Looking back on the past year, we see that the equity markets remain in excellent shape, despite a number of clear risk factors. These include the fear of a slowdown in growth, associated with flare-ups in the pandemic, concerns about supply chains, the sharp rise in inflation and, of course, Evergrande and the Chinese property market.
Inflation more structural than expected
None of these elements is likely to be strong enough to push us into a bear market.
But the reason why equity markets have little or no concerns about the potential risks is that central banks' monetary policy remains extremely expansionary. And on the fiscal front too, governments continue to pump billions of stimulus into the system.
Philippe Gijsels, Chief Strategy Officer: “All this of course creates inflation, which the central banks say is transitory. And admittedly, there are some elements that support this view. We can hope that once the supply lines are back in order, the upward pressure on prices will ease a bit. And there are also the so-called base effects. At the moment we’re comparing today's high price level with last year's very low price level. But next year we will be comparing with this year's high price level, a calculation that should lower inflation somewhat.”
But there are also elements that are of a more structural nature, such as globalisation, the huge amount of liquidity being pushed into the system, and high energy and raw material prices, to name a few. This leads us to believe that we have entered a prolonged period of structurally higher inflation. The message for investors is clear: real interest rates, the difference between nominal interest rates and inflation, will remain extremely low and even negative for quite some time. This means that cash will continue to depreciate at an unprecedented rate, making it very uninteresting and even toxic, and that money will continue to flow towards real assets.
Buy real assets
The heart of our strategy remains buying real assets in any potential downturn. In doing so, we want to nuance the view that they are all too expensive. The US indices, in which growth stocks are strongly represented, have indeed already risen sharply. But if we dig a little deeper, we see that at present only about 60% of the equities are participating in the rise. In other words, there are quite a few laggards.
Philippe Gijsels, Chief Strategy Officer: “If we look at the European indices in which quite a few value stocks and cyclicals are included, we also see a nice rise. But this is much less pronounced. For example, the French Cac40 has only just broken through its highest point of 21 years ago, and the Bel20 is still some 7% away from that.”
In addition, the low interest rate continues to ensure that if we calculate all profits, dividends and cash flows from the future back to today, this gives a much higher value.
The Barbell Strategy
The question remains, what to buy? We see quite a few opportunities. Firstly, we continue to use our Barbell strategy of trying to pick out laggards, but still in combination with technology stocks that remain a drag on the future. Completely ignoring the technology and biotechnology sector over the past 12 years has not been a great success.
In addition, there are a number of attractive longer-term themes such as the greening of the global economy, infrastructure, the undervaluation of listed real estate compared to the ‘physical’ real estate market, and among others, the new capex investment cycle, robotisation, internet security, nearshoring, energy efficiency and the metaverse.
It is clear that the market in the coming years will be a lot more volatile than the abnormally low volatility we’ve seen this year. But this will certainly create great opportunities. There is no shortage of themes and ideas.
Consumption under pressure
Inflation remains the key topic for both financial markets and the real economy. The question of whether the current uptick in prices is a temporary phenomenon will continue to dominate the headlines in the coming months. We think that the inflation spike will linger longer than expected by the market, but it will finally abate. In the long run, however, inflation will remain higher than before covid.
Chief Economist Koen de Leus: “One certainty is that higher inflation can weigh on private consumption. This is particularly true for the Belgian economy, which made a rather swift partial recovery from the corona pandemic. In fact, all but one of the underlying components of the country's GDP - consumption - have exceeded their pre-corona-levels.”
“We conducted an historical analysis to determine the expected impact of an increase in inflation on the growth of private consumption. Looking at the period 1960-2019, we find that private consumption growth slows when inflation exceeds its four-quarter moving average by 1 percentage point or more.”
For Belgium, the historical average since 1960 is a decline in private consumption growth of 0.2 and 0.3% points respectively when the inflation shock persists for one or two quarters. This negative effect is doubled when the rise in inflation is (partially) caused by rising oil prices, as it is today.
Another drag on household spending will come from increasing daily covid-cases and the subsequent stronger social distancing measures. The former seems to matter more than the latter. Retail spending correlates more with reported virus numbers than with the announcement of government measures. In other words, we adjust our (spending) behaviour out of fear, rather than waiting for new restrictions to be (re)imposed.
The causes of increased inflation are manifold. In the United States, strong demand is the main driver, with demand for durable goods 15 percent above the long-term trend. Consumers are eager to get their hands on durable goods and are consequently driving up prices. For Europeans, the supply-side dominates with logistical and raw material problems limiting the availability of goods throughout the economy, and fuelling inflation. In the US, supply-side issues are also present - here it is more about a lack of personnel, even more so than in Europe.
Stagflation not likely
Chief Economist Koen de Leus: “With the global economic recovery still in its early days, the risk of stagflation, a combination of low economic growth and high inflation, looms large. We insist on pushing back on this narrative. While it is true that the long-term consequences of the current accommodative monetary policy risk unhinging future inflation-expectations, many other factors, such as normalising energy prices and shipping costs, convince us that the price acceleration will only be temporary in nature.”
An unexpected helping hand will be the Chinese economy. The slowdown in the real estate market will weigh on raw material prices. In order to boost economic growth, China could decide to depreciate its currency. This would see global import prices of Chinese goods diminish.
The - temporary - spike in inflation will cause the Fed to accelerate its rate hiking cycle. We expect the Fed to hike rates three times next year and four times the year after. The ECB will maintain its course. As for rate hikes, we expect the first 10bp hike to come in June 2023, with the ECB then playing catch-up with another 15bp in September and 15bp in December.
Future inflationary surprises
The inflation spike has taken everybody by surprise. The green transition is certainly playing a role in the booming energy prices. In the future, oil shocks might be repeated, as oil reserves are peaking, investment in exploitation and exploration remains subdued and green energy cannot yet take over. Another possible long-term inflationary element is carbon taxes. The longer the world waits to introduce these taxes, the higher their level will have to be. And the greater the ensuing price increases that businesses will push through to save their bottom line. The IMF also expects much higher prices for several base metals that are crucial for sustainable applications such as batteries. The four metals where demand will far outstrip supply are nickel, cobalt, lithium and copper.
Ultimately, a higher debt ratio could lead to fiscal repression. Historically, this has also been a cause of inflation. So, if history is any guide, very low and even negative real interest rates are probably here to stay for a while longer.
Note 1 : the editing of this text was closed on November 29,2021.
Note 2: the sources used can be found in the accompanying slideshow published at https://www.bnpparibasfortis.com/nl/newsroom
Videos only available in Dutch & in French:
CHINESE GROEIVERTRAGING ONVERWACHTE BONDGENOOT IN STRIJD TEGEN INFLATIE – Koen De Leus
RALENTISSEMENT DE LA CROISSANCE CHINOISE, ALLIE INATTENDU DANS LA LUTTE CONTRE L’INFLATION – Koen De Leus
CENTRALE BANKEN BLIJVEN DE STIERENDANS STUREN – Philippe Gijsels
LES BANQUES CENTRALES CONTINUENT DE MENER LA DANSE… DE LA HAUSSE – Philippe Gijsels
Review the press conference