A new regime of inflation and growth is coming, favouring “risky” assets
The economic responses to the health crisis have been unprecedented and, more to the point, will have a durably reflationary impact on the economy. The general expectation is that a positive "demand shock" will lead to a change towards an inflationary and growth regime. This scenario works in favour of the asset classes dubbed "risky" or particularly exposed to reflationary trends.
The first response to the health crisis was a quasi-shutdown of economic activity, worldwide, for several weeks.
It will take a long time to make up the lost ground, and that will durably prolong the recovery.Christophe Morel
Next, to tackle the economic emergency caused by this initial shutdown, governments in the developed countries injected revenue into their economies, resulting in an increase of the public debt-to-GDP ratio of 10 to 30 percentage points, depending on the country. “To summarize, we are witnessing a “positive demand shock”, leading to a change of regime with regard to growth and inflation,” adds Christophe Morel.
Three growth levers: lagging stocks, consumption and investment
Households and companies will be taking part simultaneously in this exceptional recovery, via three transmission levers. First,, there is the need to reconstitute stocks, which are at historically low levels. Inevitably, this reconstitution will involve production, and therefore growth.
Second, with the recent health restrictions, households have accumulated a degree of “forced” saving. This reservoir of “forced” saving in the United States and the Eurozone is estimated to represent 11% and 7% of GDP, respectively. Even with prudent hypotheses regarding how households may choose to use these savings, the rise in consumer spending will forcibly be sustained.
Finally, we can note a dawning awareness of the needs for investment, which are considerable in health, education, infrastructure and the environmental transition. “This will mean a new push by governments, which will in turn impel companies to invest. The horizon is opening out at last”, observes Christophe Morel
Inflation rate to remain higher
So, the disinflationist forces observed over the last few years will be counterbalanced by the appearance of inflationist forces that are both cyclical and structural. First, the cyclical inflation force stems from the fact that demand exceeds supply. On the one hand, a boom in consumer spending, financed by the surplus in saving, is expected, while, on the other hand, stocks are insufficiently replenished. This imbalance will be rectified in part by a rise in prices.
On the structural side, reflation will also be encouraged by the environmental transition. “The price of pollutant energies must be increased in order to encourage their substitution. This in turn means a risk of higher prices for energy-sector raw materials (oil, coal, gas and even electricity). As long as renewable energies are not available in sufficient quantities, the energy transition will continue to fuel inflation,” explains Christophe Morel. Inflation will also be structurally fuelled by the new geopolitical situation, or, to be more specific, by the ambition of the most powerful countries to recover their strategic independence. This trend will progressively lead to a “regional” relocation of supply chains, with resulting increases in labour costs.
“For all these reasons, we are expecting an environment of durably higher inflation, above the targets of the central banks, forcing them to engage in delicate balancing acts to avoid an over-rapid tightening of monetary policy, which would disrupt the stability of the financial markets,” he adds.
Inflation-indexed securities, convertible bonds and growth securities
This scenario works in favour of the asset classes dubbed “risky” or particularly exposed to reflationary trends. This is the case of inflation-indexed bonds since their potential performance is directly “sensitive” to sources of inflation.
This bond segment automatically profits from the rise in the consumer price index (CPI). So, investors can benefit from the link to inflation.Julien Moutier
Head of Directional Management and Global Aggregate
Groupama Asset Management considers these securities to be attractive, in particularly because of the protection they can provide to portfolios of sovereign debt or investment grade credit. “Inflation-indexed securities provide potentially solid ramparts against the erosion of returns on conventional money-market and fixed-income asset classes. Our own preference is for securities with a maturity of 1 to 5 years, with broad international diversification,” adds Julien Moutier.
Due to their intrinsic properties, convertible bonds will also offer various advantages in a long-term inflation regime. “Historically, convertible bonds tend to perform well in periods of rising interest rates. The return on these securities is correlated to that of equity or high-yield credit, while there is only minimal correlation to the fixed-income markets,” observes Jean Fauconnier, Head of Convertibles Management.
Here too, convertible bonds can potentially provide good protection to portfolios due to their convexity – historically, these securities are less sensitive to downward cycles than to upward cycles – and also due to their maturity: “The longest convertibles are about 7 years, which does not leave much room for steepening yield curve risk,” explains Jean Fauconnier. “We particularly favour green economy and technology sector issuers. These recent sources are currently growing at full swing and offer new opportunities for investment,” he adds.
Finally, Groupama Asset Management is maintaining its convictions on certain stock market themes. With inflation high but not out of control, the long-term trends of health sector innovation, the digital economy, energy transition, increasing scarcity of resources and new consumer spending habits should continue to prevail in the global economy, stimulating the growth of the best positioned companies. “We identify companies whose ability to create value is “protected” by their capacity to reinvent their positioning, disrupt their industry or, even more broadly, to revolutionize society. With these strengths, they will be able to impose their pricing power*,” comments Philippe Vialle, International Equity Manager.
In summary, selective picking of growth stocks remains a structural investment pillar, as confirmed in conclusion by Stéphane Fraenkel, Associate Head of Equities and Convertibles Investments: “over the medium and long term, we are convinced of the potential for profit growth of the companies we invest in. Their status as leaders in their segment and the strong economic growth that we are anticipating give them a powerful lever to impose their prices and improve their profitability.”
*Pricing power: ability of certain companies to “impose” their selling prices due to various factors, including their positioning as exclusive supplier or market leader, their distinctive innovation capabilities (R&D, marketing, products etc.), a disruptive range of products and services and/or high barriers to entry. These capabilities are conducive to the generation of high and/or sustainable profit margins.
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