Investing amid the great inflation debate

There is a sense that the world is slowly “getting back to normal,” after more than a year of COVID-induced economic lockdowns and other restrictions. Unfortunately, many countries — and even some parts of the US — are still grappling with more contagious and virulent strains of the virus (e.g., the so-called “Delta variant”) and troublingly low COVID vaccination rates. We are not out of the woods yet. But broadly speaking, the global economy has been recovering with the aid of accommodative fiscal and monetary policy, supporting the strong performance of risk assets and the ongoing rotation from growth- to value-oriented exposures.

The threat of rising inflation is a bogeyman now. Amid supply/demand imbalances in labor and other factors, we believe inflationary pressures are likely to persist in the period ahead. Against this backdrop, our investment outlook remains largely pro-risk, but is tempered to some degree by what we see as a worsening growth/inflation trade-off. Here are a few thoughts on how investors might navigate this mixed picture.

Stick with value-oriented equities

In our view, the specter of higher inflation and interest rates favors the potential outperformance of value-style equity exposures going forward (Figure 1), including smaller-cap stocks and more cyclical market sectors such as financials, consumer discretionary, materials, and industrials. From a geographic standpoint, we generally prefer non-US equity markets, particularly Europe, which we believe is on the cusp of an economic upturn. We are moderately bullish on emerging markets, given their leverage to an accelerating global cycle, elevated commodity prices, and continued US-dollar weakness.

Maintain fixed income for diversification

We are moderately bearish on government debt, especially in Europe, where negative interest rates look vulnerable to the improving global cycle. However, it still makes sense for many investors to retain an allocation to high-quality bonds in the event of a sharp equity sell-off. In addition, a global fixed income universe gives investors numerous opportunities to potentially add value to their portfolios. We also think municipal bonds can play a key role for many taxable investors, while option strategies can help supplement certain bond exposures.

Get more selective in credit markets

Most credit spreads appear rather rich (read: expensive) as of this writing, but we don’t see a likely catalyst for them to widen meaningfully from here. In our judgment, some of the most compelling risk/reward opportunities in today’s credit markets can be found in often-overlooked sectors like bank loans, collateralized loan obligations (CLOs), and residential-housing-oriented structured credit. We also believe select emerging markets sovereign and local debt may offer attractive upside potential from both a spread and a currency perspective.

Seek inflation protection with commodities

Inflation could reach higher levels and/or last longer than many observers and investors currently expect. If we are right, commodities may benefit from this trend, which is why we are moderately bullish on the asset class as a whole. While value-oriented equities may provide some inflation protection, commodities (excluding precious metals) have historically been the most inflation-sensitive asset class. For example, energy and industrial metals may help investors hedge their portfolios against rising inflation and interest rates.