Inflation fears won't derail rally

Below is a commentary I wrote that was published by The Straits Times here.

Hospitalisations from the coronavirus are finally falling worldwide, and vaccination roll-outs are gaining pace. The world economy is on the rebound, government policy remains generous and earnings growth rates are set to break records in many regions.

Yet as growth recovers and corporate earnings pick up, so have 10-year global interest rates. The yield on the benchmark 10-year United States Treasury note now sits at nearly 1.5 per cent, up from a little over 0.9 per cent at the start of 2021.

And with the US moving closer to another record-breaking fiscal package, investors have grown jittery that the Federal Reserve will be forced to bring forward tightening to temper runaway inflation.

Equity markets have slumped as a result, with tech stocks bearing the brunt of the recent correction. But while volatility spikes are likely to persist, we retain a favourable view of markets overall and recommend using the dips to add exposure.

Inflation fears testing the bull run

A new economic cycle has begun, which portends particularly robust activity this half. UBS economists anticipate a vigorous economic expansion this year globally (+6.4 per cent) and for Asia overall (+8.1 per cent).

Recent data in the US underscore the vibrant recovery under way.

But with such a strong growth outlook, inflation concerns have made a comeback. Notably, the yield on 10-year Treasury Inflation-Protected Securities rose by 16 basis points on Feb 26. This rise is attributable to robust jobs data and other emerging signs of climbing prices.

The US ISM Prices Paid subindex increased to 82.1 in January, up from 77.6 in December and a low of 35.3 last April. The UN Food and Agriculture Organization's food price index jumped 4.3 per cent month-over-month in January to its highest level since 2014.

We estimate a global shortage of semiconductor chips could push prices up 10 per cent this year. And the recent surge in the cost of container freight suggests upward price pressures could feed through supply chains.

But we think the inflation spike is likely to prove transitory. Much of the expected rise in prices reflects unusual supply-demand mismatches this year, which should revert as economic activity (and supply) normalises.

Concerns that the scale of fiscal stimulus could spark persistent inflation also appear overstated. Last year's US fiscal packages were aimed at offsetting a collapse in private sector activity in an effort to bring the economy back to its pre-pandemic levels.

The Trump administration's tax cuts also provided stimulus to a growing economy, yet core PCE didn't rise sustainably above 2 per cent.

This yield spike shouldn't derail the equity rally. For one, rising nominal yields and equity rallies have tended to go hand in hand. In the past 25 years, the 10-year US bond yield has risen by more than 100 bps in 10 periods, and in all instances global equities delivered flat or positive returns.

Crucially, yields are rising because of the strong growth outlook - a similar phenomenon to 2016, when stimulative policy led to higher growth expectations rather than a monetary policy tightening scenario (such as the 2013 taper tantrum).

Indeed, Fed Chair Jerome Powell has said that interest rates will remain low and that the Fed's US$120 billion monthly assets purchases will continue "until substantial further progress" has been made toward its goals of maximum employment and 2 per cent inflation.

Choppy markets but outlook intact

Still, inflation concerns are likely to remain, and investors should brace for periodic volatility spikes ahead. We have reduced the interest rate sensitivity of our credit portfolio in recent weeks, but three key factors should keep the equity rally alive.

First, generous government and central bank support should persist longer than in the past cycles. The policy narrative has, after all, shifted to pursuing a high-pressure economy to help achieve a more broad-based and inclusive recovery.

Second, the unlocking of pent-up demand could drive further upgrades of earnings expectations for 2021 and 2022.

And third, real bond yields have bottomed out, but should remain low. Even after the recent move in the 10-year bond yields, the implied equity risk premium is 315 bps - still within the 285 to 470bps range it has traversed since 2015.

Corporate earnings in Asia look likely to rise by nearly 30 per cent this year, which could fuel around 10 per cent upside for the broad MSCI Asia ex-Japan index despite elevated valuations (price-to-book now up to 1.9x, versus 1.6x historical average).

Global markets, too, could keep climbing for the same reasons. We expect the S&P 500 to reach 4,100 or higher (from 3,829 now) and see better risk-adjusted returns in global equities than in credit.

What should investors do?

We recommend taking advantage of the volatility and going cyclical for the recovery.

With policy rates set to remain below the rate of inflation for the foreseeable future, volatile periods may yield more investment opportunities than threats. Investors who are overexposed to cash should look to put capital to work in the context of a disciplined financial plan.

This includes averaging-in purchase programs, structured investments, and option strategies to gain more advantageous market exposures.

As the recovery picks up speed, the rotation out of concept growth stocks may have further to go. Investors should tilt their equity exposure toward stocks that are likely to benefit from higher growth and a steeper yield curve, including financials, industrials, and energy stocks.

Korea is one such typical cyclical play. Another is Singapore, whose banking and property sectors should benefit from the next tranche of the rotation. China's internet and banking sectors are also likely to attract interest due to their attractive valuations.

Furthermore, the recent dips present opportunities to gain long-term exposure to emerging secular themes like greentech and 5G in Asia, which offer attractive growth prospects for the years to come.

Given the rise in yields, it's important that investors monitor their duration risks. But since economic normalisation could arrive sooner than we think, investors should put cash to work in line with their financial plan, despite the near-term uncertainty.

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