Reflation

Belal Khan

  • When the consensus is wrong, markets tend to sharply adjust.
    Higher inflation is here and here to stay; however, the consensus is that inflation is transitory.
  • We believe the risk of a sharp market drop has increased. However, such a market drop should be viewed as an opportunity to selectively enter the market and add risk, given our positive economic outlook for developed markets.
  • Our portfolio positioning remains centered on our reflation convictions in key developed market economies for several reasons including massive fiscal initiatives put in place since the pandemic surfaced over a year ago.. Summary of our select views:
    • Global Fixed Income remain at underweight
      • Sovereign bonds (US) remain underweight, but overweight inflation protected US treasuries (TIPS)
      • Credit (US & EU) remain overweight investment grade and quality high yield
      • Emerging market debt, we remain underweight
    • Global Equities remain overweight
      • We remain overweight US, EU, and Switzerland
      • We remain underweight emerging markets
    • Currencies remain positive on USD
      • We remain negative on EUR, GBP, and CHF vs. USD
      • We remain negative EUR and GBP vs. CHF

Investor focus has so heavily fallen on the recent developments in China and key Asian markets that risks and opportunities in key developed markets appear to be somewhat overlooked.

This extraordinary and very disappointing market activity in emerging Asia markets has mired many portfolio managers. While many have been trying to understand and decide what, if any, portfolio adjustments to make, some of the recent data and data trends for key developed market economies seem to have gone under the radar.

In the US, recent economic data suggest a continued build-up of price pressures. We see inflation and inflation risks as one of the main areas of focus in markets. While the consensus opinion calls for inflationary pressures (being temporary and transitory) to fade in the months ahead, we expect that inflation is here to stay.

With regards to US inflation, the “game changing” moment occurred last August (2020) when the US central bank (Fed) revealed its new monetary policy framework of average inflation targeting (AIT). This framework shift taken in conjunction with the plethora of sizeable fiscal initiatives, the likes of which have not been seen in modern history, will result in sustained upward pressure on prices. Granular economic data, such as the National Federation of Independent Business (NFIB) association economic reports, are vital in gaining insights into the health and outlook of the US economy and to understand the bottom-up price pressures.

“Small businesses account for 44 percent of U.S. GDP, create two-thirds of net new jobs, and employ nearly half of America’s workers.” (White House, 2021) Additionally, since taking office, the Biden Administration has put the health and welfare of small US businesses front and center in the Build Back Better and other fiscal initiatives. Staying abreast of data and developments on the US small businesses provides valuable insights.

NFIB reports, such as the Small Business Jobs Openings Hard to Fill Index, which has hit all-time highs, shows unprecedented labor price pressures. Additionally, the NFIB Small Business Higher Prices Index has climbed to levels not seen since the early 1980s.

1. NFIB Small Business Job Openings Hard to Fill Index

NFIB Small Business Job Openings Hard to Fill Index
The National Federation of Independent Business is the largest small business association in the U.S. It is headquartered in Nashville, Tennessee, with offices in Washington, D.C., and all 50 state capitals. Data source – Bloomberg as at August 25 2021.

2. NFIB  Small Business Higher Prices Index

NFIB Small Business Higher Prices Index
Net Percent (“Higher” Minus “Lower”) Last Three Months Compared to Prior Three Months. Data source – Bloomberg as at August 25 2021.

Our assessment of the US growth and inflation outlook suggests the market has not fully priced in inflation price risks. Perhaps this is due to the US Fed’s insistence that price pressures are transitory and will fade. However, we expect the Fed to begin to change its view on inflation.

In our view, there is a high chance that the Fed Chair Jerome Powell will begin to more clearly articulate upside inflation risks. In such an event, the markets seem ill prepared.

If Fed communication over the next several days and weeks, leading up to the September 22-23 monetary policy meeting does develop as we expect, the US yield curve may once again quickly bear steepen (Treasury bond yields in the long-dated maturities rise faster than the short-dated maturities). A fast bear steepening may push risk-on assets to much weaker levels.

Sharp falls in risk-on markets should be viewed as an opportunity to enter and add risk given that we expect continued key developed markets to continue to grow at a healthy rate. Additionally, even if the treasuries yield curve bear steepens, we do not expect real rates to move into positive territory. If real rates are negative, policy support remains largely in place, and there is growth, investors will continue to seek out and allocate to a diversified basket of assets in their attempt to generate a positive real yield.

Our GMG portfolio positioning remains centered on our reflation convictions in key developed market economies for many reasons, especially large, historic fiscal policy initiatives.

3. Charts below of Discretionary Fiscal Response to the COVID-19 Crisis.  Advanced Economies, top chart, Emerging Economies, bottom chart

Sources: Database of Country Fiscal Measures in Response to the COVID-19 Pandemic; and IMF staff estimates. Note: Estimates as of June 5, 2021. Numbers in U.S. dollar and percent of GDP are based on July 2021 World Economic Outlook Update unless otherwise stated. Country group averages are weighted by GDP in US dollars adjusted by purchasing power parity. Data labels use International Organization for Standardization country codes. AEs = advanced economies; EMEs = emerging market economies; LIDCs = low-income developing countries.