How to invest in inflationary times
After a year 2022 which will have been very difficult for the stock and bond markets, what does 2023 have in store for us? Four experts went there with their predictions.
“There is a worrying lack of vision from central bankers who say they want to bring inflation down to 2%, whatever the cost. It may be a central banker’s strategy to put pressure through words, but such a goal would be tantamount to guaranteeing us a deep recession. We are no longer in an environment where we can live sustainably with such a level of inflation. If we do, we will break the capacity for growth, because the structural inflationary forces remain at work and should prevent the achievement of a key sustainable level of inflation below 2% for several years, “believes Frédéric Leroux, manager and head of the Cross Asset team at the French asset management company Carmignac.
The latter believes that central banks should give themselves other objectives, such as managing the debt burden in relation to gross domestic product (GDP).
“The strong conviction, with us, is that we are in a potentially lasting inflationary environment. We are far from the transitional inflation that the chairman of the American Federal Reserve (Fed), Jerome Powell, evoked in 2021. Inflation will also not remain high for two or three years. We are entering a period that will look more like the period 1965-1980, in the developed universe,” he believes.
Frédéric Leroux recalls that during this period, inflation was stimulated, among other things, by energy prices, and we saw a succession of increasing peaks and troughs. In his view, the past 40 years of disinflation have been underpinned by demographic, business and sociological structural trends.
He maintains that, from a demographic point of view, one reason which explains the low inflation of the last decades comes from the profusion of young Chinese who had to be integrated into the labor market, to allow China to become an economy of export at low cost. “All of this has weighed on wages in the rest of the world. It was impossible to raise wages quickly without risking losing all competitiveness. Today, this cohort is integrated and is no longer disinflationary,” he says.
On the global trade side, after COVID, many countries have taken steps to bring a lot of production back home, which will be done at higher prices than they are today. “In addition, e-commerce has started to contribute positively to retail price inflation,” says Frédéric Leroux.
The French manager also notes strong sociological trends that rely on ethics, inclusion and sustainable development. “Today, we want more and more green energy rather than cheap energy. This has the effect of reducing investment in fossil fuels at a time when green energy is unable to replace the shortfall at the same rate. In this context, one or two more rate hikes will not be able to put a lasting stop to inflation. It will rise again at the slightest sign of monetary easing. The forces involved are far greater than just the supply chain bottlenecks associated with the COVID-19 pandemic,” he said.
Look beyond the tip of your nose
Martin Roberge, Managing Director, Portfolio Manager and Quantitative Analyst at Canaccord Genuity, believes investors need to look beyond their noses when it comes to inflation. Although the latter fell in the second half of the year in the United States, the components of the service industry, which constitute 70% of the consumer price index, remain between 6% and 7% of annual growth. “In this context, the Fed’s message is aligned with what we see in services. The American central bank will have to create a slowdown in consumption, which will cause job losses to break inflation on wages, the main component of services. We will have rate increases in the spring and maybe even this summer,” he predicts.
In Canada, the situation is a little more precarious, he says, but he thinks it will take job losses on both sides of the border for the central banks to pull over to the sidelines. For the moment, we are far from this breaking point, the month of December having seen the creation of 223,000 jobs in the United States and 103,000 in Canada.
“The job losses will herald a lull in wage increases. However, the current situation is very different from previous recessions, which saw job losses concentrated in three or four quarters. There, we could have smaller losses spread over two years, which has never happened before. We will therefore be in uncharted territory,” says Martin Roberge.
“Not to mention that for the first time in history, we are facing demographics that allow companies to reduce their workforce through attrition rather than layoffs. For example, in Canada, there are 280,000 retirements per year and only 240,000 new people of working age. In Quebec, it’s 65,000 retirements for 10,000 new workers. These are staggering data. During the financial crisis of 2008-2009, we never had figures like that,” adds Stéfane Marion, economist and chief strategist at the National Bank.
He says that for the first time, the economy is idling with demographics that allow companies to increase their operating margins by letting their older workers, whose salaries are usually the highest, retire in order to reduce their workforce.
“This leaves a lot of uncertainty about the evolution of corporate profit margins. Reducing its workforce by attrition is much less damaging to disposable income from a macroeconomic point of view,” he says.
Negative economic data
Economic data will be worse in 2023 than it was in 2022, according to Sébastien McMahon, vice-president of asset allocation at iA Financial Group. “The trough in economic data will probably be seen in the second half of the year. You have to understand that when you tighten monetary policy, it takes between six and eight quarters for each increase in the key interest rate to have a full effect,” he says. Under this scenario, all the increases that occurred in 2022 will be felt more and more throughout the year.
Inflation remains, according to him, the enemy to be defeated. Central banks may not cut rates this year and pivot only next year, as Jerome Powell hinted at the end of 2022.
Stéfane Marion believes, on the contrary, that the Fed may have already gone too far and that a first key rate cut could occur in the second half of the year.
“Remember that historically, after the last Fed rate hike, six to eight months later, it goes down. The Fed says it won’t happen before 2024, but we think it will happen before,” he predicts, saying he is ready to redeploy his cash as soon as the American central bank has made its “pivot”. i.e. when it will have ended the monetary tightening that began in March 2022.
This year, reconnect with the bond portfolio to be divided into three
Martin Roberge, Managing Director, Portfolio Manager and Quantitative Analyst, Canaccord Genuity
“In 2023, investors can go back to betting on bonds and divide their portfolio into three: one-third treasury bills, one-third corporate bonds and one-third high-yield bonds. If the three categories give returns of around 3.5%, 6% and 8% respectively, this will give an overall return of around 6%. When we have more long-term visibility, we can increase the portion of high-yield bonds, until the stock market drops to a level where it can compete with bonds.
Sebastien McMahon, Vice President, Asset Allocation at iA Financial Group
“The 60-40 balanced portfolio (composed of 60% stocks and 40% bonds) had one of the worst years in history in 2022*. The financial markets made a “forced bearish passage” last year. Equity valuations at the end of 2021 were at 2000 highs in the US, interest rates were at zero making bonds very expensive and central banks were seen starting to raise policy rates. It was obvious that we were going to have a difficult year, even if we didn’t think it would be so difficult. But now, bonds can be a solid plunger in a balanced portfolio with interest rates that are the most attractive in 15 years. Over a five- to ten-year horizon, equities are expected to generate an average return of 7% in Canada and 5% in the United States, compared to 5% for bonds, and that a 60/40 portfolio generates an average annual return of 7% in Canada and 5% in the United States. This will ensure that the 60/40 portfolio should yield a relatively stable positive return over time.”
* A portfolio comprised of 60% an exchange-traded fund (ETF) replicating the S&P 500 and 40% an ETF replicating the Bloomberg US Aggregate Bond Index would have generated a negative return of 16% in 2022, its second worst year since 1976 and its worst year since 2008, according to Vanguard figures quoted by the American magazine “Barron’s”.