The fashion for retro has hit financial markets: stagflation playbooks from the 1970s are back.
That’s because the latest shock move by oil producers to restrict supplies is likely to fuel inflation, just as central banks were expected to pivot to rate cuts to prop up growth and give up their fight against rampant price pressures.
Investors are in no mood to let their guard down on inflation and are building up protection, having been repeatedly caught out by its staying power since the pandemic struck. Now the OPEC+ group’s one million barrels-a-day crude production cut has sent oil prices soaring and poses a new risk for the global economy.
“Here we go again — another problem thrown at the market. It just doesn’t go away,” Marija Veitmane, a senior multi-asset strategist at State Street Global Markets, told Bloomberg Television. “It’s increasingly challenging for central banks. Inflation fighting is not over.”
As investors put money into inflation hedges, the best-performing assets are starting to resemble those of the 1970s, when oil shocks sent prices spiraling. Bank of America Corp. strategists led by Michael Hartnett pointed to gold, small caps and emerging markets bringing in some of the highest returns year-to-date.
While the OPEC+ move is leading traders to reassess bets on whether policymakers can pivot yet, it throws another bone to those who think inflation won’t slide all the way to 2% central bank targets.
“There is potential of more inflation volatility in the coming years,” said Christian Mueller-Glissmann, the head of asset allocation for portfolio strategy at Goldman Sachs Group Inc., seeing short-duration Treasury Inflation-Protected Securities as a way to add protection. “This strengthens the case for larger allocations to real assets on a strategic allocation basis as those help diversify inflation risk.”
Even before this week’s move by oil producers, concerns around US regional banks in the wake of Silicon Valley Bank’s collapse had significantly changed the macroeconomic narrative. Traders have gone from pricing in several more Federal Reserve rate hikes to aggressive cuts later this year.
Markets have seen evidence that higher borrowing costs are starting to sting and that’s mounting pressure on global central banks to abandon rate hiking in favour of steadying the ship.
“It’s likely that the Fed will prioritise financial stability over price stability,” said Patrick Armstrong, chief investment officer at Plurimi Wealth, in an interview, adding he expects the Fed to ease financial conditions a little bit too much. “This sows the seed for the next wave of inflation.”
He’s shorting Japanese 10-year bonds on the bet that global inflation will remain sticky and the Bank of Japan will have to get rid of its bond yield curve control. He also sees value in emerging market inflation-linked bonds, particularly in South Africa, Mexico and Brazil, given their commodity-linked currencies can act as a hedge against the inflationary fires on the horizon.
Frederic Leroux, head of cross asset at Carmignac, is also preparing his portfolio for the next uptick in inflation. It would be a “huge mistake” for investors to expect it to moderate back down to around 2-3% and stay there, he said. Leroux argues that despite a disinflationary phase, investors will soon see the resilience of inflation, making protection such as breakevens essential.
“The biggest story in the next few months will be not to miss the train for cyclical and value sectors,” Leroux said in an interview. “It might last 1-2 years as we see a structural move towards more inflation.”
Even those convinced that inflation will eventually converge back down to target are sticking with hedges.
Andrew Sheets, chief cross-asset strategist at Morgan Stanley, sees inflation settling around 2.9% at the end of this year but expects elevated uncertainty around its trajectory. That means he favors real rates, commodities and equity sectors like consumer staples, likely to show good pricing power and perform equally well in an environment of falling inflation and weakening growth.
“Higher inflation is now the biggest risk facing most portfolios,” said Lindsay Politi, head of inflation strategies at One River Asset Management.
© 2023 Bloomberg
