Market Views: How would stagflation impact asset allocations?
Stagflation risks are looming over investors’ heads as expectations of higher inflation continue to rise and global economic growth faces disruptive headwinds.
Investor sentiment for global economic growth is increasingly bearish, with 62% of respondents in the latest Bank of America survey predicting the US economy will experience stagflation. The survey compiled the responses of over 300 fund managers overseeing a collective $1 trillion in assets.
Surging inflation and geopolitical uncertainty from Russia’s invasion of Ukraine has seen the US stock market fall into correction territory this year. In Europe, the economic risks appear to be even more acute with the Ukraine crisis causing a surge in the price of essential commodities such as natural gas.
While it does not expect outright stagflation, the European Central Bank (ECB) did discuss the possibility of a stagflationary shock at a recent meeting on March 11.
Speaking at a Bank of Cyprus conference on Wednesday, ECB President Christine Lagarde admitted that economic conditions remain “quite fluid” because of the disruption caused by the Ukraine conflict, and the bank is constantly revising different scenarios. Lagarde was, however, adamant that no data currently suggests Europe will fall into stagflation.
With the US and European economy marching towards an unpredictable future, we turned to our panel of fund managers to ask how stagflation could affect Asian asset owners' asset allocation strategies.
READ ALSO: Market Views: Which assets will perform under stagflation?
The following responses have been edited for brevity and clarity.
Michele Barlow, head of investment strategy and research, APAC
State Street Global Advisors
Prevailing market and macro conditions will influence asset owners’ asset allocation. Over the last decade we’ve seen a broad shift from domestic to international markets, out of government bonds into credit, an increase in equity holdings and, for some investors, into alternative assets.
As we move into a higher inflationary environment, the diversifying role of bonds is being scrutinised. Given historically how yields, their ability to cushion balanced portfolios when equity markets drop has become more limited (but still does remain). This suggests that investors need to look for other safe havens such as gold or currencies like the US dollar, Japanese Yen or Swiss Franc, and look to add alternative diversifying assets which provide buffer to higher inflation.
Equities can still perform well in higher inflationary environment, but the mix in investors’ portfolios may shift from a more growth-heavy exposure (which has done well in a low rates, low growth environment) to a more balanced mix of factors. We’re recommending investors consider gaining selective exposure to cyclicals as growth should continue to hold up this year but also add to quality in light of the more uncertain macro and policy environment.
Colin Graham, head of multi asset strategies
Robeco
We are in a very different regime compared to the recent ‘goldilocks’ economic history. Simply put, we are moving from a cost-cutting model through outsourcing globalisation to one where pricing power and supply chain security will be the driver of revenue growth.
We are assessing commodity and commodity stocks that will benefit in the short term, until the notoriously ill-disciplined company management will spend to increase supply. Property is another very popular asset class with Asian investors which has real asset characteristics if rents are indexed to inflation and supply is restricted. Companies with pricing power, low leverage and cost controls will provide some inflation protection to equity investors.
Finally, we believe parts of the fixed income universe will underperform as the real purchasing power is eroded. There are bright spots such as floating rate notes, loans and possibly short-dated inflation linked bonds and high yield.
Currently, global stagflation in our view is an outlier scenario with low probability. However, financial markets might price in negative growth and high inflation as rates rise. Our current thinking is allocating away from nominal bonds into assets with inflation protection.
Zhenghao Phua, portfolio manager, investment solutions
Eastspring Portfolio Advisors
A clear resolution to the Russia-Ukraine conflict remains uncertain. Along with oil, Russia is a major supplier of food, fertilisers, and materials. Any impact from sanctions on these products will cause further supply-side shocks. Commodity prices are approximately 29% higher this year^ and mounting inflationary pressures will likely impact consumer spending, slowing global growth.
Additionally, persistent supply chain disruptions with China’s latest COVID outbreak and US Fed’s hawkish stance are causing further woes, leading to increasing stagflation fears. During the 1970s stagflationary period, US economic activity, measured by the ISM manufacturing index, fell below its average trend, and coincided with an above trend inflation rate. Currently, ISM index is trending downwards, and we are monitoring if it breaks below average, with inflation having already ticked up.
We remain neutral on equities and may add to EM as policy shifts seem more supportive in China. On bonds, we have a neutral view on rates as US Treasuries historically have been reliable “safe haven” assets; however, there is uncertainty over US Treasuries’ effectiveness as a recession hedge amid a rising commodity price / high inflation backdrop. Gold and inflation-linked bonds look attractive currently.
Hyde Chen head of investment strategy of asset management
Haitong International
A backdrop of high inflation and rising rates are a challenge for investors as inflation erodes the real value of wealth, while higher rates undercut the nominal valuations of bonds and equities.
An environment like this speaks in favour of ensuring portfolios are well diversified, including exposure to alternatives in investors’ strategic asset allocations. Diversifying with alternatives including hedge funds, private markets, and real assets can help long-term investors reduce overall portfolio volatility and manage risks around inflation and rising rates. We see hedge funds as an effective diversifier that can reduce overall portfolio volatility, especially if inflation fears drive increased equity-bond correlations. Real assets such as direct real estate offer investors an overall stable, mostly inflation-linked income stream. As their total return is not closely correlated with other asset classes, it can offer diversification benefits in a portfolio context.
We are currently overweighting alternatives in our global multi-asset investment strategy. We believe alternatives as an asset class offer an appealing combination of the potential for attractive risk-adjusted returns, historically less downside sensitivity than equities, and low correlations to other asset classes. As a result, they can enhance a portfolio’s long-term resilience to the changing monetary policy environment.
Robert Almeida, portfolio manager and global investment strategist
MFS Investment Management
While every cycle is different, by and large, we would expect large caps to outperform small caps in a stagflation scenario. Larger size companies tend to be better able to manage higher input costs such as labour and raw materials etc. and protect margins, which ultimately drives asset values. Small companies have a much higher beta to input costs such as labour, debt, and energy and struggle to shed non-essential costs in a low growth environment.
Generally speaking, equities in aggregate will inevitably suffer as the multiple falls. All assets compete with cash yield or risk-free return. In particular, rising cash yields may expose the high price vulnerability of expensive assets without material profits and vice versa. For example, during the 1970s, the last period of stagflation there were companies who doubled their stock price because they were share takers as peers struggled. Margins drive asset prices over the long term. As returns on risk assets deflate, we can expect to see dispersion of returns skyrocket. When uncertainty is high like it is today, investors may want to concentrate on owning assets where cash flow visibility is clearer and where the products are mission-critical and under-owning assets where profits are dependent on factors outside of companies’ control or on unproven concepts.
Commodities are an obvious beneficiary as well as real assets such as REITS. REITs are a hybrid of asset class that reside somewhere between equities and bonds. They’re viewed by investors as equities due to their potential for real capital growth, but also as bonds because of their income streams and focus on consistent capital return through dividend income. As a result, inflation matters in this asset class, though REIT performance during inflationary periods has been mixed.
Subash Pillai, regional head of client investment solutions Apac
Franklin Templeton Investment Solutions
Inflation continues to exceed expectations. More recently, inflation has been driven by supply-related factors such as shortages of commodities, infrastructure, and labour. Geopolitical tensions have exacerbated many of these supply constraints. Supply-driven inflation that lowers demand and employment is the hallmark of most stagflation definitions. We feel that markets today reflect the risks of continued high inflation together with ongoing moderation in growth.
Our view for growth and inflation is slightly more pessimistic relative to consensus expectations, although risk of a strong stagflation environment remains low. Most economies have experienced more moderate upward pressure in inflation compared with the US, with countries like China, HK, and Japan still likely to record “below target” inflation in 2022. If we do move into a strong stagflation environment, there are challenges for both bond and equity investments, but greater opportunities within alternatives. Indeed, we do observe a greater focus on alternatives from Asian asset owners. We would favour higher allocations to inflation-linked bonds and assets with inflation protection including infrastructure and commodities.
Within equities, we favor defensive equities with stable cash flows and upstream producers with greater pricing power. Regionally, Japan would be better placed as higher inflationary pressures are less likely to lead to materially tighter monetary policy, unlike the US and the UK. Within EM and particularly across Asia, we would suggest being especially tactical and selective, seeing better opportunities in countries with less challenging inflation profiles.
Irene Goh, head of multi-asset solutions, Asia Pacific
abrdn
The probability we assigned to the stagflation scenario has increased significantly in recent months. Such a market condition would curb growth and consumer spending, add pressure on corporate profitability, compress market multiples, challenge weaker business models, and put central banks in a difficult position with a hawkish bias. Stagflation thus represents a headwind to long duration assets with scope for commodity, financials, and alternative assets to benefit.
From a multi-asset investment point of view, some repositioning of portfolios to protect against or even benefit from a stagflation scenario is justified. Since start of the year, we increased our exposure to US financials that will benefit from rising rates, and commodities-sensitive assets such as gold, energy, and industrial metals that shielded portfolios from rising geopolitical tensions and demand-supply imbalance.
Higher inflation is also likely to see a supply side response with larger investment in infrastructure and focus on sustainable energy. For example, we find PPP and renewable infrastructure assets appealing as the underlying revenue tends to be inflation-linked while the demand is less directly sensitive to the economic environment. We have also invested in logistics real estate assets, which not only shields us from rising inflation but also benefits from long-term thematic trend of ecommerce growth. These types of assets have generally outperformed the broad market in 2022.
Henning Potstada, head of investment strategy, multi asset & solutions,
DWS
Stagflation risks are looming as inflation expectations are on the rise while economic growth is increasingly facing headwinds. Lower return expectations stem from both inflation expectations and current valuations — real yields still in negative territory while equity valuation multiples remain above the average observed over the economic cycle.
In the current context, DWS takes a distinct approach to diversification to mitigate stagflation risks and flexibly navigate current markets. We would reduce duration sensitivity for both sovereign and corporate bonds as interest rates are poised to rise. Keeping overall equity exposure stable as returns are essentially coming from there still. However, we favour diversification within the equity sub-portfolio. We invest across 4 buckets: digital/IT, cyclicals, infrastructure and defensive. We have for instance reduced of late the share of IT/digital stocks that are more sensitive to higher interest rates and reallocated to infrastructure and defensive stocks.
Building exposure to gold and currencies which may act as diversifiers in the current inflationary context is also important, as well as to utilise liquid alternative strategies such as momentum, relative value opportunities or long/ short strategies that by definition have a low sensitivity to both duration and equity beta risk.
Inigo Fraser Jenkins, co-head of Institutional solutions
Alla Harmsworth, co-head of institutional solutions and head of alphalytics
AllianceBernstein
Stagflation risk in Europe is especially high compared with other regions. As a result of Russia’s invasion of Ukraine, expensive energy has already raised input prices to a level that will hurt growth. There is the risk of a curtailment of energy supply, and the European Central Bank has outlined a hawkish line on inflation.
Given this backdrop, the clamor to consider stagflation hedges for portfolios is understandable. Commodities have been the most effective hedge in the recent crisis, but they will be replaced in part by return streams from delivering renewable power. Real estate also has a role as an inflation hedge. It can lag in the short term if rent reviews lag rapid inflation moves, but it’s ultimately a claim on a cash-flow stream set in the real economy.
A set of factor strategies is also important in this context, including free-cash-flow (FCF) yield in equities and foreign exchange carry in bond markets. The two factors are slightly different from the experience of value factor, which tends to respond well when inflation rises moderately. Momentum or trend strategies can be interesting too: they benefit from a sustained price move but suffer if prices don’t move or sharply reverse.