oil have sparked concern about more persistent inflation and the possibility of a consequently hawkish policy response.
Our base case remains that supply chain issues will wash through in the next few quarters, both in energy and other goods markets. Base effects will also begin to work in the opposite direction. At the margin, we do anticipate a higher level of inflation in this cycle than the last, but to extrapolate a level from recently high inflation data releases is likely to lead to an overestimate. Ultimately, stagflationary outcomes result from negative supply shocks, which simultaneously depress growth while pushing up prices. Current conditions can more easily be described as a positive demand shock – resulting from highly stimulative policies and the rapid easing of emergency pandemic conditions – against the backdrop of constrained supply, leading to a combination of strong growth and rising prices.
We believe central banks can ultimately avoid a hawkish shift
For now, we expect central banks to be broadly tolerant of inflation. Not only have they told us that they expect higher inflation rates – higher rates are also implicitly necessary for their average inflation targeting frameworks. More than this, there is a concern surrounding the appropriate use of policy tools. Ultimately, current inflation issues relate to supply-side constraints, many of which are temporary. Policy rates are ultimately a demand-side tool with a relatively longer period of operation. Using a demand side tool and expecting it to solve a supply side issue would not only be a bizarre response but could put at risk the recovery that central banks have worked so hard to nurture.
The monetary policy landscape has, however, begun to shift. As noted, demand is running hot and highly stimulative demand-management policies no longer seem necessary. Correspondingly, many major central banks have begun the process of scaling back asset purchases and will be mostly out of the quantitative easing game by late 2022. Policy rates will soon begin edging higher, but this process should unfold gradually and will still leave interest rates in historically low ranges for some time to come. What could spur faster action on that front would be a large, sustained rise in inflation expectations. As long as expectations stay anchored around central bank targets, monetary policymakers should feel comfortable forecasting an eventual moderation in inflation. But if expectations seem to be shifting higher, as happened in the 1970s, central banks will tighten policy more aggressively to avoid a self-perpetuating inflation process, pushing real rates into positive territory.
Asset allocation implications
In the meantime, for an asset allocator, negative real rates are a strong reason to avoid bonds but are ultimately supportive for stocks. Yet concerns that higher energy costs will squeeze corporate margins are combining with fears over high valuations to undermine sentiment in equities. In our view, the strong capex cycle, together with healthy household and financial sector balance sheets, should backstop economic growth, in turn providing a supportive backdrop for company revenues. While some corporate margins are significantly challenged by high energy prices, the issue is highly concentrated in specific areas of the market, such as materials and heavy industry, that are far from dominant in most developed market indices.
Investors may need a little more favorable guidance from company chiefs during earnings season to feel reassured. But in our view, the likelihood of continued upbeat nominal growth continues to outweigh the risk of stagflation and, by extension, reinforces the case for a continued pro-risk tilt.