“Economic growth will soon slow but inflationary pressures could linger for some time, which means investors should consider a more defensive stance”, says Luca Paolini, chief strategist at Pictet Asset Management
“Inflation has become investors’ chief concern. Price pressures are clearly building –US core CPI in April hit 3.0 per cent year-on-year, its highest level since 1995.
“Our analysis paints a positive picture over the short term. Strip out Covid-sensitive items from price gauges and inflation looks modest, having barely picked up at all in April.
“Look ahead, however, and the potential for a build-up in price pressures is considerable. Even if there is little evidence of a rise in wages, US consumers have plenty of disposable income, having accumulated some USD2 trillion in savings. Should as little as a third of that be spent on services – a bigger component of CPI than goods – it is possible to see core inflation hovering between 3.5 and 4 per cent in a years’ time.
“However, what worries us more is the possibility of high inflation coinciding with a slowdown in economic and corporate profit growth.
“Our leading indicators point in that direction. Growth is already moderating appreciably in China and also easing a little in the US; the global three-month rate of expansion has recently halved to 7 per cent.
“So, with financial markets facing the possibility of persistent price pressures and weaker growth we retain our neutral stance on stocks and shift to more defensive areas of the equity market.
“Signs of deceleration have multiplied in China. Industrial profits for the month grew at a year on-year rate of 57 per cent, down from 92 per cent the previous month. Elsewhere in emerging markets, price pressures have been building, with CPI having risen from below 2 per cent at the end of last year to above 3 per cent on average.
“The provision of monetary stimulus from central banks remains just about sufficient to underpin riskier asset classes. The volume of liquidity flowing into the financial system is growing at a much slower pace, currently only one standard deviation above the long-term trend rate, down from four standard deviations a few months ago.
“Valuations indicate equities are expensive relative to bonds. The gap between equities’ earnings yield and bond yields is at its lowest level since 2008 while our ‘equity bubble’ index has now reached levels last seen in 1999 and 2007.
Equities regions and sectors: the case for the defence
“There are tentative signs that economic growth has peaked, especially in China and more recently in the US. And although corporate profits have been extremely robust, as seen with stellar first quarter results, we believe that consensus forecasts for corporate earnings per share and profit margins are too optimistic for 2022/25.
“We are reducing our allocation to some of the more vulnerable and expensive-looking cyclical stock sectors, while dialling up our exposure to more defensive areas. This reflects the current mood of the market, where the performance of cyclical stocks versus their defensive counterparts has turned a corner in favour of the latter.
“We are downgrading consumer discretionary stocks to underweight and closing our overweight position in industrials. On the flip side, we are turning less negative on health care and utilities, upgrading both to neutral as defensive stocks’ valuations are quite attractive in relative terms.
“However, we’ve stopped short of going fully defensive. Financials and real estate are the most attractive sectors in an environment in which bond yields are rising and economies re-opening. Rents in real estate are usually tied to price indices, so the sector can also offer a degree of inflation protection.
“Separately, we see growing potential in UK stocks and like the UK’s sector mix as it has a higher than average proportion of financials and quality stocks – sectors we believe should do well during this phase of the business cycle.
Fixed income and currencies: sticking with the havens
“With economic growth in China and the US set to moderate in the second half of the year after a rapid recovery from the pandemic, conditions should favour some defensive fixed income assets. Against this backdrop we maintain our overweight stance in US Treasuries and Chinese bonds.
“More broadly, we continue to remain overweight Chinese government bonds. They offer attractive diversification as their returns are not highly correlated with those of other asset classes.
“We are neutral on other emerging market debt.
“We maintain our underweight position in US high yield bonds as the asset class remains vulnerable to tighter monetary conditions as yield spreads remain near the low seen in the previous cycle in late 2008.
“On currencies we are broadly neutral on the US dollar. We believe the currency should stabilise before it resumes its secular downtrend later in the year when economic growth loses steam, rekindling concerns about fiscal and current account deficits. We maintain our underweight in sterling.