We are now in a fundamentally different market regime from the one we’ve seen over the past decade – one propelled by higher supply-driven inflation and a more muted cumulative central bank response to such inflation. This macro backdrop reinforces a significant asset reallocation in favour of equities and away from developed market (DM) nominal government bonds that our strategic asset preferences have already been positioned for.
The dislocations in markets so far in 2022 - driven by an adjustment to this regime shift, geopolitical concerns and by near-term confusion stemming from the unusual economic restart, a surge in inflation and new central bank frameworks – presents long-term investors with a potential opportunity to bump up equity allocations.
Confusion over the restart, supply-driven inflation and new central bank frameworks has been evident in markets this year. This confusion, alongside mounting jitters over the Russian-Ukraine standoff, has weighed on equity markets. The swift repricing in the path of short rates has sparked a surge in bond yields and triggered a rotation away from long-duration sectors such as tech that have dominated equity markets over the past decade.
For long-term investors, we see this selloff as a mispricing to exploit by adding to equity positions. We believe equity markets are not making the distinction between the repricing in the near-term path of policy rates – which has been sharp yet has a limited impact on long-term expected returns – and the muted change in long-run policy rate expectations – far more important for equity valuations and returns. Valuation gauges such as the equity risk premium – that consider both the outlook for interest rates and corporate earnings – suggest DM equities are still fairly, or even attractively, valued.
The confusion gripping markets may persist over the near-term. On a strategic horizon of five years and beyond, we believe fundamentals will matter more, spurring us to take advantage of the recent selloff to add to our DM equity overweight. It is not strange that the central banks should want to get policy back to neutral and away from emergency measures – and do so quickly – as the restart does not require stimulus.
We believe central banks will ultimately choose to live with inflation. The unusual supply-driven nature of inflation means fighting such inflation aggressively with monetary policy will dent growth while doing little to address the underlying cause. This suggests a more muted policy response than seen historically that keeps real rates relatively low and supportive of risk assets. We expect supply-triggered inflation to last far beyond the restart. Why? We see the transition to reach net zero carbon emissions by 2050 completely rewiring the global economy and altering supply-demand patterns across sectors.
We believe bond markets are not fully pricing in higher medium-term inflation. We expect higher term premium to become a driver of higher nominal yields. This is also why we prefer and remain strongly overweight inflation-linked bonds. Our central case is for nominal yields to continue to rise. Yet they remain close enough to lower bounds to limit the effectiveness of DM government bonds as portfolio ballast.
Hypothetical U.S. dollar 10 year strategic tilts, February 2022.
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