Manulife Investment Management’s Chief Investment Strategist Philip Petursson provides his inflation and interest rate outlook, and explains how to position your portfolio for the coming months
As the prospect of higher inflation and interest-rate hikes gather momentum, advisors have been warned not to chase returns through certain sectors or individual stocks. Disparate performances are widening, according to Manulife Investment Management’s Philip Petursson, who believes the strategies that worked for the past year are unlikely to work for the next 12 months.
The Chief Investment Strategist and Head of Capital Markets Research told WP that active management will be critical to navigating the rally as economies reopen and the vaccine programme rolls out.
He said: “I caution advisors on chasing performance, whether it be Bitcoin, the FAANGs, technology, or individual stocks and sectors, because I think we've seen a rotation in the market already.
“I believe we're going to get a continued widening or disparate dispersion of performance where you're going to have some sectors do quite well and others underperform, and the ones that underperform are probably the ones that lead through the first stage of the rally.”
Petursson told WP that, as we entered 2021, a rising rate and higher inflationary environment was the most underappreciated aspect to the market. Petursson’s non-consensus call was for the 10-year Treasury yield to hit 1.5%, with risk to 2%, by the end of 2021. It hit that mark by the end of the first quarter.
The reason can be found in the numbers. The amount of committed fiscal and monetary stimulus globally is about $16 trillion, which equates to roughly 16% of global GDP. In addition, excess savings in the United States alone stand at approximately $1.7 trillion.
“We say never underestimate the propensity of Americans to spend their way out of a problem and that's what we're expecting,” Petursson said. “We've started to see signs of it [already] and we expect more of that in the back half of this year through a rapid economic reopening.”
What this equates to, essentially, is a strong economic recovery, which means higher inflation and rates. Petursson said the majority of the market, however, was almost in denial that yields going higher was inevitable. Then the momentum caught on, and things advanced quicker than even Petursson and his team thought. He believes that as inflation becomes more realized, yields are going to continue to trend higher.
The consensus on inflation, meanwhile, is that it will rise in March, April and May, and then settle down nicely close to 2%.
“We believe this is the biggest fallacy out there,” Petursson said. “Why would that be the case? If the Fed is saying economic growth is going to be 6.5% over 2021, and we know that the Fed consensus always underestimates economic booms, it’s going to be closer to eight or nine to the upside.
“Commodity copper prices are $4 a pound, oil’s over $60 a barrel, every commodity is higher year to date … how is that not inflationary? Inventories are low and the backlog of new orders is extremely high. This is all inflationary.”
He believes there is a good chance inflation will hover around 3% for the next couple of years. The Fed will be in no hurry to tamp it down, making sure everything is in place to support inflation over the next couple of years.
The consequence of this is that central banks are likely to raise rates sooner than first envisioned, and ahead of the Fed’s 2023 timeline. But they will do so for the right reasons, Petursson said, because it will be driven by growth.
With that backdrop, many investors will have been left scratching their heads and wondering how to position their portfolio for the months ahead. The big factors are rising yields, which are bad for bonds, higher inflation, which means an erosion of purchasing power, and a huge increase in money supply, which is inflationary.
Petursson believes that “There will be a point in the future where your bond yield is big enough to absorb further rate increases. But we are not there right now. If you buy a bond today, 1.65% on the U.S. 10-year might look attractive, but you can lose that with a 50 basis points move, or less.”
So, underweight bonds and within that, overweight credit and overweight corporate bonds, and stay shorter duration.
Meanwhile, to address the purchasing power issue, turn to equities. Companies have some element of pricing power, which means they can raise their prices commensurate to inflation and, therefore, hold their value. Petursson said: “If we do see higher inflation, and an erosion of purchasing power through a devaluation of currencies, you want to be overweight equities relative to their historical level.”
Some areas of the equity market will do better than others, of course. Through its research, Philip’s team determined that Canadian equities should do better as they’re commodity sensitive, while emerging markets and U.S. mid-caps are also primed for a rally.
There is nuance in the equity market that advisors should be aware of. Go back to the end of October, for example, when there was a shift in leadership and tech stocks underperformed and interest-sensitive stocks did better.
“That’s where the risk is,” Petursson said. “The risk is in expensive, long-duration growth stocks. By long duration, I mean the stocks that say, ‘I've got a great idea today, but the real revenue won't be realized for five years down the road’. They're going to be highly sensitive to changes in yields and inflation. That’s where we would continue to be underweight in equity portfolios.”
A big part of Petursson’s work is helping advisors navigate these challenges. He leads the Capital Markets Strategy (CMS) team, which has a range of investment strategy responsibilities and expertise across multiple asset classes and geographic regions. It analyzes and interprets the economy and markets, providing commentaries on strategies and asset allocation weighting. During these times of lockdowns, the team’s views are in demand and its podcast has proved particularly popular.
To assist in its investor education programme, the CMS team has a model portfolio, based on the traditional 60-40 mix, that it updates and revises on a quarterly basis, and uses as a guide for advisors.
It’s currently overweight equities – waiting for opportunities to add to it - and, crucially, it’s put together with a 12-month view, giving advisors a clear view of how they might set their portfolios a year out.
Petursson said: “It lends itself well to how an advisor runs their business, in terms of how often they can see a client, and how often they can and want to make changes in their portfolios. We release it on a quarterly basis but for many quarters, we don't make changes, because we're comfortable with the asset allocation for the next 12 months.”