Inflation is the biggest risk to growth, not Delta variant

Now that nations have progressed beyond the initial stages of the recovery cycle, investors are fretting over macro-economic data as they look for potential warning signs of a reversal in growth.

We suspect perceived shifts in data in areas such as US payrolls and unemployment will drive investor allocations and market sell-offs based on fears over further spread of the Delta variant.

However, the greater risk to markets is that inflationary pressures are not transitory, as most observers think. Persistent inflation would weigh on company earnings by raising costs and hurting wages, causing central banks to raise interest rates and negatively impacting equity markets.

There’s also a risk that central banks react to inflation too late and hike rates too quickly, which would cause equity multiples and valuations to correct. Further, if the US corporate tax rate is raised back to 28 per cent as proposed, it would also serve as a drag on company earnings expectations.

However, vaccine manufacturers worldwide have been busily researching how to enhance their products, bolstering our belief that they will be able to improve protection against virus mutations.

It’s why the Delta variant is more likely to delay than derail global growth, in our view, extending the existing recovery cycle as some economies take longer to bounce back than others.

Gradual economic reopening is easing constraints on supply chains and governments are likely to be surgical when it comes to lockdowns as they look to contain virus outbreaks.

Moreover, central banks are already on the alert for shifts in inflation and poised to act to prevent problems before they develop fully.

Looking ahead, we expect equities to outperform over the medium-term, driven by the supportive macro-economic environment and robust company earnings growth.

Still, investors should adopt a balanced approach since we anticipate that equity markets will fluctuate between phases that favour growth, value, cyclical and defensive stocks intermittently.

In months where macro-economic data disappoint, growth (technology and communication services) and defensive (healthcare) stocks should do well; in months where data beat expectations, value (financials and commodities) and cyclical (industrials) stocks should benefit.

We retain an underweight to fixed income at a portfolio level. But if the recovery cycle becomes extended as we expect, it would place a soft cap on how bond yields can rally. This would provide an investment case for bonds in select markets and across different quality tiers.

We favour high-yield US dollar bonds where spreads offer a buffer against a rise in yields, especially given our expectation that commodities will remain supported, with upside potential.

We believe the US dollar will outperform most Asian currencies in the near-term, given spread of the Delta variant and low vaccination rates in Asian countries such as Thailand, Malaysia and the Philippines.

We forecast that the US Federal Reserve will announce a tapering of bond purchases in some form later this year, to begin at the start of 2022. This would raise the interest rate differential between the US and the rest of the world, which would also drive US dollar support.

Conversely, looking ahead over the medium-term, Asian currencies look set to catch up as we expect central banks in the region to raise interest rates in 2022 (i.e. Korea, India and Singapore), ahead of the Fed in 2023.

Within Asia we find select local currency sovereign debt markets appealing. We favour government bonds where carry is high, currency is stable and the roll-down from holding bonds is attractive.

One market that offers appeal is China. There the central bank is dovish and using its policy tools to support growth. China’s reserve requirement ratio (RRR) cut in July sent easing signals to the market.

Moreover, the RMB is stable, with the government wary of both a weak currency that would trigger outflows and a strong currency that would hurt exports.

What remains to be seen is how much more policymakers will do in the rest of this year to support growth, as they strive to balance their long-term structural reform objectives and short-term growth targets.

What levers China will (or will not) pull will have different implications for Chinese stocks and bonds. Should policymakers focus on ensuring liquidity, Chinese bond yields would likely compress further, driving equity growth and benefitting quality companies with strong finances and good governance.

If the structural reform agenda outweighs 2021 growth targets and policymakers continue to tighten regulation across internet, education and property sectors, negative sentiment would likely affect these sectors.

Regardless of which path policymakers take, we do see significant alpha opportunities in China for the winners of these policy decisions.

Having a broad allocation to Chinese equities and bonds, or both, is preferential in our view. It offers diversification benefits to a global multi-asset portfolio.

Irene Goh, head of multi-asset solutions, Asia Pacific, Aberdeen Standard Investments

Neil Griffiths

Neil is the Deputy Editor of the wealth titles, including ifa and InvestorDaily.

Neil is also the host of the ifa show podcast.