From reflation to stagflation, how to position?

Bonds
Althea Spinozzi

Senior Fixed Income Strategist

Summary:  Identifying risks and opportunities is crucial amid a fast-changing market. We believe that it has arrived the time to weigh in on the threat from stagflation. In this analysis, we look at what that means for one's portfolio and which assets can help investors navigate these markets.


Did you know that people that identify safety vests and exits are more likely to survive adverse situations?

In this analysis, we’ll try to explain what does stagflation mean for your investments. Even if this scenario does not materialize, we believe it is necessary for investors to consider it and to identify safety vests and exits well ahead of time. Therefore we determine what assets are detrimental to your portfolio and which can be helpful in such a context.

Stagflation might be the real challenge ahead for markets as elements point to the fact that it may take over the reflation trade.

While the reflation trade sees a strong pick-up in economic growth and inflationary pressures, stagflation sees higher inflation without much real growth. So far, the economy seemed to strengthen together with inflationary data. However, the nonfarm payroll miss last week and strong CPI readings today suggest that inflation may pick up before the problems hindering growth are resolved.

This changes investors' approach towards their investments completely because it means that economic growth might not be strong enough to sustain record high asset prices. Thus valuations will need to correct according to the real economy’s activity. Otherwise, nominal growth (real growth plus inflation) may continue to rise through inflation, eroding value from asset prices.

Assets that will strive amid stagflation:

  • Inflation-linked bonds could be helpful as they pay the inflation rate. Right now, the majority of TIPS and European inflation linkers are pricing with a negative yield. This happens because the market’s inflation expectations are well above the yield offered by nominal government bonds. Albeit negative-yielding assets are a turn-off, they remain a pure inflation play that will hedge one from inflation risk. Indeed, if inflation will not pick up, investors will pay a small yield, but if inflation picks up, they will receive a coupon equal to the CPI index.
  • Higher-yielding nominal bonds will provide a buffer against rising inflation and interest rates. This is a point we have been vocal about, and we continue to stress. Unfortunately, only junk bonds and emerging market bonds provide a yield high enough to hedge against this risk. We like junk bonds the most because they are closer to a recovery in the US and Europe. Emerging market debt, especially EM sovereign bonds, remain vulnerable to a delay in vaccinations and local accommodative monetary policies that will inevitable devalue their currency. The latter is a critical issue in light of the exponential amount of hard currency debt that these countries took in the wake of the Covid-19 pandemic, raising important questions concerning the sustainability of their debt.
  • Commodities. Despite the economy is not growing and inflation continues to rise, there will always be a need for commodities. Yet it is important to highlight that while in the short term inflation and commodity prices are correlated, in the long run, higher prices will depress economic activity, pushing commodity prices back down.
  • Consumer staple stocks. Staples will be a good bet because they are necessary to live despite high inflation. Stocks that are sensitive to increasing interest rates, such as those that my colleague Peter Garnry calls bubble stocks, are most likely to struggle.

What to avoid at all cost in the bond market:

  • Nominal bonds offering low yields, such as sovereign bonds. This is what makes this cycle utterly different from others in history. While in the past nominal yields were giving a buffer against rising inflation, now they are not anymore a reliable source of income. Although accommodative monetary policies might keep interest rates low for longer, the risk to hold these securities outweighs the benefits.
  • Duration. Since the global financial crisis, the economy has been characterized by a deflationary environment and easy monetary policies. This made it possible for assets with long duration to perform quite well. However, since yields have started to rise in the US and in Europe, assets with long maturities have begun to lose value quickly. The more yields will rise, the more bonds will be decimated.

To simplify your search, below are some ETFand bonds, which can be helpful to consider in this environment.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Full disclaimer (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Saxo Bank (Schweiz) AG
Beethovenstrasse 33
CH-8002
Zürich
Switzerland

Contact Saxo

Select region

Switzerland
Switzerland

All trading carries risk. Losses can exceed deposits on margin products. You should consider whether you understand how our products work and whether you can afford to take the high risk of losing your money. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. The KIDs can be accessed here or within the trading platform. Please note that the full prospectus can be obtained free of charge from Saxo Bank (Switzerland) ltd. or the issuer.

This website can be accessed worldwide however the information on the website is related to Saxo Bank (Switzerland) Ltd. All clients will directly engage with Saxo Bank (Switzerland) Ltd. and all client agreements will be entered into with Saxo Bank (Switzerland) Ltd. and thus governed by Swiss Law.

The content of this website represents marketing material and has not been notified or submitted to any supervisory authority.

If you contact Saxo Bank (Switzerland) Ltd. or visit this website, you acknowledge and agree that any data that you transmit to Saxo Bank (Switzerland) Ltd., either through this website, by telephone or by any other means of communication (e.g. e-mail), may be collected or recorded and transferred to other Saxo Bank Group companies or third parties in Switzerland or abroad and may be stored or otherwise processed by them or Saxo Bank (Switzerland) Ltd. You release Saxo Bank (Switzerland) Ltd. from its obligations under Swiss banking and securities dealer secrecies and, to the extent permitted by law, data protection laws as well as other laws and obligations to protect privacy. Saxo Bank (Switzerland) Ltd. has implemented appropriate technical and organizational measures to protect data from unauthorized processing and disclosure and applies appropriate safeguards to guarantee adequate protection of such data.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc.