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Article | 7-minute read

The stagflation conundrum

November 2021

Stagflation concerns have weighed on investment markets recently. Our Chief Investment Office believes stagflation remains a risk to markets rather than its base case. Find out why in our latest House View.

 

Our view

Inflation — or more specifically stagflation — has dominated market headlines recently. Stagflation is an economic environment where both inflation and unemployment are elevated, and economic growth is below potential. In this scenario, persistent inflation is the most troubling aspect for policy makers, representing a significant conundrum as those fiscal and monetary measures traditionally used to combat the issue, actually have the potential to escalate it.

Loosening monetary policy has the potential to encourage further spending (increase inflation further) and expansive fiscal policy can stimulate demand — causing the same issue. Therefore, the only real way to combat this is by aggressively hiking rates; something Australian homeowners are currently grappling with following the RBA’s decision to adjust its forward guidance on the cash rate.

The RBA decision was brought about by a Q3 CPI print which surprised most analysts. The headline level was in line with consensus. Rather, it was core inflation (which lifted back to the target band for the first time since 2015) and specifically the broad-based rise of underlying constituents, which took analysts by surprise. Of greatest concern was the increase in non-tradable inflation (goods which are priced locally) where there was surprising strength in a range of services like insurance and restaurant meals. While perhaps concerning in isolation, the expectation is for wage growth to remain stymied, and this dynamic should keep rates under control for now.

Back to the global economy and stagflation. We don’t see the economy as being on a direct path to stagflation. Economies have experienced a major shock — the COVID-19 pandemic. Lockdowns suppressed household demand; policy makers reacted swiftly and sharply — snapping economies out of their down-turn, and fiscal measures lifted growth rates well above what would be considered as normal potential growth. These stimulus measures saw demand roar back above pre-pandemic levels, which combined with supply chain bottlenecks and soaring energy costs has led to higher prices. As economies reopen fully it is the rebalancing of these demand and supply-side issues that should see inflation ease — although not pass altogether. We believe the globe is still in a reflationary environment. Economic momentum remains strong, albeit having peaked, and labour markets tight — both factors should counter the emergence of stagflation.

Core domestic inflation lifts to the target band 

Source: ABS, Macrobond – ANZ Research, Australian Economic Update, 27 October 2021

What this means for our diversified portfolios

We hold our mild preference for growth assets this month. There is a clear level of uncertainty across markets with most investors asking, ‘what next?’ This type of environment is typically conducive for volatility and any sizeable dips could present good opportunities to increase growth assets further.

Bond markets came under immense pressure in October, as short-term rate markets tested the resolve of central banks. Our underweight to the domestic bond market served portfolios well over the period.

The sell-off in domestic bonds saw our underweight to the asset class drift further lower. While domestic bonds remain our least preferred asset class within defensive assets, the sell-off has taken us well below benchmark and any major shocks could unwind the gains made to portfolios in October. As a result of these factors we have rebalanced Australian bonds back to those levels held prior to the recent sell-off. This was funded via a reduction in cash.

ANZ investment strategy positions - November

Investment position
Asset class Reasoning
Growth Assets

 

Developed market shares

Markets continue to exhibit lofty valuations, sentiment has normalised and economic momentum, fiscal stimulus and liquidity appear to have peaked. The combination of these factors leaves markets vulnerable to any disappointments. The upcoming reporting season presents a potential risk-off event, particularly given the slowdown in activity, supply-chain bottlenecks that are impacting volumes and energy costs which are crimping margins.

Despite this, we retain our mild overweight to developed market equites this month — our preferred exposure within growth assets. Positive earnings momentum continues to be supportive of global share markets for now and TINA is again a prevailing theme. Seasonality should also provide a base on which equities can push marginally higher towards year-end.

Australian shares

Our position and outlook for the domestic share market hasn’t changed materially since last month. A challenging outlook for earnings momentum and potential implications for commodity prices.

stemming from slowing growth and increasing environmental regulations in China are the main headwinds for the market.

On a more positive note, all capital cities are free from lockdown and international borders have begun to reopen — although perhaps perplexingly for some, numerous domestic borders remain closed for the time-being.

We continue to favour global developed market shares, where we see better earnings momentum and diversification characteristics. There is still scope for the ‘value trade’ to re-emerge this year if labour market conditions remain tight, inflation persists, and bond yields shift higher again. If this were to eventuate, we may consider building our position in the asset class. For now, we remain at benchmark – albeit slightly below neutral in Australian shares.

Emerging-market shares

Valuations are now extremely cheap compared to developed markets and at some point, investors will focus on this rather than the perceived headwinds — the containment of the Evergrande crisis removes at least one of these.

When balancing the two, we believe a slowing Chinese economy, uncertainty surrounding Chinese regulations, doubts over the upcoming earnings season and continuing vaccination challenges across emerging markets outweigh the attractive valuations. For this reason, we retain our benchmark position this month.

Listed real assets

Overall, we remain mildly underweight listed real assets, as a construct of a mild underweight to listed infrastructure and a benchmark allocation to Global REITs (GREITs).

Real assets outperformed global equity markets over October. As both global hedged infrastructure (+5.9%) and hedged GREITs (+6.1%) provided solid gains to portfolios. GREITs are now the standout performer across all asset classes on a 12-month basis, having risen more than 40% over the period. Given this meteoric gain, we have less conviction for near-term outperformance from the asset class. However, similar to Australian shares, should the ‘value trade’ re-emerge later this year GREITs could benefit. Recognising this dynamic, and the additional benefits the asset class provides to portfolios — namely an attractive dividend yield, diversifying effect for multi asset portfolios and hedge against inflation — we remain at benchmark.

We remain mildly underweight listed infrastructure. While underperformance relative to global equity markets has stabilised, the 12-month performance gap remains significant. Despite large fiscal spends and global promises of infrastructure investment our hope for a strategic opportunity to increase exposure is yet to materialise.

Foreign Exchange Hedge Ratio*

The AUD had a positive October as improving sentiment both domestically and abroad saw outperformance against most major crosses. Domestically, higher vaccination rates and the end of lockdowns should set the stage for a strong rebound in activity. How much this feeds into wages and inflation will become increasingly important for policy as the economy reopens. While the domestic outlook is improving, the RBA’s reliance on actual rather than forecast inflation and stronger wages means it will likely remain a laggard this tightening cycle. Short positioning in the AUD is at historical extremes and leaves the currency vulnerable to a short squeeze as stabilising global growth and favourable seasonality come into play.

Within our diversified portfolios we maintain our benchmark position to the AUD this month. We prefer more developed market foreign currency exposure (in particular the USD) which should act as a form of protection in the event of any equity market pull-back.

 
Defensive Assets

 

International fixed income

Our central case hasn’t changed since last month, although we are slightly more constructive on duration, we believe the market continues to underestimate the economic recovery and job tightening potential. Inflation is expected to be more enduring than initially expected, however, as economies reopen, the rebalancing of demand and supply-side dynamics should see inflation ease, although not pass altogether. Higher yields may eventuate as a result.

We remain at benchmark this month and continue to favour global bonds to domestic bonds, owing to our preference for credit versus sovereign bonds. The global market has a higher credit allocation than the Australian market and credit should outperform sovereigns in the near-term given continued monetary policy support, the hunt for yield and broader economic prospects.

Australian fixed income

Domestic bonds sold off heavily in October, following higher than anticipated inflation figures and expectations that the RBA would shift its forward guidance on the cash rate. Ultimately, the RBA did as most punters expected and kept the cash rate unchanged at 0.1%, reaffirmed its commitment to continue purchase government securities at the rate of $4 billion a week until at least mid-February 2022, and abandoned the yield target on the April-24 bond, reflecting “the improvement in the economy and the earlier-than-expected progress towards the inflation target.”

The October sell-off in domestic bonds saw our underweight to the asset class drift lower. While domestic bonds remain our least preferred asset class, the sell-off took us well below benchmark and any major shocks could have unwound the gains made to portfolios in October. As a result of these factors, we have rebalanced Australian bonds back to those levels held prior to the recent sell-off. We are underweight Australian fixed income.

Cash

We hold a benchmark position in cash, having used part of our cash allocation to increase our domestic bond holdings following our last investment committee meeting. The position provides liquidity and risk reducing characteristics to portfolios.

 

Notes:

*Percentage of developed market and emerging market equities hedged from foreign currency into Australian dollars.

Tactical Asset Allocation is current as at 1 November 2021.

 

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