Stagflation Fear: Mirage or reality?

Market’s assumption for “long duration” stocks in particular Technology to underperform in rising yields environment is a misconception
Chief Investment Office22 Oct 2021
Photo credit: AFP Photo

Stagflationary” concerns overblown; inflation pressure to transit to “reflationary” as supply chain bottlenecks clear. Global concerns on stagflation have come to the fore given the uncomfortable mix of moderating growth and spiralling inflation. But to compare the current situation with 1970s/80s-style stagflation would be a stretch in our view.

The stagflationary periods of the 1970s/80s were characterised by rising unemployment and inflation. During 1973 to 1982, US unemployment rate and core inflation averaged 7.0% and 8.1%, respectively. The situation today is different. The job market has improved vastly since the pandemic, with unemployment rate standing at 5.1% with core inflation also markedly lower at 4.0%.

The global supply chain bottleneck, which has caused massive disruptions around the world, is a function of demand-supply imbalances. Lifting of pandemic lockdowns has boosted the demand for goods (from semiconductors to automobiles) with manufacturers unable to keep up given labour and logistical constraints. This drove prices higher across the board.

However, we believe the impact on inflation will be transitory given:

-   Peaking of supply chain bottleneck: The global supply chain bottleneck is showing signs of peaking – for instance, (a) ISM prices has stopped rising as demand eases, and (b) Industries that benefit from the supply chain bottleneck, such as shipping and semiconductors, have started to underperform.

-   Dampening of inflationary pressure as growth moderates: The medium-term outcomes of supply chain bottleneck are weaker business activities and moderating growth. This should dampen consumption demand. 

Twin headwinds: Will rising energy prices and bond yields derail risk assets? Global risk assets are currently facing the twin headwinds of rising energy prices and spiralling bond yields. On energy, we expect oil price to stay elevated given demand-supply imbalances. Rising global green initiatives has led to acute underinvestment in oil fields and the supply shortfall coincided with strong rebound in demand. However, we believe the rise in energy prices will not derail the risk rally for two reasons:

1)       Falling energy intensity to GDP: According to Enerdata, global energy intensity has fallen from 0.177koe/$15p in 1990 to 0.114koe/$15p by 2020 amid rising energy efficiency. This reduces the negative impact from higher energy prices.

2)       No evidence of inverse correlation: Monthly correlation between oil and the S&P 500 stands at +0.55 and this suggests the absence of strong inverse relationship between energy prices and risk assets.  

Figure 1: Stagflations fears overblown?   

Figure 2: Falling energy intensity

Source: Bloomberg, Enerdata, DBS

Meanwhile, global bond yields are expected to rise as the world emerges from the ashes of the pandemic.

As yields grind higher, a common assumption is for “long duration” stocks trading at high valuation (such as Technology companies) to underperform. The rationale here is: these companies derive a huge proportion of their value from future cash flows which will come under pressure (from a discounted cashflow perspective) as bond yields increase.

This is, however, a misconception. During the entire monetary tightening cycle from 2013 to 2018, the Nasdaq has seen vast outperformance over the S&P 500 and this suggests that rising yields have limited impact on “long duration” stocks.

Rising energy prices and bond yields – how should you position your portfolio? To navigate rising energy prices and interest rates environment, we recommend investors to gain exposure to:

-   US Technology: Rising energy prices are detrimental to companies with thin operating margins and heavy reliance on energy inputs. Hence, investors are advised to gain exposure to companies with resilient operating margins, such as US Technology.

-   US Financials: Rising rates and bond yields benefit US Financials as net interest margins increases.

Figure 3: Rising yields are not necessarily negative for “long duration” industries like US Technology

Source: Bloomberg, DBS

Figure 4:  A rising rates environment is positive for US Financials

Source: Bloomberg, DBS

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