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September Investment Committee – The Return of Inflation Expectations

By Tim Sharp, Hottinger Investment Management 

The pullback in major technology stocks at the beginning of September saw the NASDAQ reach 12,000 before retracing 11% in a week, giving the bulls an opportunity to implement the buy-on-dip strategy prevalent throughout the pandemic period. There is little doubt that “Tech” was expensive, having reached valuations not seen since 2000, so any weakness is healthy for general markets. However, the major questions that will potentially affect the real economy and financial markets going forward are whether the move by the Fed to average inflation targeting will increase the threat of inflation and whether the recent weakness in the dollar will be short-lived or a structural change in direction.

Following the mounting levels of fiscal and monetary stimulus, there is little doubt that the risk of inflation is firmly to the upside and recently, there were signs of a pick-up in inflation in the near term through a rise in US core Personal Consumption Expenditure (PCE) index in July, and US Purchasing Manager’s Indices (PMIs) in August saw input prices strengthen on the higher cost of raw materials. Conversely, the Eurozone core Consumer Price Index (CPI) weakened in August suggesting that inflation is weaker in Europe, and the fall in UK inflation was attributed to the “eat out to help out” scheme pushing down food prices. In the short term, it is unlikely that inflation pressures will build significantly when the future path of the recovery remains uncertain and this is shown by market expectations’ continued downtrend.

During a recent weekly “Market Watch” webinar, Chief EAM Strategist at JPMorgan Asset Management, Karen Ward, and portfolio manager Myles Bradshaw, forecast the effects of the Fed’s new average inflation targeting policy. They pointed out that between 1994 and 2020 US average Core PCE was only over the 2% target for the period of 2004 to 2007, suggesting rates are going to be anchored near zero for the long term if average inflation over 2% is to be achieved. However, a reactivation of fiscal support for economies, a continuation of the global recovery, and increasing central bank tolerance for higher inflation, does suggest that the threat of future inflation may be higher than current market indicators suggest, leaving the risk firmly to the upside. By association, therefore, markets are also susceptible to US 10-year Treasury yields moving back to 2% as opposed to falling into negative territory.

The low level of nominal yields on government bonds does mean that the ability to offset equity risk is diminished despite the negative correlation, and negative real yields mean that there is a cost to the risk-free rate once more. The low default rate in investment grade corporate bonds and the positive sloping yield curve is proving an attraction to investors seeking a real return without the risk of high yield bond investing, which has resulted in yield spreads over Treasuries tightening over the month.

When global growth starts to recover and US real yields fall, the combination often leads to a weaker dollar. The policy choices of whoever enters the White House after the election will be difficult with negative implications for the currency. The positive developments in the Eurozone, namely the establishment recovery fund and the more successful re-openings of its economies, have painted a positive backdrop for the Euro that may put further pressure on the dollar, even allowing for a second wave of the Covid-19 virus. However, long-term weakness in the dollar has its headwinds as foreign demand for the dollar continually exists to execute international trade and the USD continues to hold global safe-haven status as the world’s reserve currency. We have highlighted before that a weak dollar is very beneficial for international growth, particularly in developing economies but this may be more of a strong Euro story than a weak dollar story over the long term.

The UK government has passed the Internal Markets Bill which looks to over-ride parts of the Brexit Withdrawal Agreement at a time when negotiations over the EU-UK trade agreement were set to re-start. This could be seen as a high-risk negotiating strategy but seems to have significantly damaged trust to the point where the EU is threatening to seek legal assistance to uphold the treaty. Société Générale has raised the threat of no-deal to 80% probability and any deal that can be achieved of limited scope[i]. They estimate that this scenario will knock 3% off UK GDP in the medium term, which is the mid-point of the Bank of England’s own 2.5%-5.5% range to 2024, while only affecting the EU by 1%. Furthermore, Karen Ward of JPMAM believes a no-deal will see sterling weaken 10%. Therefore, the risk to sterling is once more to the downside in the short term which will probably once again prove positive for the large cap UK-based stocks with substantial overseas earnings.

Finally, we believe that a persistent inflation threat will need to see the strong recovery that we have witnessed so far in the developed world continue. However, this may be checked by a second wave of the virus and there remain concerns over the further levels of fiscal support that governments will be able to provide to fundamentally weak underlying economies. Regardless, the perception of an inflation threat can drive markets and a defensive position for investors could rely on the support gained from real assets such as commodities. Increased supply will possibly check the price of oil, but industrial commodities have seen higher prices over the last month. Few assets benefit from higher inflation but commodities usually do, offering protection as strengthening demand causes prices to rise. Furthermore, commodities tend to bear a negative correlation to stocks and bonds so are a useful addition to a multi-asset portfolio and may reduce overall portfolio volatility.  Gold also remains a useful diversifier for investors despite the rally year-to-date when real yields are so low and geo-political risks so high.


[i] UK Heading for No Deal – Brian Hilliard & Yvan Mamalet – 17/09/2020




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