Where to Shelter?
Risk assets are falling, and have ample reasons to fall. What to do about this? In the short term there are decent arguments that it’s time for a rally within the bear market. But how best to deploy assets for the longer term?
We now have three central scenarios ahead of us. All can be described in terms of economic growth, inflation and interest rates. They are:
• Soft landing: The Federal Reserve and other central banks succeed in bringing inflation under control quicker than most anticipate, and don’t have to raise rates as far as many now fear, while growth slows down a bit but never dips into a recession.
• Recession: The Fed’s tightening squeezes the life out of the economy swiftly, even as it brings inflation under control. As a result, rates don’t rise as much as feared, and instead central banks have to pivot yet again and start easing.
• Stagflation: Inflation keeps rising despite central banks’ best efforts, and that means rates also keep rising. Inflation combines with higher rates to destroy demand, so the economy submerges.
None of these ideas is stupid on its face, and two huge factors over which central banks have no control could yet determine the outcome. If the Covid-driven disruptions to economic activity in China, and the Ukrainian conflict drag on, a soft landing grows far harder to achieve, and vice versa. The selloff since the turn of the year has reflected growing concern that this benign outcome isn’t going to happen, and that we should guard against an outright recession, with or without inflation. The latest Chinese data, showing that both the consumer and industry are contracting as the economy grapples with Covid shutdowns, does tend to suggest recession is looking more likely. A China that is actively contracting would be a deflationary force for the rest of the world.
Rather than go into the details of which scenario is most likely, it’s best to look at what opportunities the market is offering at present. And it seems to me that the upshot of much of the recent excitement is to position the market more for the “recession” scenario above, while making it cheaper to hedge against the risk of stagflation (and the China news might well accentuate that). So if you’re still concerned by the stagflation risk, and at least want to take out some insurance against it, now would be a good time.
The inflation-linked bond market itself is now offering a good opportunity. Breakevens (the implicit forecast derived from the gap between inflation-linked and fixed income yields) rose steadily on both sides of the Atlantic, before taking a sharp dive this month. That reflects a belief that the recessionary scenario — in which the Fed has to desist early as the economy weakens more than bargained for — has picked up in likelihood compared to stagflation. At present markets are saying that inflation from 2027 to 2032 will be below 2.5%, in both the US and Germany. Two weeks ago they weren’t saying that. Put differently, if you want to bet on protracted higher inflation, the market has decided to give you one more shot at some generous odds.
Australia and Canada
If we are doomed to stagflation, then commodity prices will keep rising, by definition. In that case, one of the purest ways to take advantage is through the dollars of Australia and Canada, two well-run economies backed by plentiful raw materials. During the last commodity bull market, the US dollar lost much ground to both; this time around, neither currency has strengthened as much as might be expected with materials prices rising. Currencies have the advantage that they are a zero-sum game. Whatever happens to the economy, a currency trade will always make money, if you take the right side. So this seems a reasonably straightforward way to get on the right side of stagflation.
Value Over Growth
The success of the value factor has been one of the stories of the year. Value indexes have slipped for the year so far, but provided you paired a wager on relatively cheap stocks with a bet against the growth companies that dominated throughout the post-global financial crisis era, you made money. Is the trade played out? Probably not. Investors have been piling in to growth stocks, with their value weighted in profits that will need to be made long into the future, ever since the GFC. Particularly in the US, but also in the rest of the world, value could surge much further.
Retreating into the Alpine redoubt could make sense, because Switzerland should be less prone to serious producer price inflation (and its currency, regarded as a haven, should do well in times of global trouble). Vincent Deluard of Stonex Group Inc. points out that producer prices in Switzerland, whose exports concentrate on luxury goods and pharmaceuticals, both of which are relatively unaffected by surging raw materials, are inflating radically less than in Germany, which is more dependent on heavy manufacturing.
If stagflation takes hold, then that promises to be awful for German industry. Swiss stocks, according to the MSCI indexes, have outperformed of late (shown on the left-hand scale), while they now trade at a higher multiple of prospective earnings. But it’s easy to imagine the trade being taken further.
Betting Against the Bank of Japan
Trying to make money in Japan has been dangerous and unrewarding for many years now. However, Deluard offers a scenario in which it could make sense to bet on the yen. The Bank of Japan is holding out Canute-like against all other major central banks by continuing to intervene full-speed-ahead to keep bond yields down. If a stagflationary environment takes hold, there is no way it could continue with this. Abandoning yield curve control would mean higher yields, lower share prices, and a stronger yen.
This is what has happened to a strategy of going “long” the yen versus the US dollar while shorting the Nikkei 225 stock index over the last three decades. It’s been difficult to lose money by betting against Japanese stocks over that period, but if you coupled it with a bet on the currency to do well, you would indeed have lost a lot of money in the last few years. The present position looks unsustainable — which in turn implies that Deluard’s suggestion of betting on the BOJ to capitulate might be a good one.