For now, the mere re-emergence of inflation risk is the more pressing consideration for investors, not what inflation will be one or two years down the road, says Evan Brown, head multi-asset at UBS Asset Management. In his latest Macro Monthly ‘Navigating the return of inflation risk’ he explains why.
For the first time in at least a decade, the balance of risks for inflation is tilted more to the upside than downside. According to Brown, appropriate risk management entails that investors need to act and adjust portfolios to account for a potential fundamental change in the landscape – even if they believe those price pressures ultimately prove to be temporary. “The key point is that markets will need to trade this shift in the risk distribution now, regardless of what inflation ends up being in a year or two.”
Brown believes this should catalyze flows away from long-duration assets like growth stocks and sovereign bonds in favor of assets that benefit from higher nominal growth. “As such, we expect the dollar to continue to weaken, particularly against high-beta emerging market currencies, developed market bond yields to rise as curves steepen, and procyclical relative value positions in European, Japanese, EM ex-China, and value stocks to outperform. We are positioned for both growth and inflation to be cyclically stronger during this expansion than the prior one, but do not expect the type of upward spiral in inflation that would serve as a sustained headwind to risk assets. That being said, inflation’s ascension as a threat to certain portions of the equity market is one reason why we have moderated our overall risk asset exposure.”
The case for inflation demands investors’ attention because it involves many layers that may unfold over different time horizons, says Brown. “This multi-faceted case for inflation must be respected, particularly as this phenomenon is relatively foreign to a generation of investors. But so too should the powerful structural forces that have kept price pressures subdued across advanced economies through those decades be acknowledged – aging demographics, technological innovation, and globally integrated product and labor markets.”
According to Brown, considerable uncertainty as to the persistence of inflation will remain in place through year end. “This will add to its longevity as a market catalyst and spark bouts of cross-asset volatility over the coming months.”
Here you'll find the complete Macro Monthly ‘Navigating the return of inflation risk’ from UBS Asset Management.