Inflation and the impact on global equities

By Jayson Forrest - Managing Editor  - IMAP Perspectives

Katie Petering (BlackRock) and Alex Donald (Ironbark) discuss how inflation could hurt long duration growth stocks, and how global equity portfolios should reposition for this new environment.

Speaking at the 2022 IMAP Portfolio Management Conference, the Head of Strategy, Multi-Asset Strategies and Solutions at BlackRock Australia, Katie Petering, says 2022 will herald a new investment regime that delivers global stock gains and bond losses for a second year, which is the first time it’s happened in 50 years.

“This is a very unusual combination. The reason this happened last year was due to the surge in supply-driven inflation, and the failure of central banks to respond. As a result, nominal bond prices fell,” Katie says. “We think this will be the same again this year.

“Already, we have seen some unusual situations. There is the conflict happening between Russia and Ukraine, oil prices are already spiking at historic highs and gas is up to 500 per cent higher compared to just 12 months ago.”

Not surprisingly, Katie says there is currently a lot of confusion in the market, given the number of competing issues. And while BlackRock started the year thinking that supply-driven inflation would settle, this has not happened. Subsequently, she concedes that central banks have a difficult task to tackle inflation.

Against this backdrop, the BlackRock Investment Institute has identified three key investment themes it believes will underpin the global market outlook for 2022. They are:

1. Living with inflation:

“We expect inflation to be persistent and settle above pre-COVID levels. Central banks will kick-off policy rate hikes but remain more tolerant of price pressures, keeping real interest rates historically low and supportive of risk assets. As an implication of this, we prefer equities over fixed income and remain overweight inflation-linked bonds,” says Katie.

2. Cutting through confusion

“A unique mix of events – the economic restart, new virus strains, supply-driven inflation, and new central bank frameworks – could cause markets and policymakers to misread inflation. Therefore, we keep the big picture in mind but acknowledge risks - to the upside and downside - around our core view. As such, we are trimming some risk amid a wide range of economic outcomes.”

3. Navigating net zero

“Climate change is part of the inflation story. We believe a smooth transition is the least inflationary outcome, yet even this still amounts to a supply shock playing out over decades. As such, we favour developed market equities over emerging markets.”

Irrespective of the situation currently playing out in Ukraine, BlackRock’s view is that the emergence of new COVID virus strains are likely to delay, but not derail, the restart of economic growth, thanks largely to effective vaccine campaigns. Katie confirms that outside of a short-term macro impact, the big picture at BlackRock remains unchanged: less growth now, but more later.

“The GDP in large global economies, like the U.S. and Europe, continue to be on par with GDP levels pre-COVID. And while GDP is close to trend in China, with Chinese economic activity snapping back sooner than the rest of the world post-pandemic, the rest of emerging markets still have a material shortfall before getting back to pre-COVID trends,” says Katie.

In fact, from an equity perspective, BlackRock remains “mildly” pro China, with Katie pointing to some recent developments in China - including the teleconference between China’s President Xi Jinping and U.S. President Joe Biden, as well as announcements by Chinese policymakers to support markets - which have had a positive impact on China’s equity markets.

“While these developments have allowed for some improvement and growth in China’s equity markets, it’s still not back to where it was historically. But these developments have provided significant confidence and improvement in China’s equity markets, particularly in respect to Government policy in a number of sectors, like technology and education,” she says.

Although BlackRock remains “mildly’ pro China, the issue around governance and political risk remains omnipresent. So, how does the fund manager discount political risk in China?

“It’s a good question,” says Katie. “There is geopolitical risk when looking at China. BlackRock has economists based in Hong Kong and mainland China, so we are close to the ground and feel that we understand the China environment really well. Our view is that China, as a market, is incredibly important for global growth and supply chains. Any sanctions on China, as a result of economic and logistic support to Russia in its campaign against Ukraine, will be devastating for global growth.

“We believe China has a larger place in global growth than is currently recognised. For example, it has about 80-90 per cent of supply chains for our wind and solar power, which are essential for the tectonic shift that is currently happening with renewable energy. And with a growth base of US$17 trillion, China’s growth alone this year is about the size of Australia’s GDP. It’s a significant economy, with a middle class comprising of 300 million people.

“So, while we always look at China with caution, when you put all these factors together (including recent policy changes), it does make a compelling case for China.”

However, as a net food and commodities importer, China is still vulnerable to inflationary pressures. Given this scenario, what are the inflation issues China faces and what does this mean for an Australian investor in a global context?

Katie emphasises that China is a very different story compared to the rest of the world. For example, it is looking to cut rates, at a time when Western economies are increasing them. However, she accepts that China will face inflationary pressures due to the current energy shock impacting markets.

“While China will not be immune to inflation, it has an enormous middle class, which is expected to continue to drive a lot of the growth for the economy. And while BlackRock does factor in inflation when looking at China, you also need to look at the bigger picture,” she says.

“This includes how well China has rebounded from the COVID pandemic compared to other emerging markets, the size of its population, the recent relaxation of some of its policies, and its restraint from economically supporting Russia with Ukraine. We think these factors are all positives for China.”

Katie confirms that BlackRock expects central banks to stay behind the curve in raising interest rates. That’s because if central banks push too hard to raise rates to curtail inflation - which is difficult for supply-driven inflation - they will stunt growth.

“Instead, we believe central banks, like the Fed, will be more patient with inflation. We will have to continue to live with inflation. Real rates will stay relatively low on a long-term historical basis, which should support equities, and we prefer developed market equities over emerging market equities,” says Katie.

“We prefer equities over credit. So, if we’re going to take risk, we prefer to do that in equities rather than credit. Equity risk premium valuations are at relative historic average levels. Tactically, we are overweight equities but strategically, we are overweight even further with developed market equities.”

Alex Donald - Head of Funds Management, Director at Ironbark Asset Management - agrees that the current inflationary environment is reasonably good for equities. He adds that inflationary environments traditionally have been generally good in inflating cashflows and earnings of equities, and have tended to be a good hedge against inflation.

However, he concedes that the way inflation affects equities is extremely complicated, with stocks being affected differently.

“In an environment with a high level of market uncertainty, you need to take a stock specific approach with your investments, to mitigate the need to make a ‘call’ on what happens next with inflation and/or the style environment,” Alex says.

This means advisers and portfolio managers need to focus on stocks with:

• strong cash flows;
• pricing power and profitability;
• high capital replacement costs; and
• strong balance sheets.

“One of the benefits of managed accounts is you’ve got the flexibility to think about these themes and be able to act on behalf of clients very quickly,” says Alex. “You can be really active in global equities at the moment. But what we’re seeing clients do is reduce the extremes of style out of growth and value, and go a bit more core. They are also very focused on active managers that can pick stocks on a bottom-up basis.”   

When it comes to Australia and how macro conditions will impact the local market, Katie states that Australia continues to travel at a different pace to the United States. She points to the local market, which hasn’t had anywhere near the almost 8 per cent inflation of the United States. However, she does see the RBA raising interest rates, but staying behind the inflation curve like other large central banks.

“Australia will continue to benefit from the commodity boom, at least over the short-term,” she says. “Growth in Australia remains strong, so BlackRock continues to have a lot of confidence in the Australian market.”

Alex agrees, adding: “Two sectors that historically do well when you have rising rates are financials and commodities, especially when you don’t have inflation. Also, the environment for Australian small caps is as good as any small cap market anywhere in the world. So, there’s a lot to like about Australia.”

Alex Donald is Head of Funds Management, Director at Ironbark Asset Management; and

Katie Petering is Head of Strategy, Multi-Asset Strategies and Solutions, BlackRock Australia.

The session was moderated by Toby Potter - Chair of IMAP.