In the Federated Hermes 2023 Outlook, head of fixed income – public markets, Fraser Lundie, said that with the amount of backward-looking, short-term noise involved in predicting inflation, the market has ignored the prospect of inflation falling faster than expected.
“Forward curves are informative, showing the market has priced in the risk of inflation staying higher for longer. Yet, the prospect of inflation falling further and faster than current forecasts suggest has not been fully priced in,” Mr Lundie said.
“At present, the expectation is for price rises to stabilise from Q1 2023 but for inflation in most developed economies to remain above central bank targets. There are multiple factors shaping this prediction: firstly, greater pricing power for companies as consumers begin to accept inflation-driven price rises.
“Secondly, deglobalisation — reshoring supply chains, for example — and the workforce starting to target real income levels. There may also be an element of fiscal outspend being reflected, keeping inflation stubbornly high. Even longer term, demand for investment in the energy transition is inflationary, as is a lack of investment in carbon-heavy forms of energy generation, which will have its own impact on supply.”
While this makes the case for a higher-for-longer inflationary scenario very possible, Mr Lundie said the alternatives are also worth considering, particularly with the complexity involved.
“The outlook is massively complicated by the nexus between fiscal spending, energy pricing and monetary policy,” he said.
According to him, there are few if any comparable periods in history to garner insight from, as well as other unknowns that have to be factored in.
“Financial stability, for instance, is an obvious concern. Depending on how things play out, we might witness a destabilisation of markets and a fall in asset values, which would be disinflationary in the short term,” Mr Lundie said.
“But the potential for disinflation is very real in mid and long-term scenarios, too. Take a secular stagnation scenario. Has that been written off too soon? Sure, we might be seeing a change from what we’ve experienced over the past decade or so, but is it wise to entirely discount the effects of ageing and shrinking demographics on aggregate demand? Or the impact of advances on aggregate supply? These megatrends must not be forgotten as we strive to maintain a long-term approach to investing.”
Federated Hermes head of global equities Geir Lode added that despite the fact that much of the focus has been on the short-term inverse relationship between inflation and stock returns, stocks have provided an inflation hedge over the long term.
“Often, investors focus on nominal yields rather than real yields when valuing cash flows. Value stocks with high current rather than future yields tend therefore to perform better when inflation is high. Indeed, value stocks have outperformed growth stocks by a wide margin this year,” Mr Lode said.
“Although there are signs that inflation may have peaked in the third quarter, in most markets, CPI is still above what the central banks would be comfortable with. Interest rates will peak higher next year than investors previously envisioned, and then decline.
“Stock prices historically have adjusted 12 to 18 months ahead of interest rates. Investors should therefore start to position their portfolios into growth stocks. Stocks with both high expected earnings growth and sustainable low-carbon business models have lagged the market this year by a wide margin. This is an excellent opportunity for the long-term investor to buy these stocks at very attractive prices,” Mr Lode concluded.
