Adapting Investment Strategy for Inflation

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Luc de la Durantaye

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Luc de la Durantaye, chief investment officer at CIBC Asset Management.

Certainly, with fiscal and monetary stimulus set to boost the global economy, the consensus has evolved closer to our sort of strong growth forecast, with exceptionally strong nominal growth this year. So, investors have celebrated this, with equity markets doing relatively well. And this has been seen also … the economic activity per se has been seeing strong economic activity in the ISM number, like the manufacturing numbers in Europe; even the Service Sector Index is at the highest since the series began in 1997. This, though, is bringing what we think is going to be a shifting focus in the next two, three quarters, which is, you’re going to use up the slack in the economy, and investors are increasingly going to be switching their focus towards the risk of inflation.

So, let’s first think about this for a second. First of all, let’s acknowledge that forecasting inflation is notoriously difficult. Economists don’t have an A-plus track record in that — it’s very difficult to do. But we also need to recognize that the recent past that we’ve seen — the last five, 10 years — is probably not a good blueprint for what is likely to come in the next two to three years. We’ve never had a combination of zero interest rates by central banks in most major economies and very large fiscal stimulus the size we have rarely seen in decades. So, there’s a lot of skepticism out there relative to inflation, in the sense that we’ve seen just before the financial crisis in 2008 very low unemployment rate with no wage growth. But this time around is likely to be different. There’s also … we have to think about the large and growing government debt. There’s an incentive on the parts of government officials to generate growth and inflation to help grow their way out of this debt burden that we’ve accumulated, particularly after the pandemic.

So, other ways of reducing the debt burden are not politically acceptable. That would be raising taxes, reducing services or — worse for some countries — rescheduling debt or even debt default. So, that’s a non-starter. So, what do you do when you have a high debt level? You run the economy hot, you raise inflation so that your nominal debt to GDP starts to normalize. So, that’s, I think, what’s different in the lookout, and that’s why I think investors are going to grow more and more leery of this strong growth and how passive central banks are likely to be. So, from there, I think where we’re going to likely see some cost pressures is if you look at material costs — lumber, oil, some of the chips, some of the transportation costs — have already risen. Debt servicing costs, or interest rates, have started to move up. So, debt servicing costs will go up. And most likely we’re going to see — we’ve already started to see — labour …. Unemployment will go down quite a bit, job creation will go up quite strongly. Just to give you a sense, the labour market in the U.S. is recovering very fast. Over the last 12 months, the unemployment rate has fallen from a post-war high of around 15% down to six. By comparison, it took five years from the death of the 2009 recession for unemployment to fall to 6%. And so, this is likely going to bring wage growth a little faster than in 2009, 10, 11 — particularly with all the stimulus that we have. So, that situation that we’re in, this change in policy that needs to be recognized, has important implications for the outlook for strategy over the next six, 12, 18 months.

So, it makes sense to think of it this way: given that central banks are going to be waiting to see the numbers of inflation printing, as opposed to be anticipating like they did in 2018 for example, and the Fed started to raise rates. This time around, they will keep short-term interest rates at zero for longer than in the past. This means that good economic news will be priced in to the longer end of the curve — the five, 10-year maturity, 20-year maturity. So, you’re going to have a steepening of the yield curve that’s going to continue. We’ve already seen some of it, and it’s a good thing. There’s been a renormalizing of interest rates from what were way too low interest rates.

That has a number of repercussions for the rest of the financial markets. So, when you have a steepening yield curve, that means that the more cyclical part of the market is going to be outperforming the more interest-rate sensitive part of the market. It also means that those stock sectors that are more interest sensitive, like the interest-sensitive ones in the growth sector, are going to be negatively affected by rising interest rates relative to more cyclical and more value-oriented stocks. So, this shift in the portfolio — remember, people have been growth-oriented in their portfolio for quite a long time, so that has started to shift, and that’s going to continue to shift. The steeper yield curve also helps the financials — the banks — outperform. So, there’s probably a little bit more outperformance from that sector. And sectors that are linked to commodities, and commodities per se, we expect commodity prices to continue to be relatively firm. Like in copper, like in oil. And so, we would recommend being exposed to those sectors.

And finally, if you look at the composition of the U.S. market versus the non-U.S. market, the U.S. market is less commodity driven, it’s more growth driven than value driven. So, there’s a likelihood that the U.S. will continue to underperform the non-U.S. part of the marketplace. So, those are just areas for investors that they should focus on going forward.