CA-EN Advisors

Positioning for Peak Growth and High Inflation

Two concerns are top of mind for investors: inflation overheating and peak economic growth.
June 2021

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Two concerns are top of mind for investors: inflation overheating and peak economic growth. The latest U.S. inflation report showed an eye-catching jump in headline Consumer Price Index (CPI) to 4.2% and in core (ex food and energy) CPI to 3.0% in April, and wage growth is heating up. Meanwhile, U.S. growth indicators like the Institute for Supply Management (ISM) Purchasing Managers’ Index (PMI) pulled back from multi-decade highs, and fiscal stimulus is set to peak in Q3 before turning to fiscal drag by 2022.

Peak growth and rising inflation may suggest the early innings of late cycle growth or, worse, stagflation. We disagree and expect inflation to peak in May, though remain somewhat elevated, and growth to remain above-trend into next year as economic slack is further absorbed. Accordingly, we remain overweight equities vs. fixed income but recommend select cyclical exposures and inflation hedges.

Peak Growth is Not Ringing Inflation Alarm Bells

It is unlikely that the economy is fast approaching late cycle, and we continue to believe that any inflation pickup this year is largely due to reopening and will not result in a persistent overshoot (see our previous piece on inflation, (Source: BMO GAM). We expect U.S. growth to slow sequentially but stay at an above trend rate with PMIs holding above 50, underpinned by record savings. Meanwhile, growth outside the U.S., particularly Europe, is catching up. Labour market slack is still elevated globally, meaning room to absorb unemployed workers. Finally, and perhaps most importantly, financial conditions are very easy, reaching record levels of accommodation. This all implies recession risk is low and a cyclical upturn has room to run.

Looking Through the Inflation Noise: You can only reopen once

We emphasize that a new inflation regime looks unlikely, especially one marked by the 1970s. First, the latest U.S. inflation has few alarming elements suggesting a new inflation process taking hold, but instead indicates price-level adjustments. Pandemic-related factors are primarily at play—e.g., economic reopening, stimulus payments and supply shortages, all of which are impacting a range of goods and services. For example, large increases in airfares, hotels, restaurants and admissions reflect reopening, and continued strength in household furnishings, recreational goods and IT goods point to a boost from stimulus payments. Shortages in the semiconductor industry have led to excess demand in new vehicles, pushing up used car prices.

It’s worth noting that some prices of COVID-19 related goods or services are still recovering, as price levels remain below pre-pandemic levels. These categories also account for just 20-25% of CPI. It’s more important to look at inflation measures that exclude the most volatile categories in order to capture the underlying inflation trend. For example, the trimmed-mean and median CPIs remain relatively tame. We also give more attention to cyclical, underlying categories for signs of overheating, e.g., Owners’ Equivalent Rent (OER, a proxy of home prices), rent and medical services. These categories suffered significant weakness last year and are only slowly recovering.

A New Inflation Regime?

The main question for investors is whether these price-level adjustments will de-anchor expectations of consumers and businesses and lead to persistent inflation well above 2%. So far that is not the case in surveys (University of Michigan) of long-term expectations, although a de-anchoring would take years to unfold. In other words, it will be hard to take much signal from inflation this year.

During the overheating of the 1970s, the Federal Reserve was not an inflation-targeting central bank and was pressured to keep interest rates low for an extended period to boost employment while inflation ran at a double-digit pace. The Fed today, like other inflation-targeting central banks, will be more reactive well before those levels are reached.  Demographics today are also less skewed toward young prime-age workers which have higher propensities to spend, and worker bargaining power is weaker with lower unionization rates. Globalization, while having peaked, is still far higher than decades ago, with trade openness in the U.S. more than three times the level in the 1970s.

Peak Inflation, but Higher Uncertainty

Economic reopening, supply shocks and record levels of stimulus are unlikely to unleash 1970s-style stagflation under the supervision of an independent, inflation-targeting central bank that stands ready to act. Furthermore, fiscal stimulus is mainly counteracting the COVID-19 deflationary shock and is also temporary, as U.S. fiscal stimulus will turn to fiscal drag in 2022. This suggests that even though money supply growth has skyrocketed, money velocity is unlikely to meaningfully follow, limiting inflationary pressures (Source: FRED). Finally, the structural headwinds of digitalization, automation and eCommerce, all of which have been accelerated by COVID-19,  will allow firms to cut costs and increase productivity. These structural changes along with rising productivity that usually accompanies a recovery are important deflationary forces that are still weighing on inflation.

However, we remain of the view that inflation uncertainty will stay elevated going forward as the economy adjusts to a post-COVID-19 world and the Fed commits to flexible average inflation targeting. Supply shortages and wage growth will be key to watch, especially if shortages persist and productivity growth fails to pick up, as cost-push inflation would be unnerving to investors (as opposed to demand-pull inflation). Shortages however already appear to be waning as shipping and airfreight volumes are picking up and global trade is booming (Source: Bloomberg). It’s important to note that shortages in industries like semiconductors or skill mismatches among workers are nothing new, and previously have not led to sustained price or wage growth.

At the same time, the path to synchronized growth could remain uneven this year amid COVID-19 variants, slow vaccination rates in parts of the world and slow labour market recoveries held back by skill mismatches in an increasingly digitized world. Noisy price pressures and a bumpy recovery generally set up a backdrop of low real yields, which is positive for real assets, from equities and real estate, to gold.

Investment Implications for Fixed Income: Inflation to remain a headwind

With the global economy set to move in a more synchronized cyclical upswing, inflation will remain a headwind to fixed-income assets. For fixed-income heavy investors, we think it will be even more difficult to preserve their purchasing power as the economy recovers and expands beyond pre-COVID-19 levels. Because inflation is ultimately the process of firms raising prices, we think equities are probably one of the best hedges against ongoing inflationary pressures as firms will try hard to at least preserve their profit margins, if not outright increase them as demand rebounds.

For more balanced-type investors, while we think inflation will remain elevated this year,  we don’t expect a new inflationary regime whereby the equity-bond correlation would turn from negative to positive. Preserving a low to negative equity-bond correlation leaves traditional balanced portfolios diversified enough to sustain economic and market turmoil as we saw during the pandemic. With disinflationary headwinds still in full force in our view, government bonds should remain a natural hedge for equities, especially if economic growth, or inflation, were to disappoint in 2022.

For bond duration, we think the opportunities are more nuanced despite our conviction on where we think the economy is headed. Uncertainty over the global recovery, high economic slack and negative real yields pinned down by the Fed suggest plays on interest rate duration could be even more challenging into 2022.

With inflation uncertainty to linger, the addition of Treasury Inflation-Protected Securities (TIPS) in a portfolio looks attractive. Rising uncertainty points to a higher inflation risk premium, which can continue to boost inflation break-evens, and therefore TIPS (see Chart 6). They are not perfect hedges in themselves because a key risk in the coming years is a Fed policy mistake whereby interest rates would have to suddenly rise, killing the bull cycle and causing sharp losses in inflation hedges like TIPS and commodities. 

Investment Implications for Equities: Select Cyclicals, Inflation Hedges with an Eye on Defensives and Quality

We remain overweight equities but continue to see less scope for meaningful differentiation across equity regions given more synchronized global growth this year. When looking at equity sectors,  we like exposures to select cyclicals like industrials, materials and energy, and we have a small overweight of Canada vs Europe, Australasia, and the Middle East (EAFE) along with an overweight to U.S. small caps, the latter benefiting from the U.S. infrastructure bill likely to be passed this year. Within the U.S. equity market, given peak U.S. growth relative to the rest of the world, areas with greater exposure to regions outside of the U.S. is also a good tactical play, such as materials. We find financials less attractive as earnings look less positive going forward without a pickup in lending or a return to higher interest rates. Though interest rates have scope to move higher, they are likely to remain much lower than in past cycles. 

Rising inflation uncertainty and peak U.S. growth could shift investors toward defensives and quality, or areas with better balance sheets and pricing power, another reason we still like the tech sector and see opportunities in consumer staples (see our latest monthly commentary, Source: BMO GAM). There is scope in our view for inflation to disappoint over the next year as commodity prices correct from lofty levels and economic growth moderates. With already much priced into inflation break-evens, investors should consider more defensive plays as the year progresses.

Disclosures

This article is for information purposes. The viewpoints expressed by the Portfolio Manager represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp., BMO Asset Management Limited and BMO’s specialized investment management firms. 

®/™Registered trade-marks/trade-mark of Bank of Montreal, used under licence.

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