Macro Research

Inflation risk on the horizon? Strategies for rising inflation

While the tug of war between virus fears and growth optimism unfolds in the foreground, inflation has rapidly wriggled back into the narrative. Despite raging concerns, we expect inflation to remain manageable this year but looking ahead, strategies for navigating rising inflation will be a growing necessity.

iFAST Macro Research Team
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Published on 01 Mar 2021

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Rising inflation expectation has taken many investors by surprise lately. Market’s primary concern is an out-of-control inflation and a potential tightening by the Fed. The last time Fed attempted that, in early-2013, market volatility spiked and global equities corrected severely.

We see mild inflation risk in 1H21, where readings will predominantly be driven artificially higher by base effect. Inflation risk will pickup in 2H21 as transient factors (re-opening, quicker vaccination and US fiscal stimulus impact) come to play. We expect a core PCE (Fed’s inflation indicator) of 2.0% – 2.3% at year-end and thus, the inflation path should be manageable.

Probability of a Fed tightening this year is also low under its new AIT framework, but rate hikes will likely get pulled forward. Heightened macro-driven volatility should manifest in asset markets, especially in 2H21. Nonetheless, the macro picture right now points to reflation (rather than out-of-control inflation) and the consensus ‘reflation trade’ will have legs to run.

Regardless of a reflation or an out-of-control inflation, we recommend an underweight for fixed income. Within the fixed income universe, our preference remains tilted to high-yield bonds and we recommend underweighting high quality bonds given strong negative relationship with inflation. We also favour short duration bonds.

Equity markets can digest rising but manageable inflation. Particularly in the early business cycle while uplifted by a reflation undercurrent, cyclical and value plays (such financials, industrials, materials, energy) can thrive. Regionally, we again reiterate our preference for EMs as its favorable sector mix (relatively higher weights towards cyclical sectors) can bolster returns moving forward.

The growing inflation chatter – what is worrying markets

Since the start of the year, virus fears amongst market participants have been reignited and pitted against growth optimism. While this tug of war unfolds in the foreground, inflation has stealthily and rather rapidly, wriggled back into the narrative, taking many investors by surprise. What followed was a violent selloff in bonds market, flashy movements in longer-dated US treasury (chart 1) and a spike in inflation expectation and even real rates (chart 2).

Aggravating the inflation concern is the fact that prices of goods and services are climbing in unison across major economies. From US to Japan, inflation forwards (5Y5Y inflation swap rate) have all trended higher (chart 3) - a sign that inflation is a global macro event and not just a localised one.

Having said that, we note that some levels of inflation when accompanied by growth is actually healthy for real economies. However, with markets cradled by unprecedented level of stimulus, investors are particularly concern that the mounting inflation might spiral out-of-control and eventually trigger a policy tightening by the Fed.

Such worries were not unwarranted as the last time Fed attempted that, in early-2013, market volatility spiked and a hefty correction in global equities soon ensued. Given stretched equity valuation and boisterous sentiments, investors fear that another market tantrum akin to 2013 may re-visit.

Chart 1: Sell-off in bonds market saw longer-dated USTs explode higher

Chart 2: Real rates drove nominal yields lately, overtaking inflation expectation

Chart 3: Rising inflation expectation a global event, not a localised one

The likely inflation path this year

With inflation concerns mounting, we note that it is not completely unfounded. Inflation is indeed rising, underpinned by a confluence of fundamental inflation drivers since 2H20 – i) massive monetary injection raising money supply, ii) significant demand pressure from unprecedented levels of fiscal stimulus, iii) cost push inflation from supply bottlenecks and higher commodity prices, which is worsened by iv) a US dollar bear market.

Aside from the fundamental drivers outlined above, we see transient factors such as base effect, ‘normalisation’ and faster-than-expected vaccine progress coming to play in 2021. We believe inflation risk, while minor currently, is skewed to the up-side and inflation in the US is likely to run higher in 2021 (chart 4). (While our view extends to global economies, we narrowed our focus to the US given the global implication).

In the first half of 2021, base effect will likely be the predominant culprit of inflation in the US, artificially driving readings higher. Some cost push inflation from supply bottlenecks and higher commodity prices will also feed into prices, as price indicators are picking it up. Given the current low level of core inflation and how base effect may distort readings, we expect mild inflation risk in 1H21.

All eyes will be on inflation prints in 2H21 as base effect fades. Most of the transient factors like re-opening, quicker vaccination programme and lagged impact of US fiscal stimulus will feed into prices. Inflation risk will pickup with the potential for upwards surprise and prints should be taken more seriously. That said, we are expecting a US core personal consumption expenditures (PCE) ( inflation indicator which Fed pays most attention to) of 2.0% – 2.3% YoY at year-end as implied by inflation proxies comprising of leading economic, market-based and commodity indicators (charts 5 – 9).

Chart 4: Our expected inflation path this year

Source: iFAST research
Data as of Feb 2021

Chart 5: Empire State index (leading indicator for ISM manu. index) implies higher inflation to come…

Chart 6: …ISM manufacturing price index reflects the same…

Chart 7: …as also implied by US CBO’s official output gap forecast…

Chart 8: …as do commodity prices…

Chart 9:… and even sensitive market-based indicators

Inflationary risk in 2021?

While our expected inflation print constitutes almost a 1% climb from current core PCE level, such level is still considered manageable and we do not expect a sharp rise this year. Our reasons are anchored by the fact that i) 2.0 – 2.3% YoY is still relatively low against history (chart 10), where we consider ‘high inflation’ to typically be above 3.0%, ii) US output gap is still wide (ample room before overheating), iii) transient factors in 2H21 takes time to feed into economy. Again, we would like to note that this manageable rise is inflation will be accompanied by positive growth (our house view, chart 11), which can healthy for the real economy.

Extending our view further, we therefore see low probability of tightening by the Fed in 2021 under its new average inflation targeting (AIT) framework. The inflation gatekeeper should tolerate such core PCE level, in our view, as the sluggish US labor market is unlikely to hit max employment by year-end. However, rate hike expectations might get pulled forward as we are starting to see markets participants pricing in hikes as soon as 2022.

We do however expect heightened macro-driven volatility in markets moving forward. Markets may react more aggressively to Fed's comments and inflation readings, especially in 2H21, which maybe amplified by the likelihood that core PCE crosses the 'conventional' 2% target.

Chart 10: Current core PCE is still relatively low and very much below 'high' levels

Chart 11: Cyclical recovery firmly underway as projected. Economic growth when accompanied by higher inflation can be good for real economy

Reflation theme firmly underway

With all things considered, the macro picture right now points to reflation rather than a runaway inflation, an outcome which will spook many investors. A strengthening of the macro backdrop across 2021, rising (but manageable) inflation outlook and a steepening of the US yield curve are classic signs of a reflation.

Seeing how well the ‘reflation trade’ has performed over the past one - two quarters (chart 12), we note that it is firmly underway and most certainly a consensus view. Leaning on to our view of manageable inflation and continued cyclical recovery this year, we think the consensus ‘reflation trade’ will have legs to run. As we outlined in our 2021 outlook, we once again reiterate that reflation will be a dominant theme for much of 2021 and positioning accordingly can improve overall returns.

A caveat to the ‘reflation trade’ will be rising real rates (nominal yields minus inflation expectation). History shows, that sharply rising real rates can be detrimental to the returns of both equities and fixed income, which can potentially derail the ‘reflation trade’.

Chart 12: Rising inflation expectation drove recent reflation trade (US equities as proxy)

The fixed income playbook on rising inflation

The shift from deflation to rising inflation, more specifically reflation, is a key inflection in the macro picture. While it opens up alluring opportunities for investor, there is also a certain level of need for inflation-protection.

With rising inflation painted as the backdrop, the appeal of fixed income has swiftly diminished as mounting downside risk in prices (as yield rises, bond prices fall) can overwhelm the upside from higher yield. Regardless of a reflationary or a out-of-control inflation, we recommend an underweight for fixed income as an asset class.

Within the fixed income universe, our preference remains tilted to high-yield bonds and we recommend underweighting high quality bonds relative to the former. Both high quality government and corporate bonds have strong negative correlation with inflation (which increases with duration) (chart 12) and given the inflation path for 2021, returns may be subpar. Moreover, credit spreads of the latter are already very tight, around historical lows, and are vulnerable to widening.

In this current climate, we also lean towards short duration bonds as it curtails downside risk from rising interest rates. Particularly when paired with a higher bond yield, this can provide a larger buffer when rates eventually rises (chart 14) (the higher the yield/duration ratio, the larger a rise in rates is needed to erode away the bond yield). Asian high yield is our favourite, in that regards, for its strong yield, low duration and manageable credit risk.

Chart 13: IG bonds have strong negative correlation with inflation expectation, which increases with duration

Chart 14: Short duration bonds with higher yields (like Asia HY) can offer much protection in this climate

The equity playbook on rising inflation

Unlike fixed income, equity markets fare better and can digest higher inflation. Particularly in the early phases of a business cycle while supported by the reflation undercurrent, cyclical and value plays can thrive. History shows, cyclical sectors such financials, industrials, materials, energy perform well during periods of climbing inflation given its high sensitivity (chart 15).

Financials sector benefits from the robust cyclical-value rotation, which is fortified by a strong reflation narrative. Yield curve steepening with a rising 10s2s spread can be bullish for financials looking ahead. Industrials excel during periods where inflation and growth accelerates and especially during the early business cycle, the sector can outperform relatively.

Commodities possess the attributes of being an effective inflation hedge, which not only protects return in periods of raging inflation but also generates strong return. Energy and materials sectors are great equity play on the commodites market, and to a large extent also exhibit the same attributes.

On the contrary, we see risk building for structural growth sectors (i.e. Tech) under this inflation backdrop. Rising real rates may continue to test these stocks/sectors, especially if it turns positive and/or climbs too drastically, given current heady valuation levels.

Taking a step back, from a regional perspective, we reiterate of preference for EM equities this year. Relative to DMs, EMs showcase a favorable sector mix (chart 16) comprising higher weights towards cyclical sectors and lower weights towards growth sectors. Implications can be profound as such a sector mix makes cyclical EMs i) decent inflation hedge, ii) prime candidates for cyclical-value rotation, while iii) mitigating de-rating risk from growth sectors. Taken together, we believe this supports relative outperformance for broad EMs, reinforcing our constructive EM view outlined in our EM 2021 outlook.

Chart 15: Cyclical sectors have strong correlation with inflation expectation

Chart 16: Sector mix favour most EMs - tilted towards cyclicals and traditional inflation hedges

The Research Team is part of iFAST Financial Pte Ltd.

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