Battle Between Reflation and Secular Stagnation
Posted 19 April 21
Interview with ausbiz, 19 April 2021
In an interview with Ausbiz, Paul Ashworth, our Chief Investment Officer, outlined his thoughts about the rising expectations for Inflation and more importantly, how Cameron Harrison's Asset Allocation Strategy is positioned.
Firstly, we acknowledge inflationary expectations over the last 3 months have increased. There has been and continues to be a lot of talking, thinking and speculating about inflation, so it’s not surprising that expectations for inflation are indeed rising.
Tellingly though, on a detailed review of diverse factor inputs from Treasury Inflation-Protected Securities (TIPS) breakeven, swap rates, household and business surveys and professional CPI surveys, inflation expectations seem to be higher than the Federal Reserve’s own measure which has been fairly static. While not yet at the Federal Reserve’s target of 2%, inflationary expectations are indeed advancing to this level.
Despite this, and as noted recently, we do not see a full-blown inflation breakout as the base position. The secular stagnation forces of the last 30 years do not reverse that simply.
Key at this stage is that the rising inflationary expectations may necessitate earlier restricting policy action from the Fed than markets are anticipating. Much depends on their position to allow inflation overshoot to generate higher employment levels, yet keep inflation expectations reasonably managed. We consider this multi-factor dataset very credible, as such, it is considered material in the context of the impacts for our Asset Allocation Strategy.
We view that US equities should continue to perform reasonably. The headwinds caused by rising inflation expectations and bond rates should be compensated by robust growth in earnings which are supported by stimulus, infrastructure spending, reopening of COVID sensitive sectors and the spending of accumulated savings.
Cameron Harrison’s view, noted in November 2020, is that the better part of US equities performance should invariably be driven by high quality industrials with cyclical leverage. In this respect, the rotation from growth to what we describe as ‘smart industrials’, appears to have good distance yet to travel.
The European equities should perform quite well from the weak, COVID-ravaged base they are coming off. The medium-term outlook for Europe and the EU continues to concern us, and the coordination problems for the approach to COVID and now vaccination, is a ‘looking glass’ into the abject failure that is the EU and a malaise that may continue well into a second decade. Above all, we remain unconvinced that the EU can properly manage their medium-term fiscal response, and will again tighten too early.
Our view is that Australian equities are well-positioned to advance further through 2021, resulting from the combination of stimulus, spending of accumulated savings, Homebuilder housing stimulus and the continued (albeit slower) opening up of the COVID-hit economy.
We expect the vaccination program to hit its straps leading up to the end of 2021 and that immigration through targeted skills visa and offshore student entry will resume. The economic drivers are significant:
- sustained economic growth beyond the COVID handout sugar hit;
- wages growth;
- moderation of inflation expectations; and
- a reduction in China demand for core bulk commodities necessitating a widening in growth options.
We continue to see 2022 presenting some significant challenges for Australia, with much depending on continued sustained China export demand (where we see downside risk) and the fiscal 'sugar hits' fade. Again, we favour the ‘smart industrials’ and cyclicals with leverage.
Government Bonds & Corporate Bonds
We remain pessimistic on returns for government bonds due simply to increased yields on longer bond rates, with 10-year US Treasuries operating between 2.25% and 2.50% through to 2022, on the back of more elevated inflationary expectations.
For corporate bonds and high yield debt, the story is a little better. We are cognisant of the policy of yield suppression by policy makers, particularly in the curve up to 5 years. We broadly view that policy makers are pregnant with this position for a considerable time and this makes bond returns look rather sickly.
Listed Property (REITS)
REITS will face headwinds, both from rising real yields and structural forces occasioned by COVID (retail + CBD office). That said, we continue to see good relative value in industrial logistics and associated office and fringe CBD centres. These assets provide a stable valuation to real yield increase through CPI indexation or contractual rent increases combined with the necessary demand.
And finally, but by no means the least (especially for Australia), for industrial commodities we see a cycle decline. This will be led by a slowing China cycle and demand for industrial commodities, which have been the buttress of Australian exports and national income growth. This is going to create a significant drag on Australian growth, corporate tax receipts, and as previously noted, will see increased pressure on the opening of borders, as a minimum, to support renewed immigration.
Have the increased inflationary expectations altered our Asset Allocation Strategy?
Taking these factors into account, since the beginning of the year, Cameron Harrison’s asset allocation strategy remains largely unchanged although with returns more moderated by virtue of rising real yields.
However, we remain yet to be convinced that secular stagnation is ‘dead and buried’ and trends in China reflect this view, whereas US policy may well be truly charting a higher inflation course, which will challenge market expectations.
Careful, bottom-up analysis and research-led selective investment across all classes is (we believe) the order of the day.
Peace of Mind Investing
Cameron Harrison have been advising business owners and their families on asset allocation and intergenerational wealth management for over 50 years. We have demonstrated over a long period our ability to manage investments through both the good times and bad by keeping the client at the centre of our business.
For more information on our approach to investment strategy or any other inquiries, please contact us on +613 9655 5000.
Photo by Annie Spratt