At the Janus Henderson Global Media Conference, “New Investment Paradigm: Uncovering Opportunities and Challenges,” our senior leaders and key portfolio managers from around the globe shared their insights and outlooks for their markets. In this session, Enrique Chang, Global Chief Investment Officer, moderates a panel discussion on inflation with Jim Cielinski, Global Head of Fixed Income; Alex Crooke, Head of Equities for EMEA; and Paul O’Connor, Head of Multi-Asset.
Louise Beale: I’ve had word that everyone is ready, so we will move on to our next panel, which is on an inflation outlook. Inflation is definitely on the rise. It’s a topic that everyone is concerned about, so I’m excited to hear from the panel on their inflation outlook and what they expect and how they are managing their portfolios to reflect changing inflation dynamics. So I will now hand over to Enrique Chang, Global Chief Investment Officer here at Janus Henderson, to lead that debate.
Enrique Chang: Thank you so much, and you did say something that’s very interesting: Inflation is on the rise. That is actually the question that we’re going to discuss today, and with that, let me introduce the three panelists who are very senior investment professionals and leaders in our organization.
Alex Crooke is the Head of Equities for EMEA for us and has been with the firm for over 25 years. Jim Cielinski heads up our Fixed Income group and has been with the firm roughly four years now, Jim, and then last but not least, Paul O’Connor, who’s also been with the firm for a long time. And he heads up our Multi-Asset Team in London.
We’re not a top-down macro shop, as they say, but we do think long and hard about macro factors and what impact they have on each and every one of our portfolios. And the one macro factor that everyone is talking about today is inflation, and the question for us today, or the couple of questions that we have for us today, first one being is, is inflation coming? Is it a short-term blip? Is it circular? Cyclical? Is it structural?
So there’re many ways to think about what the next three, five, 10 years look like from an inflation perspective. But the question that we all need to have an answer to is what kind of inflation and is it here or is it not here for the long term. The second question is the obvious one: Whenever we think about the first question, how do we think about the impact that we have or could have in the portfolios due to inflation? So we’ll take that on, secondly.
Let me start with Paul and move from Paul to Alex and then Jim in regard to the first question. Paul, every central bank today is scratching their head about inflation and about what to do with interest rates and about how to manage to a reasonable level of inflation. So is it a blip? Is it transitory? Is it cyclical? What are your thoughts on that from a macro perspective?
Paul O'Connor: I’d say, Enrique, the concerns are probably most intense in the U.S., where we see CPI over 5%. We see core inflation at a, I think, 20-year high. If you drill into the data, though, what you see is that the big uplift in inflation has been mostly in sectors where we have fairly acute surge in demand with reopening or where we have supply shortages or labor shortages. And if you look beyond these, the uplift is much less notable. And if you look across the world, look at the UK and Europe where economies are already reopening, we don’t really see the same story. We see very little happening on the inflation front in China. Inflation is 1%, 2%.
And of course, as usual, there’s very little inflation in Japan. So I think, in the short term, the story is very U.S. centric, and it’s very much related to bottlenecks and reopening frictions. I think where it gets interesting is when you look into next year, and to try to think about next, I think there’s a couple of really important features of the current macro environment that are really worth thinking about.
One is we come out of this recession with the private [sector] unusually healthy in terms of balance sheets. That applies to banks, to the corporates, and to consumers as well. I’ve seen estimates that U.S. households alone have accumulated $3 trillion-plus of savings over the pandemic. And obviously that’s a lot of potential inflationary fuel if this money is put to work next year.
And I think a second thing we have got to recognize here is possibly for the first time in a generation, certainly in the U.S., we have macro policy that is set with a pro-inflation tilt. We’ve had massive fiscal easing, we have a central bank that wants to run the economy very hot, and we don’t really know how this is going to work out. We’re in an environment here where we genuinely don’t have a roadmap for how this recovery will emerge.
So while I think it’s pretty easy to conclude that the shorter-term inflationary pressures that we see in the U.S., they should fade as bottlenecks ease. I think there’s a lot of uncertainty about what happens next year, so I think we need to remain very flexible, and I would certainly be pretty wary of assuming that once we get through the bottlenecks, inflation slips back to where it was pre-pandemic.
Chang: Thanks, Paul. Let me go to Jim. Jim, obviously, as the Head of Fixed Income, you’re well aware that inflation could have the most damaging effect for fixed income portfolios, especially if inflation increase is correlated with the demand of investors for higher real rates as well. So you get a combination of both attacking nominal rates. So what are your thoughts on inflation from a fixed income perspective?
Jim Cielinski: First of all, it’s all anyone can talk about. I think inflation … to Paul’s point, this whole debate of is it permanent or transitory, I think it’s the wrong question. It’s clearly both, and inflation looks to be picking up because of base effects. And then there’s a reopening premium. Things are just in the wrong place. Shipping containers, chips not available.
And then the third component is really the one to worry about, which is do we close the output gap and see wage inflation and all things that would be a more permanent, I think, boost to inflation. And I think it’s confusing a lot of the market. I’m not overly concerned that inflation globally is going to be a big problem. I do see most of the effects as transitory.
I think a great anecdote for me is, if you look at what, say, the price of oil did through the pandemic, it was about $60 a barrel before the pandemic but then plunged below $20. And then it rose in the early stages of the recovery here back to $60, and then it’s now about $75. So you can look at the rise from, say, $20 to $60 and say oil is up 300% over the last year, which is exactly true.
But if you’re a dove, you can look it and say it’s $60 now, and it was a $60 a year ago. No big deal. But the fact is we’ve had a little bit of a premium. It’s risen above that, and I think that’s the story of inflation overall caught up in that oil or crude oil analogy. I do think most of what we’re seeing is transitory and will fall back.
And I think we’re right at the cusp of seeing that now. If strong growth were to persist and we close that output gap and see wages rise a lot, then that’s going to get the Fed worried, that’s what they’re hedging on right now, and that’s what you heard last week. I think their models also look a little bit suspect, so I think, like Paul was saying, keep your eye on the right [inaudible].
Chang: Thanks, Jim. Alex, the perspective of global equity investors is obviously critically important when we talk about inflation. You put on that the sizeable costs that we’ve seen in, say, commodity prices in the last few months, if not year now, and then the shifts in different sectors within equities globally. So there’s a lot going on in global equity. What are your thoughts as it relates to that and, on top of that, inflation?
Alex Crooke: Thanks, Enrique. If we look back historically, we find trends of inflation round about 2%, 5%. It’s generally quite bullish for equity markets. Equities outperform most other asset classes in that environment. When it’s subdued, it gets a bit more nuanced, and really you need to be in the right sectors and not in the wrong ones. And if you go back and understand why do equities perform well, there’s a few things underpinning them.
So whether that’s a business that has land, property, real assets in terms of its valuation, they tend to do well. They rise, as inflation picks up, and we’ve certainly been seeing plenty of that. Everybody that’s tried to buy a house in the last year will know house prices have been rising, but property too and land. But also you tend to have a lagged effect on purchasing raw materials, and then passing it on again can be beneficial for some companies. It gets more problematic when you think about wages, paying your staff more as wage growth picks up.
And I always think historically, when wage growth is really beginning to move above that 2%, 3% area, you begin to get this structural inflation building in. And I think actually we are seeing that in some areas, particularly temporary staff, and it’s creeping into other areas of the economy.
So I’m more leaning … I agree with both conference speakers. There’s some transitory effects in here with inflation. But I think there is some structural impacts coming, particularly around that wage growth. In terms of the stock market, it’s going to be quite nuanced. Again, as an active investor, I’m really quite interested in this. I think the index can struggle because the index is built with a lot of a very large-growth companies that don’t really have a lot of staff. They don’t have land and property. They’re built on intellectual property and things like that, and so they’ve been beneficiaries of low growth, beneficiaries of low inflation. Maybe you need a different subset of stocks as we move forward if inflation is structural.
Chang: Thanks, Alex. Let’s turn to the second question. You started to touch on it a little bit, Alex. We’ll come back to you in a minute. Let’s start with Paul. Paul, given your view of what is likely to be an inflation scenario over the next one, three, five years, knowing what we know today, we know that markets are dynamic, and they could change, given what you believe today, what are you doing in your portfolios to either hedge against inflation that’s higher than expected or hedge against inflation that’s lower than expected or hedge against inflation that’s just right from the perspective of what is priced into the markets today?
O'Connor: Thanks, Enrique. I think it’s good to start with just thinking about what is priced in, and I’d say consensus positioning today reflects an expectation of fairly strong growth. We can see that in analysts’ numbers, we can see that in economists’ numbers, and yet continued generosity from the central banks. And you can see this in price performance. Look through the pandemic. Stocks are up about 30%.
Metal prices rallied 70% or 80%, and yet U.S. 10-year bond yields have only risen about 20 basis points through this period. So it’s been quite a remarkable environment. It’s been unusual environmental because it’s been one in which government bond investors have been able to almost disregard rising growth and inflation expectations because the central banks have told them they will under-react.
So it’s been a really simple world in which good news on the growth front is good news for risk assets. I think we’re getting toward the end of that regime though, and I think the FOMC last week was quite an important meeting because I think it’s beginning to signal that we’re no longer in a world where we can celebrate every bit of economic data as being good news for market.
And we’re now moving into a more complicated environment, in which we have to think what will the central banks do, and I think that has changed because I think the emphasis is now beginning to move on when central banks will begin to taper QE and when they’ll begin to raise interest rates. So I think the market regime is beginning to change. I think, for equities, it means we should probably not extrapolate the strong returns we’ve had over the last eight months.
I think it’s reasonable to assume we move into more of a consolidation phase. I suspect we move from the strong sector leadership, we’ve had nine months of reflation trade, into something a little bit more complicated and a little bit more hesitant, maybe a more rotational market environment that can be good for active managers to add value in.
I think, in fixed income, as investors focus more and more, as we move through the second half of the year, investors focusing more on central bank exit strategy, I think we should start to see some upward pressure on yields and some upward pressure on spreads. So overall I feel we’re coming to the end of this early-cycle stage, where investors just focus on recovery and markets are now transitioning more into a mid-cycle phase, where we can think about recovery, but we also have to focus on what the central banks will do.
And I think what investors should expect is returns naturally are lower in this mid-cycle phase than in recovery. But you can make reasonable returns still. I think it’s a phase in the market where markets are typically more rotational and active managers get good opportunities to add value. And it could last quite a long time.
I think this phase ends either if we see growth rolling over, which I certainly don’t foresee in the next six months or possibly well beyond that, or if inflation was to really lift. If inflation was to really lift from here, inflation expectations, then we move more toward a late-cycle phase. But as I touched on earlier, I don’t really see [unclear] second half of this year. I think we could be entering a fairly elongated mid-cycle phase, where returns are still reasonable.
Chang: Thanks, Paul. That was very helpful. Alex, again, you touched on it a little bit. But there’s been just such a significant higher level of volatility of return across sectors, commodities, lately. But they were going the other way a while ago.
Technology certainly in the U.S., and that’s even more concentrated, a few names instead rather the whole technology sector. Consumer stocks. Healthcare stocks. So as you see again this additional worry of inflation or no inflation but, on top of that, dealing with the volatility of the last year, two, or three, how are you thinking about the portfolios that you manage globally on the equity side?
Crooke: As you say, I think, to the outside investor, as it were, just looking at indices, you’re not seeing a lot of movement. But you’re right. There’s been quite choppy periods and actually quite short almost inter-week and monthly movements violently actually between growth and not always value.
I do prefer to think of it more cyclicality, those sectors either reopening trades as lockdowns ease or more stocks attune to GDP growth as economies expand. So they tend to be quite violent moves. I think the best way I’d like to think about it is we’re half in now. I think we want to be… As we’ve all said really, inflation, whether it’s structural or transitory, it is here. We’ve seen big rises in raw materials and some other foods and all sorts of things.
So I think you want to be trimming the stocks that were big beneficiaries over the last cycle. The last cycle was all about very low growth, very low bonds artificially kept there by central banks, and therefore what we call long-duration assets, almost loss-making businesses, will generate something in five, 10 years’ time, where all the value really is in that terminal value. They did really well. So I think you want to be trimming those names, being hard on yourself. Are they real businesses? Have they got enough cash to get the escape velocity? But probably keeping the really nice growth names; the cash-generative, profitable businesses that are growing cash returns very strongly.
And then, threading into that, industrials, particularly capex. I think again we’ve seen these reopening cycles. As economies expand again, I think capex will pick up quite aggressively, and so again businesses that end of those things I think should do very well.
And then the difficult one is banks. Financials are, I suppose, the big value play. If rates start rising because it’s trying to chop off inflation, then you get a steeper yield curve. You get more net interest margin, I suppose, for banks. But it’s early days on whether lending growth will pick up, or we’re still in a structural low-growth environment. I think the banks is the one I struggle with.
But beware it could be down the road. Tapering tends to crowd out financials and bank lending. If tapering eases off, maybe bank lending picks up. But I think we’re half in. Start trimming. Start adding some new names.
Chang: Thanks, Alex, and we have one last question. And Jim, we don’t have a lot of time, so if you can take maybe 30 seconds to answer. And it has to do with an obvious fact or metric. Even though there’s all this talk about inflation, the ten-year yield in the U.S. is roughly 1.5%, which is many percentages below the historical average. So what are your thoughts on that? What interest rates in the U.S. in particular?
Cielinski: I think they’ll stay range bound, and I do worry a little bit, like Paul, that we’re moving to a different place. But there’s actually a lot of inflation priced in. Real rates are abnormally low, but that’s because of a large debt load globally, financial repression, and what is likely to be fairly low inflation on a global scale.
So I don’t think there’s great value in bonds, but I think they stay in the range. I think there are reasons for why they are low, as you say, Enrique. And I think the environment is actually still reasonably good for risky parts of the fixed income market like high yield. Little bit higher inflation is normally good for those parts of the market.
Cielinski: So we are positioned in a way that doesn’t look for [unclear] environments.
Chang: Thanks, Jim. Sorry to give you only 30 seconds to answer that question. Louise, back to you. Do we have time for any questions from the audience?
Beale: Yes, we do, Enrique. Thank you very much. Just one quick one. We’ve had one saying, what’s the panel’s view on inflation-protected security such as TIPS?
Chang: Jim, you want to take that one and talk about fixed income?
Cielinski: Yes, I’ll pick that one. We don’t see much value at all in TIPS or inflation-linked bonds, and the reason, as I was saying, if you disaggregate a bond yield or if you did, say, a few weeks ago, the inflation premium was 2.5% or more. And that’s a big increase in inflation. What was really the core value was the real rate upon it, and so an inflation-protected bond, it does protect you from inflation, not from a rise in real rates, which is what I would worry about. So I’m not a lover of TIPS.
Chang: Over the last few years, TIPS have done really well because they have very long duration or long maturities. And as nominal rates have come down, they’ve benefited. It hasn’t been really that they’ve been great at protecting from inflation. I think we’ve gone over our time a little bit. Thank you to everyone that’s signed in.
It’s a wonderful event that we’re doing, and we appreciate the time you gave us. And Louise, thank you for hosting us.
Beale: No problem at all. It’s a pleasure. Thank you, Enrique, for chairing the panel. It’s really interesting. Thanks a lot to everybody.