This view turned out to exceed even our above-consensus expectations. It encouraged us to keep positioning portfolios so they were exposed to asset classes that typically perform well during the early phases of an economic cycle, when growth accelerates. These allocations included favouring:
While we did see ongoing inflation in asset prices, we thought the rise in consumer prices was more like a spike that would eventually subside – not a self-fulfilling inflation spiral that was getting out of control. It was being driven by bottlenecks as demand from most countries and sectors picked up simultaneously as reopening progressed, pressing against constrained supply. We believed the pressure would eventually ease as demand returned to more normal levels and supply eventually adjusted, with firms restocking and investing to expand capacity.
While we timed the peak or stabilisation in core inflation about right (around the final part of 2021) or, depending on the country, projected it in the early part of 2022, the spike turned out to be more pervasive and enduring – the rate of increase in core prices has slowed less quickly than we thought. However, this was mostly because of new shocks. Earlier disruptions in new and used cars, airfares and hotels, commodities such as lumber, iron ore and copper all eased and prices did see slower increases or even sharp declines. But shipping costs rose more than we envisaged, although they now look somewhat ‘peaky’, and an expected increase in energy costs ended up being more pronounced.
Oil prices did pick up as we projected, given the improvement in mobility, but gas prices soared to a greater extent, partly driven by energy policy and geopolitical factors.
We think of higher energy costs as a ‘tax hike’ putting pressure on firms and consumers. This is why the implications don’t look that different from our base case that the major central banks would taper their asset purchases, but not hike rates just yet – with a possible exception or two, but not the US Federal Reserve (Fed) or the European Central Bank (ECB). Our view was that this anchoring of short-end rates combined with less central bank bond-buying at the long end would result in “steeper for longer” yield curves relative to market pricing. This prediction materialised eventually, but with notable volatility in between as the “power of words” of central bankers clashed with a rapidly moving economic environment.
Early-cycle phases are generally associated with outperformance in assets leveraged to faster growth and beneficiaries of steeper yield curves. However, we stayed positive on themes of technological innovation and believed we were getting “back to the future”. We thought the pandemic was likely to accelerate this process of innovation – and it did.
As the cycle begins to mature more visibly and central banks gradually tighten monetary policy, the rate of growth is likely to decelerate while levels of economic activity remain relatively solid and continue to rise. The inflation spike should eventually settle down, though to a higher level than the deflationary environment of the past decade. We think of these dynamics as a big reset.
We’re moving past the ‘bungee jump’ of displaced activity as governments closed down entire economies by decree while deploying massive stimulus at the same time and the subsequent, strong rebound following reopening and the release of pent-up demand. This phase is being followed by more normal, slower rates of expansion. As we’re back from the brink, but not fully out of the woods, policy is becoming less accommodative too, while remaining supportive.
The ‘cycle’ is reasserting itself, with levels of activity continuing to improve – just more gradually. These dynamics should eventually lead to the inflation spike settling down too as, barring further shocks, bottlenecks progressively ease. Inflation is unlikely to fall back to the very low, sub-central bank target levels of the decade before the virus outbreak, when austerity took a toll. But it should decline to more reasonable levels, making central banks’ tightening fairly gradual.
We think some deceleration is normal now that most areas of the economy look fully or at least partly reopened (although we do see the risk of new restrictions to contain the Omicron variant, to be lifted again once things get back on track), and so our base case is that equities are likely to continue to outperform bonds. However, during periods of cyclical expansion but slowing momentum, equity returns tend to be lower.
That is why we are emphasising investments in long-term, secular trends and themes, from infrastructure across physical, digital and green areas to several aspects of technology and innovation, which we describe in subsequent sections.
Over a shorter time horizon, for equities, the macro environment we envisage has historically implied no clear outperformance by either growth or value stocks. In addition, we think there’s unlikely to be a clear distinction between large and small firms. However, companies operating on a global scale will probably find it easier to adjust their supply chains or benefit if existing ones are repaired, as we think they will.
We don’t see much geographical differentiation either. Some catch-up of particularly dislocated regions or sectors and styles in those regions – effectively, pockets in the developed world ex-US and some emerging markets – could take place at some point. This type of environment is often attractive for stock pickers and across riskier credit instruments too.
With central banks tapering or likely to taper their asset purchase programmes and hike rates at some point, we expect the bond market selloff to continue, with some spread widening too, albeit gradually. During the initial phases of tapering, yield curves tend to steepen, which is beneficial for banks, pension funds and insurers, as well as asset and wealth managers. When rate hikes approach, curves tend to flatten.
The Fed may raise rates once tapering is done, while the ECB is unlikely to even begin to move away from its negative-rate policy for some time. The Bank of England may hike too, though quite gradually, in the near term. We expect a stronger US dollar and sterling, and weaker ‘low yielders’ such as the euro, Japanese yen and Swiss franc.
We also think China, given the slowdown, may let its currency depreciate, which should make its exports more competitive. More structurally, we’ve a more positive view on China than the consensus, and think the development of a credible regulatory and institutional framework could be an important catalyst over time.