One primary reason relates to concerns over inflation, trade wars and the end of monetary stimulus.
We are skeptical on the “return of inflation” narrative, despite the year-on-year rise in price data and the markets’ elevated concern.
Indeed, volatility around the direction of inflation and general macro concerns in markets presents opportunities to upgrade and improve holdings, which is a positive by-product of this more cautious environment.
Should we be worried about inflation?
Last year, inflation remained unusually muted versus expectations, allowing central bank monetary policy to remain loose.
This helped dial down volatility and ramp up animal spirits for the first time in almost a decade.
This year, however, we have seen inflation move from a strategist byline to a cycle-ending scenario, if you choose to believe the bears.
Indeed, louder and more confident voices are articulating that wages, prices, and politics can drive up inflation and interest rates and finally end this equity cycle.
For us, given that inflation is important for sentiment and market fundamentals, we are closely analyzing not just the magnitude of inflation but also the constituent parts of its origins.
Cyclical inflation is showing itself for the first time in a while, but the secular debate is a crucial one, in our opinion, because so many of the secular deflationary forces we see today actually sit outside the traditional economic frameworks that economists like to use.
Inflation is, of course, a point-in-time comparison that depends on the base level of a year ago.
That base level was unusually low in Q1 2017 as a muted global economy and uncertainty over U.S. politics, and specifically the rules of engagement for companies, reined in spending and investment.
A year on, the picture is very different as synchronized global growth, strong profits growth, and clarity over taxes (lower for nearly all) have lifted sentiment and the willingness of corporates to imagine an economic outlook that implies more investment in labor and growth capital expenditure.
However, the markets’ reaction to “positive” wage surprise in January’s US jobs report gave a strong indication of investors’ dislike for regime change and their concerns over life after QE. In the near term, for as long as these cyclical forces are playing out and the market perceives inflation as “bad”, volatility is likely to remain.
As stated, the outcome of the inflation fight that will play out this year is much more complex than an economics textbook would imply.
Economic textbooks speak of the Phillips curve and how a certain level of unemployment leads to a certain level of wage inflation.
While the unemployment/wage growth relationship remains cyclically important, we see some very strong structural forces vying for superiority that are influencing inflation both negatively and positively.
Think of it this way in boxing analogy terms. We have in one corner structural disinflation being driven by technology (think of Amazon’s impact on retail prices, Spotify’s on music prices, the adoption of automation/robotics, and the impact for manufacturing jobs and wages), demographics, and globalisation.
We would also argue that the shift away from manufacturing (most notably in the US), as well as a shift away from commodity consumption (most notably in China), should be factored into lower inflation expectations.
Meanwhile, in the other corner, we have in tandem with the cyclical recovery in the US, economic policy, which, once again, looks very inflationary on the surface.
Tax cuts for corporates and individuals – tick; cancellation of the Iran nuclear deal pushing up oil prices – tick; a trade war with China/everyone – tick.
Although we continue to believe the risk of a full-blown trade war is low, it is a risk we are monitoring, given that it would inject “bad” inflation into the global economy. A full-blown trade war remains in no one’s interests.
While wages are rising and unemployment is low, the prospect of a broad breakout to the upside is also not our central scenario.
Our view remains that inflation is likely to peak in the middle of 2018 and leave an uglier version of Goldilocks behind – stability and solid growth, but absent the positive surprise factors of 2017 and with more volatility attached.
That, however, is an environment we can work with as equity investors. In particular, as growth investors, uncertainty and volatility allow us to be active and nimble.
We remain committed to our investment framework, which focuses on identifying and investing in high-quality companies where we have insights about their improving economic returns for the future.
We are focused on companies that can still grow in what we believe will be a lower-growth world – what we describe as companies that are on the right side of change.
A low-growth world does not imply a lack of change or progress. In many senses, the pace of change still feels furious to us as industries grow, with the winners winning big and the losers facing an uncertain future.
David Eiswert is a portfolio manager for T.Rowe Price’s Global Focused Growth Equity Strategy.
