How inflation could rattle markets

During our recent strategy week, when members of LGIM’s investment teams discussed the themes most likely to sway the market outlook, the related topics of rising bond yields and the threat of inflation gained by far the most airtime.

There was broad agreement on our base-case scenario: sustained inflation pressure is only likely in 2022 at the earliest; therefore, central banks should be willing and able to stop yields from moving aggressively higher in the near term. There was also consensus that such a scenario would probably lead to higher equity markets and tighter bond spreads, despite relatively unattractive starting valuations.

The problem is that the risks to this base case are generally to the downside. Should yields continue moving higher, one scenario is a repeat of the ‘taper tantrum’ of 2013, prompted by investor fears over the eventual withdrawal of monetary stimulus. This could lead to a similar sharp credit and equity market correction, although we presume central bankers would ultimately step in with verbal and perhaps actual support.

Vulnerable assets

While we think the chances are low, a more enduring risk would be inflation becoming a near and present danger as economic data continue to surprise significantly to the upside.

Here, central-bank support would likely be constrained. Such a shortening of the economic cycle could increase the vulnerability of assets that have been boosted by very loose liquidity conditions in recent months. Indeed, recent volatility in commodities, technology stocks, and even bitcoin might be a taste of things to come.

As in 2014-2015 when a rising US dollar met elevated real yields, emerging-market assets could also be vulnerable to tighter dollar funding conditions, although we think many emerging markets are in a better position today to weather such a storm.

We also covered this issue in detail during last week’s CIO call, when Erik Lueth, Global Emerging Market Economist, explained that the asset class benefits today from current account surpluses, cleaner investor positioning and what we believe are more favourable valuations. (You can listen to the call on our website, Apple podcasts, Spotify and Audioboom.)

Relapse risk

There is, of course, also a threat of an economic relapse should virus mutations prove resistant or if policymakers prematurely withdraw monetary and fiscal support (here, Europe is probably the main area of concern).

All these risks have relatively low probabilities, in our view, but with equity and credit markets having performed so well in recent months, investors will be sensitive to growth and inflation headlines in the coming weeks.

We therefore continue to reduce risk exposure in the more vulnerable areas across investment-grade credit while maintaining a positive outlook on higher-yielding credit and equities. Being underweight interest-rate duration is a hedging option for portfolios, but we see this as more of a tactical position given heightened volatility.