One of the world's largest wealth management houses asks whether the world is going through a repeat of 1970s-style high inflation or a more temporary and less damaging period of price growth and disruption.
The wealth arm of UBS is positive towards the world’s equity market, with a bias towards stocks which are able to exploit an upswing in the business cycle, preferring eurozone equities over others. The firm also downplayed worries that recent rising inflation is likely to endure, saying a repeat of the 1970s high inflation episode isn’t likely.
As far as currencies are concerned, UBS said the dollar is its most preferred currency and the Swiss franc is its least favourite, according to a monthly briefing note from Mark Haefele, chief investment officer, global wealth management, UBS.
“With current issues still appearing more temporary than structural, we believe equity markets will continue to move higher. Indeed, small increases in inflation expectations can be positive for markets if it helps to banish fears of deflation. Furthermore, by our assessment, global growth remains strong, supply chain challenges should recede into 2022, and corporate earnings should continue to grow,” he said.
“At the same time, it is important to diversify by region, sector, and asset class to manage current market dynamics. We like financials, energy, the eurozone, and Japan to position for global growth. Among defensive sectors, healthcare is our preferred pick. Investors can further diversify portfolios with alternatives, including hedge funds, which can help reduce portfolio volatility in the event that continued inflation fears raise equity-bond correlations. We also upgrade the US dollar to most preferred,” Haefele said.
Rising inflation, skyrocketing natural gas prices and supply-chain disruptions have rattled investors. In August the inflation rate was 3.2 per cent (year-on-year), up from 2 per cent in July. And rising inflation has stirred debate on when the past era of zero/negative official interest rates, and that impact on asset allocation, will end.
“For those of us old enough to remember the 1970s, we don’t take the current talk of stagflation lightly. Today, rising energy prices and supply disruptions in various product and labour markets are causing lower economic growth and higher inflation expectations,” he said. “However, the pandemic showed us that markets can look past challenging periods - provided they are not permanent. Currently, we see the challenges in energy, product, and labour markets as transitory rather than the makings of a new `stagflationary’ economic regime.”
There are several reasons why a 1970s-style high inflation period isn’t likely, Haefele continued.
“Factors like price controls, labour wage bargaining, and 'defeatist' monetary philosophies played important roles in turning what was a temporary energy crisis into a stagflationary era. Nevertheless, we do need to prepare for a period of uncertainty. In the third-quarter earnings season, we will be looking for data points and corporate anecdotes on labour market and supply chain challenges that might undermine investor confidence in the sustainability of margins. As we enter the cold season in the Northern Hemisphere, a harsh winter could put renewed pressure on energy markets,” he said.
Looking ahead, Haefele said some of the disruptions caused by COVID-19, lockdowns and other forces may be easing off.
“Large segments of the S&P 500, such as financials, internet, software, and healthcare (not to mention smaller sectors like real estate, utilities, energy, and most of materials) should be unaffected by supply chain problems. The sectors most exposed to earnings drag are industrials and consumer discretionary, and to a lesser extent consumer staples and tech hardware. Notably, the cost of commodities (including energy) is only 5 per cent of S&P 500 sales.
“There are also signs that bottlenecks may be easing. Recent COVID-19 waves in Vietnam and Malaysia have disrupted apparel and semiconductor manufacturing, but those waves are easing. Meanwhile, now that the peak import season (August and September) is past, the bottlenecks at US ports have stopped getting worse. Major ports in southern California are moving to a 24/7 schedule to clear delivery backlogs. So far, the majority of large US companies have been able to generate higher profitability despite rising costs because sales growth has been so strong. We expect the same to be true in the 3Q results, where we estimate S&P 500 revenue growth of around 15 per cent,” he added.