Stagflation looming amid the new market regime

That nasty word keeps popping up. Stagflation. And it’s a worrying sign of things to come. Expectations for future price increases have suddenly gone from ‘transitory’ to ‘temporary’ after a rise in Australian government bond yields had the RBA scrapping its ‘yield curve control’ policy which looked to peg 2024 government yields at 0.1%. Expectations […]

That nasty word keeps popping up. Stagflation. And it’s a worrying sign of things to come.

Expectations for future price increases have suddenly gone from ‘transitory’ to ‘temporary’ after a rise in Australian government bond yields had the RBA scrapping its ‘yield curve control’ policy which looked to peg 2024 government yields at 0.1%. Expectations for future rate rate rises have skyrocketed to a six-and-a-half year high. Wherever you look, prices are rising, driven by higher shipping costs, rising car prices and booming housing values, all on the back of supply shortages in inputs such as semiconductors, lithium, rare earths, magnesium and timber. And to top it off, energy and oil prices are hitting record highs and are the primary reason inflation is driving higher.

So where is inflation heading and what’s with the stagflation?

Stagflation, also called recessionary inflation, is a period where economic growth is slowing and joblessness coincides with rising inflation. Rising energy prices and supply-chain bottlenecks have created a period of slowing economic growth and rising unemployment, coinciding with rising inflation.

Europe’s largest asset manager, Amundi, published its investment outlook for 2022 and one of its biggest concerns was inflation. “Inflation will prove to be permanent and uncertain, fuelled by supply shortages and scarcity all around. De-synchronisation within growth and inflation trends are back with a vengeance, and globalisation will take a hit. Central banks will accept falling behind the curve, given their benign neglect of the inflation narrative. After an initial tiptoe into tapering, expect more, not less, monetary accommodation amid decelerating growth and the rising fiscal needs required to finance the green and just transition,” says Amundi.

In terms of portfolio construction, next year will bring more hurdles compared to 2021. Amundi says investors “should start the year with a cautious, neutral allocation (also considering stretched market valuations) and try exploiting relative-value opportunities across regions and segments. In a sequence of slowing growth followed by more stimulus, investors will likely have a window to increase risk allocation again and exploit the opportunities brought by an extended cycle.”

At the same time, the fund manager says the 60/40 portfolio model will be challenged. The positive equity-bond correlation will bring about a more dynamic allocation style. The key to success here will be “relative value plays and additional sources of diversification that can potentially mitigate inflation risk, such as real assets.”

Amundi cautions investors against going long in duration after the first round of rising nominal yields, saying, “curve movements, currencies and cross-regional opportunities will flourish in a world of divergent monetary policies. Unconstrained fixed-income will remain the name of the game.”

As the global economy reopens, growth is starting to rise. The concern here is that high energy prices and supply chain bottlenecks could impede this recovery and trigger a fresh round of central bank borrowings to rein-in inflation. To capture higher income, Amundi says, “investors should explore areas beyond the traditional bond space and consider equity dividends, real assets, EM bonds with a focus on short duration, and more generally areas offering higher yields with relatively low duration risk, such as subordinated credit and loans. Credit with longer duration and/or where spreads are too tight, will be challenged.”