Are all investors on the same page? Well, only in the sense that they are having to make quite big decisions as trends change. Inflation is not going to miraculously collapse over the next few months despite a severe Covid related lockdown in China, or war in Europe. If anything, both these events are inflationary despite the growth shocks they will cause. In essence, this is the quandary for investors: the twin fears of inflation and recession. How you think about each risk will determine your investment outlook.
In the latest Algebris Bullet: Wartime Economics, we wrote in-depth about some of the underlying drivers of inflation that will cause greater persistency of inflation than the market is currently expecting. We also take a look at the likelihood of a recession.
Globalisation has been a clear and strong trend over the last 30-years. As we analysed here, he unintended consequences include China holding a 30% market share in semiconductors and Russia 20% of the market share in natural gas. Vulnerabilities have increased. This has already created a European re-think of both defence and energy security. Solutions will be inflationary over the short, medium and long term, especially as the green transition accelerates in Europe. The US is also investing more in high-tech component production. Essentially, globalisation has peaked. This creates a long-term inflationary impulse.
The March inflation print in Europe rose to 7.5% (with interest rates still at -0.5%, the ECB has some work to do) but second-round impacts are yet to be seen. However, with EU unemployment the lowest it has been since its creation, we expect some knock-on wage demands in the coming months. Equally, the commodity shock won’t subside anytime soon, whether it relates agriculture, energy or precious/base metals.
Investors are rightly concerned with the inflationary growth shock and whether it could lead to a recession as households’ disposable income and company margins are squeezed. However, with strong growth momentum coming out of the latest Covid wave, we think near-term recession is unlikely. Despite recent moderation (according to Bloomberg data, as of 21/04/2022, Europe’s consensus GDP forecast for 2022 has fallen from 4% to 2.8%), PMIs remain in expansionary territory and unemployment rates are reaching record lows. At the same time, households are sitting on significant amounts of excess savings in both the US and Europe, to the tune of USD 2.5trn and Eur 1trn respectively (The Algebris Bullet, April 2022), which should help cushion the commodity price shock.
By now, a lot of investors realise that the bank sector benefits from higher interest rates, whilst the insurance sector benefits from higher long-term yields. According to our analysis, bank earnings can increase 20% – 50% from a 100bp increase in interest rates and we think we could see this in the US, the UK and with somewhat of a pause / slightly later, in Europe. We are finding very interesting bank stocks to buy in the US and Europe, where dividend yields are 7%+. Banks have also been issuing sub-ordinated bonds in the last month in both the US and Europe with yields around 6% – 7%.
In a world where investors are repositioning portfolios to protect themselves against inflation and the interest rate increases to come, we believe there are pockets of opportunities that exist in both the bond and equity markets. Financial stocks and sub-ordinated bonds are two examples of ways to help beat inflation.
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