Chart of the week
U.S. and euro area inflation market pricing vs. our estimates, 2015-2020
Forward looking estimates may not come to pass. Sources: BlackRock Investment Institute and the Federal Reserve with data from Refinitiv Datastream, November 2020. Notes: The chart shows market pricing of expected average inflation over the coming five-year period. We use the five-year/five-year inflation swap which is a measure of market expectation of inflation over five years, starting in five years' time. The lines are shifted forward five years. The orange and green dots show our current estimates of average U.S. CPI and euro area inflation for the same five-year period of 2025-2030.
Higher inflation associated with the expansion phase of past economic cycles was typically bearish for risk assets. It often led to higher interest rates that pressured valuations across many asset classes. Yet the traditional business cycle playbook does not apply to the pandemic, in our view. We see the shock as more akin to that of a large-scale natural disaster followed by swift economic restart. Expectations for a broad rollout of Covid vaccines have boosted the case for the restart to gather pace next year, boding well for risk assets. We see higher inflation in coming years and the policy revolution implies that central banks will limit the rise of nominal yields. Even the moderate rise in inflation that we expect may surprise markets, as the chart above suggests. Yet we see this as a positive backdrop for equities: Firmer inflation and a lid on nominal yields mean lower real interest rates. This supports equity valuations: the present value of future cash flows is higher when discount rates are low.
Our pro-risk view is fast becoming consensus, and could be quickly priced in. But we see our views departing from the crowd in three key ways: First, many are still looking ahead to 2021 through the lens of a traditional business cycle framework. But we believe this playbook doesn’t apply: in the same way that the “stoppage” was different from a “recession”, the “restart” is different from a “recovery.” This is not a story about a broad-based cyclical recovery. Instead, the story is a sectoral one: an uneven rebound across sectors combined with Turbocharged transformations – one of our three new investment themes. This is why we see tilting toward sustainability as an enduring source of potential returns. It is also an environment that we see supporting both sectors such as tech and healthcare – quality companies that are also beneficiaries of structural growth trends – as well as selected cyclical equities leveraged to the accelerated restart, such as emerging markets.
Second, we see the unusual dynamic between inflation, growth and markets – which we dub as The new nominal – as a key feature of the investment landscape for 2021 and beyond. We think the potential for higher medium-term inflation is underappreciated. The policy revolution implies that nominal yields will be less responsive to rising inflation. Together with a lower bound on bond yields and a greater reliance on fiscal policy, we see it challenging the role of government bonds in portfolios. In contrast to past inflationary episodes, we also believe that with less responsive yields, inflation can be good news for risk assets over a strategic horizon.
Third, we see a rewiring of globalization – reflected in our new Globalization rewired theme – rather than a simple trend toward deglobalization. We are witnessing the shaping up of a bipolar U.S.-China world order and a rewiring of global supply chains for greater resilience, with less focus on efficiency. We believe investors need exposure to both poles of global growth. Deliberate country diversification is key, and we see a case for greater exposure to China-exposed assets.
The bottom line: Positive news on vaccine development has reinforced our view that the cumulative economic shortfall caused by the pandemic – what matters most for financial markets – will likely be a fraction of that after the global financial crisis. This gives us greater confidence to increase our overall pro-risk stance. We have upgraded equities to overweight on a tactical basis, adding to our existing credit overweight. Read details in our 2021 global outlook.