Inflation and profitability hand in hand?

The central banks of the main developed countries are already following the same monetary policy. In an effort to control the inflationary pressures monetary institutions are in the process of raising interest rates on a recurring basis this year, which will have its effects on markets and the economy. Does this new paradigm make it possible to balance inflation and yields? Therein lies the doubt.

The rising inflation and interest rate fears caused a further sale of fast-growing companies and detracted from profitability as a whole. With consumer non-cyclicals and energy the only sectors holding firm, the global equity market (MSCI World in euros) lost more than 3% last month.

“Valuation levels for many sustainable growth business models are extremely low right now,” he says. Jan-Christoph Herbst, fund manager at MainFirst. Many of the companies that are in great shape operationally have recently been subject to significantly exaggerated downside moves in the capital market. “Consequently, the coming weeks and months will probably present the best opportunity to invest in many thematically flourishing sectors over the next 10 years”, adds the expert on the global context.

“The coming weeks and months will present probably the best opportunity to invest in many thematically burgeoning sectors”

Keep in mind that for the five-year world macroeconomic forecast, inflation and growth must be estimated. About, the recent price increase is the highest in the last 40 years. We should have seen it, because it is not just a monetary phenomenon. It is a political decision, with its fiscal and monetary components. It speaks of back to the 70’s because of the similarities with the imbalances of that time.

“However, it is foreseeable that, when the situation settles in Ukraine and the Covid bottlenecks in supply chains begin to resolve, price pressures will subside and inflation will slowly return to its post-global financial crisis level,” he says. Luca Paolini, Chief Strategist at Pictet Asset Management. “Thus, although we expect inflation to return to almost normal levels slowly, its volatility will remain high, mainly due to erratic measures of central banks to combat inflation and the risk of recession,” he adds.

One wonders if given the positive relationship between inflation and yield to maturity of bonds, we will go back to the 1970s. Some experts suggest that the current state of inflation is cyclical. “However, a return of inflation to the low level of 2020 is not foreseeable either,” Paolini deepens. Furthermore, in the long term the return on bonds depends on the savings rate of the global economy and there has been too much saving. Furthermore, the IMF expects the savings rate to reach all-time highs in the next five years. So it might be harder for bond yields to be sustainably higher than in the past.

In relation to growth, the debate is really about productivity, because, in terms of demographics, the population of working age is not increasing and the labor force is retiring earlier. Growth, then, will depend mainly on increased productivity. This has increased approximately 2% annually in developed markets for the last 50 years and according to the IMF it is probably close to 1 or 1.5%, with no evidence that it will pick up structurally. The IMF has already estimated that, for example, online sales, after increasing in 2020, have returned to the pre-existing trend. Therefore, although depending on each region, the growth trend may be back to post-Great Global Financial Crisis levels.

The cycle is very advanced

To all this is added that the moment of investment in the economic cycle matters. If you invest in equities at the beginning of a recession you can obviously lose money in the short term and in 5 or 10 years generate less profitability in relation to investing at the end of a recession or in the middle of a cycle. “In this way, we have to be reasonably aware of where we are in a cycle,” says Paolini. In this regard, the debt yield curve at maturity, wage growth, monetary adjustment and other factors suggest that we are already very advanced in the economic cycle.

With all this, in global equities, an annual return of 7% to 8% in dollars would be possible in the next five years, approximately half that of the last five years, according to the Pictet AM expert. But in US equities it can be 6%, also about half, as he analyzes. “We see more value in emerging markets and European equities”, he highlights. In emerging markets, not only due to valuation, since it has been cheap for a long time, but also due to the foreseeable devaluation of the dollar, which favors these economies. “even in china regulatory intervention is likely to be less negative. Furthermore, the regulatory pressure may rather occur in the United States”, he deepens.

In the meantime, in bonds the profitability in five years using ten-year US debt can be 3% on average, 4.6% on dollar investment grade corporate debt, one of the best return-to-risk asset classes. Outside the North American country there could be value in some bonds, especially from Brazil. “However, debt in Germany or Europe in general, is very unattractive, due to lagging monetary policies and valuation, with below-inflation average returns forecast for the next five years,” Paolini concludes.


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