Inflation, Stagflation, Debt Ceiling Concerns – How to Position?
Prashant BHAYANI CIO Asia, Grace TAM Chief Investment Advisor, Hong Kong & Dannel LOW Investment Specialist at BNP Paribas Wealth Management
- Are we entering a potential stagflationary time with rising power prices and potentially faltering budget negotiations? Should we be worried about the debt limit extension?
- What are the best places to put money now with US equity markets not having a significant correction and China still going through a growth slowdown?
US Equity Markets – How High Can It Go?
The S&P 500 has had a 5% correction since September after 300 days without a 5% correction. This is the longest period in 15 years. Low interest rates, record earnings beats, cyclical recovery, and vaccine roll-outs have underpinned the market.
How long can the easy financial conditions last? After the recent FOMC meeting, the Federal Reserve is likely to announce tapering in November. In addition, our first rate hike expectation has been moved up by a quarter to 4th quarter 2022. Overall, we believe it will be a “tantrum-less” taper as the Federal Reserve is telegraphing well in advance their intent, unlike in 2013. Real rates still remain negative, nevertheless some volatility is possible.
In addition, the US Senate approved a bill to extend the debt ceiling through 3 December, but the delayed debt ceiling fight could add some volatility in coming months.
Three Possible Scenarios:
(1) The Democrats pass the debit limit along with their budget spending proposal of $3.5 trillion. Critically, the US budget is currently under Democratic negotiation between moderates and progressives. This $3.5 trillion number will come down but can it be done in tandem with a debt ceiling raise?
(2) The Republicans join the Democrats to pass the extension. At the moment, this seems unlikely, as the Republicans would like to show their disdain for the large spending program of the Democrats. However, when push come to shove, they could acquiesce closer to the deadline.
(3) Democrats pass it separately from the budget reconciliation bill.
Our base case is an extension of the limit and any volatility likely is a buying opportunity. The ceiling has been extended 78 times since 1960. The US has not in the modern era ever had a delay in a coupon payment. This is a low probability, high impact event. If it does occur, the rating agencies may lower the credit rating of US sovereign debt, causing volatility in bond and equity markets. For this very reason, a deal is normally achieved by one or both parties. Nevertheless, it could go down to the wire and spark some market volatility.
What About Surging Power Prices?
European and Asian natural gas prices have surged. In Europe, the increase in natural gas prices has been caused by a prolonged previous winter, and lack of LNG cargoes over the summer led to tight supply conditions. This was aggravated by poor domestic production and lower supplies from Russia. In China, electricity demand has increased double digit due to robust exports and coal supply by just 5%. As a result, natural gas as an alternative fuel has rocketed in price.
Also, rules to lower energy intensity may have to be loosened temporarily. Other measures to rectify the situation include state-owned companies could acquire coal/natural gas, subsidies to electricity producers, and rationing of power intensive sectors like cement, and steel. This will likely cause some disruption into year-end and fade by early 2022. The resulting downgrade to China for 2021 GDP is 0.3 – 0.4% as a base case. Winter is Coming!
What about higher oil prices due to more demand because of substitution from natural gas? There is no lack of crude oil in the world but the OPEC+ tight supply management and the disruptions due to hurricanes in the gulf of Mexico has pushed Brent prices above 80$/b. Prices should revert to the $70-80 range in the medium term.
However, in the short-term it could eclipse this range. The weather is a key unknown variable, a cold winter could result in further spikes in oil and natural gas, and a warm winter will lead to a faster normalization of prices.
Where to Invest?
Real Assets/ Cyclicals/ Japan & Europe
The higher yields, inflation expectations, as well as steepening yield curve since the FOMC meeting favours selected cyclical/value sectors. One such example is EU energy companies, which have 15% free cash flow yields, attractive dividend yields, trade at a 50% discount to the market. Also, financials have benefitted from higher yields, and can now return capital via dividends and share buyback, while trading at an attractive valuations.
Geographically, both Japan and European indices have a high cyclical weightings. Investors can look towards these two markets as an alternative to US or China shares, particularly since majority are still underweight in these regions. European equities will likely benefit from rising yields and domestic reopening as consumption continues to improve with strong vaccine roll-out. Valuations are at a 30% discount to US equities, with attractive dividend yields and strong earnings momentum. Europe also has world-class multi-nationals and leading exposure to ESG trends.
For Japan, on the political front, the country has a new Prime Minister, which will likely lead to additional fiscal easing. At present, Covid restrictions are fading, which can aid the country in reopening. The currency also remains weak, while valuations are still attractive at nearly a 40% discount to US equities.
In addition, at the beginning of September, one of our themes we reiterated is on Real Assets (click here to read more). We continue to advocate greater exposure to real assets with positive after-inflation yields, and continue to see attractive income and diversification benefits from exposure to infrastructure, real estate and commodities.
Conclusion / Strategy
US equities have had a 5% correction since September after more than 300 days without a 5% correction, the longest in 15 years, hence a correction would actually be healthy. There are uncertainties such as the debt ceiling extension, rising commodity and power prices due to shortages of coal and natural gas. Our base case is the debt ceiling extension will eventually be agreed. The rising power prices are likely here to stay for several quarters with the winter period being crucial if it gets better or worse.
Post FOMC meeting, a steepening yield curve (as we expected) and higher yields provide opportunities in the EU energy and financials. Geographically, both Europe and Japan have superior valuation upside, higher cyclical component aided by higher yields, and catalysts for relative outperformance. We maintain our positive stance on global equities and real assets (inflation hedge), namely commercial real estate and global infrastructure. We are buyers of dips.
We expect an announcement on the Fed tapering in 4Q, with implementation in December this year. The US 10y treasury yield is likely to rise, and we target 2% in 12 months, while retaining our negative stance on government bonds.
Read September Issue of Investment Navigator : What to Do After the Recovery?
Overview of our CIO Asset Allocation for October 2021
GDP & CPI Forecasts
- Growth rate should be peaking this year and should stay well above trend next year, thanks to progress on the vaccination and support from monetary and fiscal policy.
- Stimulus plan in the US and in Eurozone should translate in a high Keynesian multiplier and enable economic growth above 5% for coming quarters.
- Sustained supply chain disruptions, higher energy prices and mismatches between labour demand and supply are boosting inflation.
- Inflation will continue to stay high but should peak early next year. Figures should converge to around 2% in 1H 2022 in the Eurozone & 2H 2022 in the USA.
- Despite taper fears and the Chinese Evergrande worries, global stock markets have been resilient. Our trend-following indicators point to maintaining long equity exposure.
- Strong earnings momentum allied with rising buybacks, negative real yields and boosted M&A activity are key drivers for stocks.
- Downgrade Asia real estate to neutral due to heightened regulatory risk as an overhang for the sector in HK and China. We prefer Singapore property developers, especially REITs, as they are relative safe heaven with much lower policy risk and higher dividend visibility.
- The Fed wants to start tapering soon and at a faster pace than expected, probably to keep its options open should inflation persists. We expect the tapering decision on 3 November and a first rate hike in Q4 2022.
- US long-term bond yields should rise given the tapering, the roadmap to rate normalisation, decent growth and sticky inflation above the Fed’s 2% target. We keep our 2% target for the UST 10-year yield on a 12-month horizon.
- Neutral on US IG corporate bonds: We expect very low excess returns given the current level of spreads. The total return of the asset class will be mainly driven by the direction of UST.
- Stay positive on EM bonds (both USD and local currency): Evergrande accounts for a very small share of the EM USD bond market. We see recent spread widening as an opportunity and stay positive on the asset class. Also, a lot of the rise in inflation and expected monetary policy tightening has already been priced into local curves in our view.
Forex & Commodities
- Less upside for EUR: The USD Index broke above 94 amid the more hawkish than expected FOMC meeting in September. We still expect the EUR to benefit from an improved economic momentum and increasing risk appetite. However, we expect no rate hike by the ECB over the coming 2 years, while we revise our outlook for the first Fed rate hike from 2023 to 4Q 2022. As interest rate differential is the key driver of the dollar, we see less upside for EUR and revise down our 12-month target for EURUSD to 1.18 from 1.22.
- GOLD: Real yields are expected to rise moderately and the USD to strengthen, both are headwinds for gold. However, the risk of more sticky inflation is positive for gold. We expect gold to trade in the $1800-2000 range.
- OIL: There is no lack of crude oil in the world but the OPEC+ tight supply management & the disruptions due to hurricanes pushed Brent prices to over 80$/b. Prices should remain in the $70-80 range in coming months.
- BASE METALS: China’s metals consumption, except aluminum, will remain soft during winter. We expect a strong recovery from spring due to China’s potential policy easing, less energy supply constraints and major automotive & manufacturing goods re-stocking in Europe and USA.
Strategic & Tactical Asset Allocation
OUR TACTICAL ASSET ALLOCATION IS BASED ON OUR CIO’S ASSET ALLOCATION VIEWS.
THERE IS NO CHANGE THIS MONTH.