Play Reflation through Real Assets and Equities

Francesco Sandrini is Head of Multi Asset Securities Solutions. 

This is the second in a series of blogs in which we analyze the main inflation drivers investors should pay attention to in 2017 and beyond, as well as investment opportunities to deal with higher inflation across fixed income, equity and multi asset.

During periods of reflation, global equities, credit and commodities have historically outperformed. Is it okay for investors to assume this will still be the case? In our view, the answer is not straightforward. When considering how to modify portfolio construction to play the reflation theme, we believe investors should consider the evolution of real interest rates, namely how the Federal Reserve will react to higher inflation in the US.

After years of Central Bank supremacy, that has altered market valuations especially in fixed income, the trajectory of real rate adjustments will likely impact the outlook of asset classes.

The dovish tone adopted by Chair Janet Yellen, in our view, reveals that the Fed is maintaining a relatively tolerant stance towards inflation and is in no hurry to raise rates. This should keep credit markets resilient, despite tight valuations.

Consequently the outlook for investment grade credit is slightly better than for core government bonds, but over a three-year time horizon our forecasts are very conservative in terms of expected returns, on these assets in both Europe and the US. The prospects for high yield and for emerging markets (EM) bonds are slightly more constructive. These can be considered for income generation within a multi-asset approach, but it is important to be aware that selection is paramount. Moreover, these assets can be vulnerable in the case of rising geopolitical risk (especially in case of EM), as well as sector-specific dynamics (e.g., the energy sector is highly dependent on oil prices), which could expose an invested portfolio to unwanted volatility.

For a multi-asset investors, we believe that the outlook – in a period of reflation – is more positive for equity markets, commodities and real assets. For equities, the earnings recovery is quite evident across the globe: here a benign inflation outlook is especially positive for companies that have pricing power that could be transferred to consumers, with a caveat that higher inflation does not erode earning through increased costs.

Earnings per Share Growth (YoY) Forecasts, Horizon Dec’17

Source: Pioneer Investments forecast and elaborations on S&P Capital IQ data as of March 16, 2017.

From a sector perspective, a reflationary environment should be supportive for financials: the steepening of yield curves should be supportive for the return on equity. Less litigation, credit expansion and a peak in the wave of regulation could also boost the return of equity. We tend to prefer cyclical sectors – energy, materials and financials – while maintaining a cautious stance on interest rate sensitive sectors, such as utilities, telecoms, staples and real estate.

Most commodity fundamentals have improved and prices for some commodities are already anticipating widening deficits in supply/demand dynamics. A healthy manufacturing sector is also supportive for the outlook for industrial metals.

US Manufacturing PMI and Industrial Metals

Source: Pioneer Investments forecast and elaborations on S&P Capital IQ data as of March 16, 2017.

Global demand for energy and industrial metals should also be supported by the fiscal expansionary plans in EM and developed market (DM) economies alike. (Read also Investing in the Era of Reflation).

A boost for infrastructure spending in the US and in EMs – Latin America especially – should support the demand for metals. Zinc inventories are already declining, while global demand for Copper and Nickel is rising. We are more cautious on the outlook for Global Crude Oil as the market has already discounted the production cut agreed by OPEC, and major Non-OPEC producers, of 1.2mln barrels/day and we don’t foresee any strong upside from current levels. In the context of a stable/positive outlook for commodities, opportunities could be found in EM commodity currencies, such as the Russian ruble and the Chilean peso, which our in-house quantitative models suggest are attractive in terms of valuation.

In periods of inflation surprises, real assets can also offer interesting inflation protection opportunities. Here we are looking at inflation-linked bonds, which offer good diversification[1] and inflation protection; commodities (as above) or specific instruments such as master limited partnerships (MLPs), which have typically benefited from more stable oil and gas prices, as well as infrastructure spending. Regarding REITs, our outlook is mixed: against a backdrop of moderate interest rate rises, the positive effect of higher rental income due to higher inflation could exceed weaker demand for mortgages due to higher rates. On the other hand, the search for income induced by abundant Central Bank liquidity has already led valuations to historically high levels.

We are also closely monitoring gold as this can be used as a “tactical hedge”, as well as an additional source of diversification. This is an asset which we believe will likely rebound during periods of declining real interest rates – for example if markets become impatient and frustrated if reflation forces weaken.

[1]Diversification does not assure a profit or protect against loss.
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