The Big Conversation
Episode 69: Should we fear inflation?
This week we look at the likelihood of inflation data taking off from here as we start to see the impact of base effects from last year’s pandemic bust. Economists are upping the ante with bolder and bolder forecasts for growth, but these impacts may be very short-lived. The dollar and yields may be self-correcting, and China’s restocking may now be complete. In this week’s Chatter, LSEG’s Head of Investment Research EMEA, Marlies Van Boven discusses the rise of smart beta strategies, which are becoming an increasingly important part of the investment landscape.
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[00:00:00] Over the last few sessions, markets have been consolidating, but the data has been stoking the fires of the inflation debate. The VIX has established itself below 20. The dollar barely flickered after a blockbuster payrolls number, although the average hours hinted at an overall report that was weaker than the headline. Attention has therefore turned to the year-on-year comparison of growth and inflation, now bouncing off the shock of the pandemic that first hit home in March and April last year. As the inflation numbers come through, many of them will beat expectations and the inflationary fervor should hit new heights. But should we be wary of this siren cry until we've passed through the oncoming period of difficult comparisons? Well, that's this week's Big Conversation.
[00:00:44] Over the next few months, we will be in the sweet spot for jumps in inflation data as we factor in the base effects from last year's pandemic shock. We've already started to see higher than expected rises in some of the data sets. Producer prices surged a full 1% in March, double the estimate, pushing year-on-year Producer Price Inflation to 4.2%, the strongest advance in almost 10 years. U.S. consumer prices also rose the most since 2012, whilst the ISM Manufacturing Prices Paid Index is hovering around the top of the long-term range. The IMF also boosted its projection for U.S. growth this year to 6.4%, up from the 5.1% estimate in January, and this helps explain why funding markets have been trying to price for a turn in interest rates and diverging from government bond yields. Front end bond yields have been suppressed by expectations that the U.S. government will use the Treasury account to partially fund fiscal expenditure, reducing the supply of bonds. U.S. consumer confidence is also beginning to rise from recessionary levels, so everyone recognizes that US growth is accelerating. But the pace might surprise economists in absolute terms, driven by that massive fiscal and monetary stimulus, plus the wealth effect of rising equity and real estate prices, although the benefits remain extremely uneven. These headline numbers are likely to embolden bond bears, although the surge in yields that we've reported before between the US and other major markets will encourage capital into the US. But even though the two point two trillion in infrastructure spending sounds like a big number, the spending will occur over years, not months. Over the next decade, it barely exceeds 1% of GDP per annum at current prices. These numbers are small when compared to the overall US capital investment numbers as a percentage of GDP, and here the US is dwarfed by the equivalent investment in China, both in absolute terms as well as percentage of GDP, where China has a run rate that is roughly three times higher than that of the U.S.
[00:02:42] Market investors also need to evaluate the role of China within the global framework. Barely 50 years ago China was utterly irrelevant to the economic welfare of the United States, but it's now the biggest actor on the global stage for commodities with whom the US will be in direct competition. Since the China-led surge in copper prices in the early 2000s, we can see how the US ISMs as a proxy for global growth, have generally ebbed and flowed with the prices of copper, which is driven by the ebb and flow of Chinese demand, reflecting the importance of China within the global business cycle. We can see just how far China's restocking has impacted the surge in commodity prices when we compare copper with the performance of the Australian dollar. Copper has massively outperformed the Aussie dollar, which itself has outperformed many other leading currencies. Much of this restocking has taken place after a complete cessation of economic activity when the coronavirus first appeared in Wuhan. China imported six point seven million tons of copper last year, which is 33% above 2019 and one point four million tonnes higher than any previous year. But what matters here is whether that Chinese demand is permanent? Prior to the pandemic, China had been transitioning away from a model of 'growth at all costs' towards one of internal consumption. They've been redirecting credit towards shoring up the state-owned enterprises and the banking sector, rather than focusing on output. After briefly reverting to supply-side policies during the pandemic, they will now return to transitioning their economy towards domestic consumption and leadership in consumer goods such as green technologies. That needs commodities like copper, but not as much as their previous rebuilding of the urban landscape and communication infrastructure.
[00:04:22] In the US, the rebound in consumer confidence is real, fueled by a mega surge in savings. Some of this will be directed towards a recovery in consumption, such as the rebound in auto sales, which will positively impact retail sales. These account for a bit more than 40% of overall personal consumption expenditures. But not all of these savings will be used for consumption. As economies open up, invoices will need to be settled and debt repayments will return. For businesses, many of the input costs are now significantly higher than prices in the pre-pandemic era. Also pricing power will be limited by a job market that remains well short of its recent peak. Higher prices have been supercharged by shortages and bottlenecks. Lumber prices have surged, and even those copper prices have been impacted by outages along the supply chains. GM warned that bottlenecks could shave operating profits this year by one point five to two billion dollars. And declining profits doesn't generally lead to real wage inflation, the one type of inflation that we'd all like to see. So inflation, therefore, in its traditional sense, is not the issue. If there are surplus funds, as there surely will be, they will be saved or placed in capital assets, bidding up the prices of stocks, land and housing rather than contributing to a surge in growth. Reflation will not be organic, and will again need to be juiced by policymakers, stuffing the channels with furlough checks or putting downward pressure on the dollar in the hope that commodities and other reflationary assets continue to give the impression of real growth and help to ignite those animal spirits. And as we discussed before, the current deflation story is really a story of US exceptionalism in the short run, where expectations of monetary and fiscal stimulus have underpinned the reflation consensus. In the rest of the world however, the outlook remains far less impressive. In Europe, Germany, France and Spain, they've all revised down their 2021 growth forecasts. While the U.S. economy will return to pre-crisis levels this year, the euro area will not do so before mid 2022, according to ECB board member Fabio Panetta. Italy reported a 0.2% gain in February industrial output, missing expectations of a 0.6% gain. Ironically it was the strongest of the big four in Europe. France was expected to report a month-on-month gain of 0.5% in industrial production. Instead, it reported a 4.7% drop, outlining the recurring issues facing all of Europe. German industrial output was forecast to rise by 1.5% but fell by 1.6%.
[00:06:51] China will be the first to report numbers that are, in theory, clear of the pandemic, China's March producer price inflation figures last week beat expectations, but they're still well within the realms of historical normality. The key question is what happens next? China has taken measures including discouraging loan growth that could have a cooling-off effect on entrepreneurship. The authorities have had to do this because credit growth has exploded over the last year and this has reignited the real estate market, one of the key areas that China would like to reign in as it moves towards consumption and away from speculation on growth. In 2020 alone, Chinese banks doled out a record three trillion US dollars of credit, and that's more than the whole US 10 year infrastructure plan. So just keeping credit at last year's levels, which is the plan, could still stoke the fires of inflation. But China will also want to keep the economy on an even keel as they head into the Communist Party's 100-year celebrations in July.
[00:07:49] Although the IMF has revised up its projections for Chinese growth this year to 8.4% from 8.1% the Chinese leadership today appears more determined to apply the brakes. Foreign expectations for Chinese growth are generally too high, and they fail to factor in the domestic desire to tone things down, given the extensive and excessive use of credit in the past. Investors have latched onto the rebound in China and signs from copper, and assume that reflation has been a global event. But emerging market currencies outside of Asia have not joined the party. The ratio of the S&P 500 versus the MSCI Emerging Market Index has already retraced nearly 62% of its underperformance from the middle of last year, and that was on a tiny bounce of around 4% in the US dollar index, the DXY. Many inflationary assets have been helped by last year's dollar weakness and the more recent rise in bond yields. The dollar has found support, but it may simply be returning to the middle of the seven-year range, having carved out a couple of cycles over that time period. If the dollar rallies further, emerging markets will continue to underperform and commodities which have been leading the perception of inflation, will also come under pressure. Morgan Stanley further note that much of the US bond selling year to date came from Japan, with most of that weakness occurring through the overnight session of the Treasury futures market. This was driven by rebalancing of Japan's domestic asset allocators back to equities, which had their best financial years performance since 1980.
[00:09:19] The financial year ended on March 31st, and this selling pressure may now reverse, given the pickup in U.S. yields over their Japanese equivalents. So rather than runaway reflation, we are perhaps witnessing reflation that has a built-in self-correcting mechanism of higher dollar and higher yields. The higher yields will suck in capital into the US if it continues to outperform other regions. And additionally, the tightening of conditions throughout speculative finance is commenced. Higher yields have already slowed economic activity to a degree. European growth is nonexistent. Emerging markets are starting to experience deleveraging pressure at the merest hint of a rebound in the dollar. Whilst the recent blow ups in hedge funds and family offices will undoubtedly curtail the extremes of leverage, even if it doesn't create an immediate unwind of excessive positions. So inflation can rebound from base effects and it can soar from bottlenecks, but if it outpaces true organic growth, then it will be transitory in nature and investors who have piled into those cyclical assets could once again be left pining for the safety of tech stocks. Now many of these distortions in inflation have been created by the influence of central banks, investors have had to adjust and smart beta has become an increasingly important investment style.
[00:10:30] In the next section, I'll talk to Marlies van Boven about the rise of these strategies.
[00:10:40] When we talk about the growth of passive versus active investing mandates, we often overlook the growth of hybrid strategies such as smart beta, which are playing an increasingly important part in the investor landscape because they're scalable and easy to manage.
[00:10:52] So smart beta are rules-based strategies that aim to capture systematic factors or market inefficiencies, and they can be seen as a hybrid between active and passive. They're passive in terms of that they're transparent, liquid, cost-efficient, and they have some characteristics of active strategies in that they try to outperform a market cap benchmark. As you can see from this graph, we have an annual survey with the asset owners where we ask questions about smart beta. And in the graph you can see the blue bars are the asset owners who see smart beta as active strategies. And we see there has been an increase to close to 50% both in Europe and North America. And this at the cost of asset owners who see the strategy as passive. And if we look at growth of asset owners using smart beta strategies, we see that the adoption rate initially was higher in Europe, but currently both in Europe and North America, as high as 65% of asset owners use smart beta strategies.
[00:11:57] Smart beta is a catch-all phrase for a variety of strategies that use specific rules to achieve a number of goals. They are being adopted by a wide variety of investors to fulfill many different goals.
[00:12:07] Smart beta strategies can deliver different investment solutions. For example, they can increase diversification, enhance returns, or get rid of unwanted risks. And we can divide the strategies into groups. So we have the so-called 'factor strategies' that aim to capture the risk premium to factors such as value, size, momentum, and this can be done in a single factor solution or in a multi-factor solution. The second group is called the 'alternative weighted indexes', and they really try to address perceived concentration risk in indexes or the volatility. So for example, the equal-weighted index can help increase the diversification relative to market cap benchmark. So there are different solutions for different problems. When we look at the graph, we see that by far the most popular strategy are multi-factor indexes. And this is because it's quite hard to time single factor indexes, so a multi-factor solution is an easy way to get an improved risk-adjusted return rate to the market benchmark over several cycles.
[00:13:14] And who is using them and why? So the growth of smart beta comes really from two sources. So the first source is a dissatisfaction with active managers, active allocations. And the second one is to believe that a rules based strategy can outperform a market cap weighted index. When we look at the larger asset owners, they tend to make a strategic allocation to smart beta and they also use segregated accounts so they can customize a solution to their particular needs. When we look at a smaller pension funds, they tend to go for ETFs just like the retail sector, and the latest figures at Morningstar, suggests there's 635 ETFs and more than 850 billion assets in just the ETF indexes. And then the final uses of smart beta is a more appropriate benchmark for active managers. So just getting factor exposure is not a skill, but facts of timing is a real skill.
[00:14:16] Smart beta is also seeing momentum build in the trends that have been impacting the wider investment industry.
[00:14:22] Yeah, so we have seen a real uptake in combining smart beta business with sustainable investment objectives. So you can target factors and sustainable investment objectives in a single framework. And we call these smart, sustainable investing. On the graph we can see that in Europe it's really mainstream, 85% of the asset owners employ some kind of ESG solution, most of them climate in their indexes. Of course in Europe, new regulation and other initiatives has led to this great adoption rate. So this is a large uptake in combining smart beta with S.I in these solutions. And if we look at the next graph, you see the outlook for smart sustainable investing is very strong. So consistent with last year, nearly half of those who anticipate applying ESG or sustainability parameters, expect to increase their allocation next year, 12% says for sure or not, and the other 42% is not sure. So this is a main trend in smart beta.
[00:15:30] Because smart beta strategies are rules based, they are devoid of the emotions that can churn active managers around inflection points. One of the biggest challenges will be adapting to new generations of investors. But the low cost and efficient implementation of smart beta suggests that these strategies will continue to play a key role in the institutional investment landscape for years to come.