Fynsa
We believe we are at a turning point for some important structural changes.The post-pandemic cycle is driving higher inflation and interest rates.
As inflationary pressures become more evident, following this week's US inflation data that left consumer prices at 7.5% over 12 months, markets are beginning to lean toward faster and probably more aggressive monetary normalization. In practice, we have gone from pricing in five rate hikes by the Fed a week ago to seven hikes in 2022 (i.e., a 25 bp hike at each meeting), with the likelihood of a 50 bp hike at the March meeting increasing.
This has clearly shifted the entire yield curve, with 10-year Treasuries trading above 2.0% and no foreseeable ceiling at the moment (something closer to the 2.3%–2.5% range seems reasonable to us).
As we move forward at this turning point, market drivers and leadership styles are likely to change. The drivers of market returns and leadership should be very different from the last cycle and should result in a different approach to investment strategy.
The turning point in interest rates
Inflation expectations have risen rapidly. The aftermath of the financial crisis saw a sharp fall in aggregate demand and inflation. Inflation expectations fell and the implied probability of high inflation above 3% collapsed, while the probability of inflation being below 1% (the light blue line) increased . This has now been reversed.
As a result, the change in interest rate expectations has been exceptional. Recently, in June last year, the market did not expect interest rate hikes in 2022 in the US, and as we mentioned earlier, it is now pricing in seven hikes by the Fed. Similarly, the radical change in forward guidance by other central banks has been exceptional. The UK rate hike to 0.5% was achieved in consecutive meetings for the first time since 2004 and was the largest change from meeting to meeting in the average vote since 1997. In Europe, the epicenter of deflationary fears a few years ago, the market is pricing in a zero deposit rate for the first time since 2014.
The transition from inflation, coupled with more aggressive central banks, has resulted in a sharp decline in the proportion of negative-yielding bonds worldwide, from around 25% to 5%, and the value of such bonds has fallen from a peak of US$18 trillion three years ago to around US$5 trillion today.
The impact of higher interest rates on equities
The first is that rising interest rates have pushed valuations down.
This is not unusual. In recent cycles, while interest rates have generally risen (the extent of which depended largely on the strength of the economy), stocks have consistently underperformed , and ultimately, positive performance has been driven by corporate earnings.
The second impact is that correlations and risk premiums have begun to shift:
The correlation between stock and bond prices has been negative for most of this century.As bond yields fell to unusually low levels, further declines in yields (or increases in bond prices) were often accompanied by weaker stocks. This made sense in a world dominated by recession and deflation risks. The rise in inflation that has pushed bond yields higher in recent weeks has pushed stocks lower, resulting in a positive correlation.
The shift from deflation to inflation as the main risk is significant. During the post-financial crisis era, the collapse of inflation expectations and the presence of central bank purchase programs reduced term premiums in bond markets and, at the same time, raised risk premiums in equities (which have more to lose from recession and deflation). The end of QE (asset purchases) and the shift to QT (asset sales), coupled with higher inflation, should shift the balance in the opposite direction, reducing the ERP, something we have seen over the past year and which likely has more to run.
Rotation to Value
In the last cycle, investors were drawn to growth stocks. As aggregate demand collapsed, inflation expectations fell, and so did nominal GDP along with long-term revenue growth assumptions. Growth became scarce and more valuable. Increasingly low rates increased the relative value of longer-duration assets.
In the decade following the financial crisis, asset markets were revalued due to declines in the risk-free rate. The following charts show different measures of "inflation" in the world driven by QE from 2009 to 2020. In the first chart, real-world inflation (the light blue bars on the right-hand side) was very low: consumer prices, wages, etc., barely moved, and commodity prices fell; interest rates collapsed, and central banks printed money. Meanwhile, inflation in financial assets (on the left in dark blue) was very high, and real yields were extremely strong.The best performers were the longest-duration assets: Nasdaq, S&P 500, and growth stocks in general.
If we contrast this with the inflationary decade of 1973-1983, we find a very different pattern. Most assets failed to achieve real returns as yields fell below consumer prices. The best performers were "real" assets and commodities. The worst performers were longer-duration stocks: the S&P and Nasdaq. While 1970s-style inflation is unlikely, it may well serve as a guide and makes the current market shift toward value investments seem rational.
The shift toward value in recent months reflects the turning point in inflation. As the chart below shows, when we look at the correlation between the relative performance of the sector and inflation expectations, we see something similar. All the sectors that underperformed in the post-financial crisis cycle (which was dominated by deflationary fears) are those that are positively correlated with inflation expectations: energy, banks, and resources.
Recommendation
Our view, for several months now, is that we believe we are entering a "more inflationary" cycle, unlike the past decade, which was basically deflationary. Therefore, we are favoring short-duration value investments (and therefore less sensitive to interest rate hikes) and positioning for a steeper curve (financial sector, energy). We are seeking greater diversification outside the US in developed markets where valuations are more attractive (Europe and Japan), as well as in emerging markets that could begin to perform better in 2022 as China eases monetary policy.
In fixed income, maintain a very conservative strategy in terms of duration.
Humberto Mora
Strategy and Investments
