The year of the stag?
Fixed-income investors have faced a myriad of challenges so far in 2021, such as low interest rates, rising inflation and compressed spreads. Now, slowing global growth threatens to cause stagflation. Stagflation occurs when economic growth slows, unemployment increases, and inflation remains high. This is perilous for investors as it causes a vicious cycle in which slowing consumer spending caused by inflation depresses companies’ earnings and leads to an increase in unemployment. In my view, stagflation is a near-term risk but is not a long-term concern for investors as I believe that inflation remains transitory and will come down as supply chain disruption eases and supply is able to catch back up with demand.
The global supply chain has been running on a ‘just in time’ model which has been severely disrupted by the pandemic. This has been one of the primary causes of the inflationary pressures which have arisen this year. The world is now more connected than ever, and this means that when a factory shuts down in China, the knock-on effects are both immediate and wide-ranging. I expect the disruption to the global supply chain will take a while to repair and is largely dependent on how successful countries are at combating the virus. If new variants continue to emerge and economies have to lockdown again then it will be a while before global supply chains heal.
Fundamental forces keeping inflation in check
Beyond that I believe there are powerful structural forces at play which will keep inflation in check. These include record levels of global debt, a globally ageing population, and globalisation. The COVID pandemic has pushed global debt to levels not seen since the second world war. Over the last year alone global debt has increased by $40 trillion to $280 trillion. This is over 3 times more than global GDP and history has shown that when government debt-to-GDP levels reach 50-60% this has a detrimental effect on growth and acts as a headwind for inflationary pressures.
The effects of globalisation are also helping to reduce inflation as wages are kept lower due to production being moved to poorer countries. This has dovetailed with an increase in technology which has made it cheaper to produce goods and therefore kept prices down. While it can be argued that the pandemic has severely disrupted some of these forces, I believe that this is only temporary, and as the world emerges from the pandemic these trends will continue to act as a deflationary force. Therefore, as much as some commentators like to believe globalisation is going into reverse the hard data suggests otherwise.
Looking at what has happened so far this year, inflation has been ‘stickier’ than many have anticipated, with larger than expected year-on-year rises in commodities and consumer goods. However, we’re already seeing weakness within these prices – lumber prices have more than halved from their peak, while copper and agricultural commodity prices show signs of rolling over, and iron ore prices have also halved from highs reached earlier this year. I suspect the fall off in the likes of copper and iron ore are due to a sharp slowdown in China. The most recent CPI figures from the US show that inflation is indeed moderating, with used car prices and air fares falling back to normal levels.
Proceed with caution
Of course, inflation is just one half of the stagflation equation, with global growth being the other factor. There are many signs that global growth has peaked. As mentioned, China appears to be slowing down based off the latest economic data, with retail sales rising just 2.5% year-on-year in August against economists’ forecasts of 7% and industrial production below target, disrupted by lingering COVID-19 outbreaks and the fallout from the Evergrande crisis. In fact, Goldman Sachs economists are predicting that Q3 GDP is set to register no growth.
Looking at how markets are behaving, we can see that the bond market also believes that inflation is transitory with breakeven inflation rates of 2.3% on a 5-year TIPS. I can see this coming down if inflationary pressures continue to ease, which could be the catalyst for yields to go even lower in the US. Therefore, the future economic environment looks supportive for fixed-income investors. There is a lot of money coming into corporate bonds in the hunt for income, and we view corporates overall as being in pretty good shape thanks to a lot of government support in the western world, unlike their emerging market peers. This gives me confidence that default rates are likely to stay low for some time, presenting the chance to selectively pick up attractive opportunities within the high yield space. Going forwards, we believe markets are likely to be increasingly volatile as central banks attempt to taper fiscal stimulus. However, the longer-term structural forces are likely to see inflationary pressures dissipate as economies normalise.
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