We are at what appears to be an important fork in the road for the global economy and financial markets. It all comes back to the ever-looming question: Is inflation transient or here to stay?
Much like the bowls of porridge from the story of Goldilocks, is the economy ‘too hot’ with inflation unabated by central bank action and becoming structurally embedded, or is it – as Jamie Dimon recently predicted – about to get very cold and hit the buffers with interest rate rises, inflationary pressure and consumers running out of the Covid savings surplus leading to a big slow down or economic ‘hurricane’?
The latter would really dampen inflation.
Some (including central banks) are predicting that things will be ‘just right’ with rising interest rates, quantitative tightening and rising bond yields helping to bring inflation and the economy into a soft landing.
It’s one of three scenarios; too hot and inflation entrenched, about to get very cold with a recession, or just right.
As you can imagine, each of these environments might lead to very different financial market outcomes increasing the importance of asset allocation and equity portfolio construction (style risk).
In an ‘inflation out of control’ and a hot running economy, stores of value might include commodities, energy, and companies with exceptional pricing power and reasonable valuations. But in a recession, sectors and stocks with economically insensitive revenues and earnings (defensives) are likely to be the best way to preserve wealth while waiting for central banks to declare victory over inflation and begin to consider rate cuts. Meanwhile, ‘just right’ is arguably supportive of consumer and industrial cyclicals at this juncture as the market has already started to price in.
What can investors do in the meantime? We focus on three things. First, balance portfolios that cover the different scenarios (unless you have a strong view on which one will emerge); second, look to pick up individual stocks in the volatility where their long-term fundamentals are mispriced in a moment of extreme sentiment; and third, be fleet of foot reacting to the incoming data and evidence.
The next six months will see a lot more data and evidence emerge as to which outcome is correct – a hot economy and entrenched inflation, an ice bath of a recession slowing the economy and inflationary pressures, or the soft landing down the middle with central banks bringing inflation down without ushering in a recession.
But one thing is certain – we are going to need some more time to find out.
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