Worried about inflation?
After a decade-long lull, markets have started to price in higher inflation expectations. However, we believe the growth outlook will be a more important driver of equities over the next 12 months as inflation gradually abates. We prefer equities over bonds and cash, but an allocation to gold can help mitigate any inflation surprises along the way.
The growth and earnings outlook remains most constructive in Developed Markets. In the US and Euro area, we prefer both
equities and High Yield bonds.
Chinese policy has turned less restrictive in pockets, though monetary policy or regulatory easing is likely needed for the outlook to improve more broadly. We prefer Asia USD, including Asian High Yield, and Emerging Market USD government bonds.
Worried about inflation?
• After a decade-long lull, markets have started to price in higher inflation expectations. However, we believe the growth outlook will be a more important driver of equities over the next 12 months as inflation gradually abates. We prefer equities over bonds and cash, but an allocation to gold can help mitigate any inflation surprises along the way.
• The growth and earnings outlook remains most constructive in Developed Markets. In the US and Euro area, we prefer both equities and High Yield bonds.
• Chinese policy has turned less restrictive in pockets, though monetary policy or regulatory easing is likely needed for the outlook to improve more broadly. We prefer Asia USD, including Asian High Yield, and Emerging Market USD government bonds.
Growth and inflation
Global equities, after correcting by just over 5% from early September to early October, have rebounded to around their early September’s all-time highs. This pattern is consistent with the seasonal September-October weakness ahead of a Q4 rally. In contrast, month-to-date, most bond markets pulled back, gold rose and the USD was little changed.
Much of the market’s current tug-of-war centres around the outlook for growth and inflation. Growth has been less of a concern, at least in the US and Euro area. While some high frequency indicators fell over the past month, above-trend growth is still expected in 2022, an outlook supported by PMI surveys and the recent earnings season.
The debate over inflation, though, is more polarised. In the US, inflation expectations started rising from late September, while consensus inflation forecasts were also revised sharply upwards (to 4.3% CPI inflation for 2021 and 3.3% for 2022).
For markets, the level of inflation and the policy reaction are key. Above-2% inflation has generally not held back risky assets unless long-term inflation expectations climb significantly. Inflation just above 3% over the coming year, a start to Fed tapering in 2021 and a rate lift-off in 2022 are largely baked into markets, in our view. A disproportionate central bank reaction, though, which leads monetary policy to become tight rather than merely less loose, is a risk to our positive equity market outlook as it would call into question the above-trend growth outlook in 2022 and beyond. The Fed and ECB’s views that current inflation is temporary and their focus on reviving growth and employment, though, suggest this is not an imminent risk.
Growth key to equities outperformance
Rising growth has been more important historically for equities outperformance than whether inflation was rising or falling. This implies that, outside of a scenario of decelerating growth combined with very high and rising inflation, equities can be expected to outperform while economic and earnings growth remain strong. We expect economic growth to remain above trend in major Developed Market (DM) economies. Earnings growth may ease to a more sustainable pace next year, but the level is expected to remain robust. Therefore, we remain comfortable with our preference for equities over bonds and cash despite today’s inflation debate.
Our preference for US and Euro area equities remains unchanged. However, UK equities face additional headwinds from an increasingly hawkish Bank of England, new Brexit related disputes and calls for new mobility restrictions amid a resurgence in COVID-19 cases.
In Emerging Market (EM) equities, turnround factors we are monitoring include the rollout of widespread vaccinations, EMs reversing their recently narrowing growth differential vs DMs, USD weakness and a significant easing of policy in China. While some of these indicators are improving selectively for certain EMs, they remain insufficient for EM equities to outperform DM, in our view.
China policy, in particular, remains key. On the upside, policy is starting to turn a little more accommodative on a selective basis
– policymakers said they are confident that property sector woes will remain contained and several mortgage and regional housing policies were eased modestly. While we do not expect a return to the days of massive stimulus, we do expect targeted fiscal stimulus and modest central bank easing to help stabilise growth. This, together with the progress on Evergrande’s debt challenges, are likely needed before China’s equity market outlook improves more sustainably. However, we continue to like Asia High Yield bonds – while China equities may await more positive growth catalysts, investors in Asian bonds are likely to find confidence in contained default rates that remain well within, or below, current market expectations.
