When we talk about a diversified portfolio, over 80-90% of the returns are explained by asset allocation decisions. Individual stock or bond selection and market timing make up the rest. I hope to cover as much as possible across different global economies in this series on asset allocation and portfolio positioning. Starting off with the biggest market in the world – the USA.
The one common theme that has been playing out across developed markets is negative real yields (inflation higher than interest rates). While real yields have started to turn positive again in the USA, a few key drivers indicate that high inflation (vs the last 10-20 years) will stay and portfolio allocations, in my opinion, are starting to take it into account. While I expect inflation to cool coming off a high base in 2022, I do not think it will remain under the 2% target of the Federal Reserve in the coming years.
What are some of the drivers of structurally high inflation?
1. Reshoring/ Friend-shoring/ Near-shoring/ Onshoring
All these terminologies indicate one aspect – de-risking supply chains globally and a potential phase of deglobalization. This has been one common theme across conference calls from top companies across the world where they are looking to shift supply chains and reduce dependency, particularly on China. The de-risking supply chain will be a long-term project and it will take massive investments. It is not cheap and will add to inflationary pressures. Vietnam, Mexico, and India seem to be the top choices for diversifying manufacturing bases and these could be potential beneficiaries in the larger scheme of things.
Capital formation as a % of GDP has remained consistent for the USA – 20% to 25% range. However, a lot of the capital expenditure in the USA over the last 2-3 decades has been led by IP investments whereas, investments in structures and equipment have slowed down (chart below). The output has been that the US has built strong brands but lacked real assets with outsourcing being the preferred choice. In my opinion, this should start changing in the coming years.
Source: Yardeni Research
2. Energy transition and potential shale peaking out?
While the focus shifted a bit from clean energy and energy transition in the immediate aftermath of the Russia-Ukraine situation, where energy prices soared, to ensuring the energy supply remains intact. In the coming years, I expect the clean energy transition to accelerate given the experience that developed countries, especially in Europe, have had in having dependence on Russia for energy supplies. Europe continues to suffer from it with inflation not seen in decades. This along with the climate change goals of net zero emissions by 2050 (difficult to achieve), heavy investments will need to happen and again this will keep inflation elevated across the world.
I also believe, post-GFC in 2008, the US shale revolution has a key part in why inflation was under control and we had a strong period of growth. There are early signs emerging that the US shale oil and gas reserves might peak out in the coming years and plateau over the course of the decade. This will keep oil prices elevated in the coming years and increase efforts to find new sources of energy which also add to inflation being elevated.
Here is a detailed note from Goehring & Rozencwajg on it.
3. Expect an increase in labor wages and shrinking corporate profitability
As per the FRED database, corporate profitability has doubled at the expense of labor compensation over the last two decades. The rising inflationary expectations will lead to increased unionization and demand for higher wages. I think this trend will reverse going forward adding pressure to US corporate profitability. The chart below (Labor compensation data available only till 2019):
Data is for USA Source: FRED Database
These are some of the points to make a case for structurally higher inflation going forward. This won’t be the case only for the USA but I would imagine this being a global phenomenon.
How do we position ourselves for higher inflation in terms of asset allocation?
Below is an interesting data point from PIMCO measuring the inflation beta of different asset classes. Commodities and inflation-linked bonds clearly stand out as having positive inflation beta. Apart from these, natural resources and precious metals like Gold also have historically performed well in a high inflationary scenario and should also be looked at. Depending upon the growth outlook, TIPS and Gold would be my preferred options in a low-growth environment, while I expect commodities and natural resources to outperform in a high growth – high inflation scenario. Constructing a well-balanced portfolio is key.
Source: PIMCO
Coming to individual asset classes;
Equities: Equities generally do not perform well in a high inflationary scenario. The reasons are clear- higher costs, reduced profitability, and thus, shrinking valuation multiples.
At an overall level, the valuations have cooled off from last year but still, remain well above the long-term average. S&P 500 P/B ratio at 3.6x (Median of 2.8 over last 20 years) and the Nasdaq 100 as well trading at 4x P/B. Another aspect that makes the current equity run weak is the lack of participation from the broader market. The top 20 companies in S&P 500 have contributed nearly the entire returns YTD. So overall, would keep the US equity allocation lower than usual. Some of the emerging markets seem better placed both in terms of valuation and growth prospects.
Here is another interesting data point, yield on corporate bonds and T-bills is currently at par with the earnings yield on stocks. This further makes the case stronger to reduce equity exposure. While it may persist like in the 1990s, equity is definitely trading at a premium in the current market.
Source: TheSpreadThread, Bloomberg
Within the equity basket, however, betting on the ‘value’ style could be a good strategic play. In terms of fundamentals, when inflation is high and real yields are low or negative, one has to be an asset owner. Cash loses value in such a scenario. Generally, companies categorized under the ‘value’ style would have higher real assets on their balance sheets, and their cost structure would be largely fixed in nature vs. the high variable cost structures of most technology companies.
The below chart adds another perspective to this thesis. The chart compares the forward (y-axis) and trailing (x-axis) 10 Year (Value – Growth Index) returns. Over the last 10 years, value has underperformed the growth index by 6.5%. Going by what history suggests, value style might just be the sweet spot.
Source: Wellington Management
Another chart, which throws up interesting data points, is the liquidity impact. The fed started “Quantitative Tightening” in mid-2022, gradually taking off liquidity in the system. The impact was equity markets corrected in 2022. Liquidity and Equity markets have had a very strong correlation since 2008.
However, with the collapse of three banks in the USA in 2023, the Fed has ended up injecting liquidity into the system and we have seen the market recover since then. Make no mistake, the Fed will at some point have to reverse it and take off the liquidity, it may happen in H2 or next year, which is to be seen. but this will be a strong headwind for equity markets in the US going forward.
As you can see from the below chart, the QT was supposed to be for ~$750 bn but the net liquidity has remained stable. The June data indicates, about ~100bn Net Liquidity added since the inception of QT.
Source: Refinitiv, Pictet Asset Management
Fixed Income: TIPS and inflation-linked bonds would be the preferred picks in this space. Inflation-linked bonds were one of the worst performers in 2022 despite inflation running high. Why was that the case?
Well, inflation-linked bonds are not a great place to bet for short-term inflation protection. In the short run, these bonds are more impacted by real yields rather than inflation. Because real yields went negative, the repricing impact led to negative returns for inflation-linked bonds in 2022. However, in 2023, with real yields starting to become positive again in the US, ILBs might be a good option.
On the other hand, with Fed taking a pause on interest rates, Emerging market bonds could be a better alternative. Especially the ones offering high real yields and where central banks will soon start reducing interest rates. Mexico, Indonesia, and South Africa come to mind straight away.
I don’t think Fed has enough room to counter unforeseen inflation going ahead with interest rate hikes. As a good portion of assets is invested in Treasuries and government bonds, all the banks including Federal Reserve have already taken big hits on their books with rising interest rates. Further interest rate hikes, will only lead to the breaking down of a few more banks. While we can’t rule out that possibility, I feel interest rates have peaked for the time being. This should bode well for Fixed income in general. However, given the challenges ahead, would stick with Investment grade bonds rather than high yield in the current scenario.
Keep a close watch on ‘inflation expectations’ i.e. the breakeven inflation curve in the market. Going long on duration/ increasing duration could be a strong trade opportunity if the breakeven curve goes below the 2% Fed target rate. Currently, the implied breakeven inflation rate stands at 2.15%, 2.21%, and 2.29% for 5, 10, and 30 Years respectively. Below is the movement that has happened in the last 2 years.
Source: Bloomberg, Wellington Management
Commodities: Commodities generally do well in a scenario where inflation and growth are high. The energy transition is a clear long-term tailwind for industrial metals. In the short term, these might be highly volatile given the possibility of a hard landing (low growth, low inflation scenario), but over the long term, some of these industrial metals are critical to meet the energy transition goals. Take Copper for example, we are at about 21-22 mn tons of production today. According to Citi Research, incremental demand for copper for decarbonization over the next 30 years is close to 400 mn tons. The production needs to grow at 10% CAGR for decades if we were to meet the full global decarbonization effort scenario. The current visibility on offer as per Citi is close to 3% CAGR production growth by 2030. There is a massive need for investments and this is a strong tailwind for industrial metals going forward.
Below chart a good guideline in terms of importance to energy needs and supply risk which could help in asset allocation.
Source: Pinetree Macro
On the other hand, Gold works best in a stagflation scenario (low growth, high inflation) which is a good probability of happening going forward, and thus, gold as an asset cannot be overlooked. Another aspect to keep in mind is the early signs of de-dollarization worldwide. The US Dollar index is well above the moving average and a mean reversion is a high possibility. Gold has a strong inverse relationship with the Dollar index and could be a big beneficiary should the dollar weaken over the long term.
Source: Capital Group
US Govt debt to GDP is at 116%, Private sector debt is at 217% of GDP currently with a fiscal deficit of 5.6% of GDP. Make no mistake, these are characteristics of an emerging market! Take any G7 country ex-Japan, and you will see a similar story. This is another reason why I believe inflation could be allowed to remain high which will help reduce debt over a period of time (Financial Repression scenario). In this, interest rates are kept lower than inflation which reduces the value of debt. Being invested in real assets, commodities thus should be a strong consideration in the portfolio.
On a closing note, there is no one silver bullet strategy to position the portfolio. Different scenarios could play out in the coming years and we can also attach a probability to it. A well-diversified portfolio is the best way to position yourself in a volatile macro environment. Traditional portfolios of equity and fixed income might not be the best suited to sail through a volatile and structurally high inflationary period.
More on other developed and emerging markets in the coming weeks! Stay tuned. Thanks for reading and wishing everyone a great weekend!
Regards,
Shivam Jain
Disclosure: I’m not a SEBI Registered Investment Advisor. All content on this website is purely for educational purposes. Please consult your financial advisor before making any investment decisions.
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