Stagflation occurs when declining economic growth and its resultant high unemployment coincides with rising prices, combining the words ‘stagnation’ and ‘inflation’. Surging natural gas prices, a massive shortage of lorry drivers that have brought some supply chains to a halt, and increased warnings of ‘cost pressures’ by companies have brought back stagflation fears as a driver for market sentiment for the first time since the 1970s.
Stagflation is particularly negative for corporate bonds, since inflation eats into their returns while a worsening economy increases the likelihood that their issuers will default. The multi-asset team has subsequently switched more of its portfolio away from credits into cash, while also remaining optimistic that the true economic outlook may surprise to the upside, which would benefit equities.
“With markets upgrading the probability of a stagflationary outcome for the global economy, we believe now is the right time to tactically reduce risk by overweighting cash relative to credit markets until the stagflationary fears blow over,” says Peter van der Welle, Strategist with the multi-asset team.
“The stagflation narrative that is on the rise in market discussions at the moment will only fade if global growth again surprises to the upside, or if evidence emerges that supply chain pressures ease, or that corporates are taking rising input costs in their stride and will still manage to report higher margins in the next few quarters.”
“Looking ahead at the macro landscape in the next 6-12 months, we think these stagflationary fears are overdone, and a more upbeat macro sentiment could re-emerge. A resilient consumer who is enjoying wage growth, elevated house prices and financial wealth, and excess savings will support the global economy in 2022.”
“US excess household savings now amount to USD 3.3 trillion. Next to that, higher corporate capital expenditure and restocking will contribute to economic activity growth beyond the fourth quarter of 2021.”
One issue is that stagflation presents central banks with a dilemma, since they can’t act to combat the higher inflation – such as by sucking cash out of the economy – without also harming a nascent economic recovery and raising unemployment further. Credit values have partially relied on central banks pumping money into the economy for many years, buying bonds in QE programs.
“The pace and magnitude of compression in the credit markets on the back of massive excessive liquidity provision by central banks has been phenomenal,” says Van der Welle. “For instance, high yield spreads (the difference between yields of credits and AAA government bonds) have declined from 900 basis points to 298 in the last 18 months.”
“This leaves us with highly valued credit markets sitting in an early expansion phase of the business cycle in an apparent disconnect with the financial cycle. High yield and investment grade bonds are exhibiting the kind of behavior we would normally expect late in the business cycle when in fact we are in the early mid-cycle instead.”
This does though bode well for equities once things start to improve. “With markets typically leading the cycle by nine months, a turnaround in macro sentiment could be around the corner, so investors need to be swift on their feet,” Van der Welle says. “Once supply pressures ease, macro surprises start to improve and corporate profitability holds up, we expect equities to continue to outperform high yield.”
“From a relative point of view, US equities are less expensive compared to US high yield bonds, taking the low interest rate environment into account. A sizeable gap has opened up between the US implied equity risk premium and the US high yield spreads, which makes equities relatively more attractive.”
“Furthermore, a spread below 500 bps – the current global high yield spread is 360 bps – has historically seen the outperformance of equities compared to high yield in the subsequent six months.”
Another issue is that developed market central banks are increasingly recognizing the need to start withdrawing excess liquidity, reducing the bond purchases that have propped up the prices of credits. The ECB is likely to wind down its Pandemic Emergency Purchase Program (PEPP) in 2022, while the Fed’s famous ‘dot plot’ hints at a rate hike in 2022.
“In an environment of declining excess liquidity, and with the Fed potentially struggling to decouple tapering from tightening in its communication to the markets, the downside risk from duration risk in credit is increasing while the upside risk from further spread compression is diminishing,” says Van der Welle.
“Equities are better positioned to leverage above-trend US GDP growth should this occur. If US GDP growth stays above trend in 2022 and 2023, equities would typically outperform high yield. The Fed is forecasting GDP growth of 3.8% in 2022, which is more cautious than the consensus estmate of 4.2%”.
“This would correspond with a US manufacturing ISM index reading of 55, where any figure above 50 implies economic expansion. If though the much-watched ISM reading were to drop below 55, then the equity upside versus high yield would start to dwindle.
“In all, we prefer to tactically scale down portfolio risk to weather stagflationary turbulence for as long as it lasts,” he says. “But we do see potential in an overweight equities versus high yield trade once markets get a clearer view on the favorable macro outlook for 2022.”
The Robeco Capital Growth Funds have not been registered under the United States Investment Company Act of 1940, as amended, nor or the United States Securities Act of 1933, as amended. None of the shares may be offered or sold, directly or indirectly in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act of 1933, as amended (the “Securities Act”)). Furthermore, Robeco Institutional Asset Management B.V. (Robeco) does not provide investment advisory services, or hold itself out as providing investment advisory services, in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act).
This website is intended for use only by non-U.S. Persons outside of the United States (within the meaning of Regulation S promulgated under the Securities Act who are professional investors, or professional fiduciaries representing such non-U.S. Person investors. By clicking “I Agree” on our website disclaimer and accessing the information on this website, including any subdomain thereof, you are certifying and agreeing to the following: (i) you have read, understood and agree to this disclaimer, (ii) you have informed yourself of any applicable legal restrictions and represent that by accessing the information contained on this website, you are not in violation of, and will not be causing Robeco or any of its affiliated entities or issuers to violate, any applicable laws and, as a result, you are legally authorized to access such information on behalf of yourself and any underlying investment advisory client, (iii) you understand and acknowledge that certain information presented herein relates to securities that have not been registered under the Securities Act, and may be offered or sold only outside the United States and only to, or for the account or benefit of, non-U.S. Persons (within the meaning of Regulation S under the Securities Act), (iv) you are, or are a discretionary investment adviser representing, a non-U.S. Person (within the meaning of Regulation S under the Securities Act) located outside of the United States and (v) you are, or are a discretionary investment adviser representing, a professional non-retail investor. Access to this website has been limited so that it shall not constitute directed selling efforts (as defined in Regulation S under the Securities Act) in the United States and so that it shall not be deemed to constitute Robeco holding itself out generally to the public in the U.S. as an investment adviser. Nothing contained herein constitutes an offer to sell securities or solicitation of an offer to purchase any securities in any jurisdiction. We reserve the right to deny access to any visitor, including, but not limited to, those visitors with IP addresses residing in the United States.
This website has been carefully prepared by Robeco. The information contained in this publication is based upon sources of information believed to be reliable. Robeco is not answerable for the accuracy or completeness of the facts, opinions, expectations and results referred to therein. Whilst every care has been taken in the preparation of this website, we do not accept any responsibility for damage of any kind resulting from incorrect or incomplete information. This website is subject to change without notice. The value of the investments may fluctuate. Past performance is no guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. For investment professional use only. Not for use by the general public.