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What You Need to Know About Inflation

High inflation and the consequences of attempts to curb it are a top concern for investors nowadays. By hiking rates, policymakers can eventually slow demand to subdue price pressures, even in an environment of constrained supply. However, this process takes time.

Prices reflect the interaction between supply and demand: when demand outstrips supply, prices must rise to re-equilibrate the economy. In fact, supply-side constraints are beyond the purview of monetary policy. In other words, many of the forces pushing prices up are beyond central banks’ control so they cannot solve these issues by changing interest rates. What they do is to slow demand such that even in an environment of constrained supply, price pressures abate, which means tightening monetary policy to slow growth to a rate consistent with the ability of the supply side of the economy to keep pace.

Once rates rise, it takes time for the economy to feel the effect in full. Higher policy rates will not translate immediately into lower demand, slower growth and an easing of inflationary pressures; however, as this year progresses, we can expect growth to slow, bringing inflation gradually lower.

As part of the growth slowdown, consumers will increasingly spend on services rather than goods. Another part of the upcoming rotation is a natural re-equilibration in an environment of higher prices. Since demand for goods has been robust and goods trade has been particularly impacted by supply-chain disruptors, goods price inflation has soared. Food prices, in particular, have risen largely due to high crop prices. 2021 was particularly a bad year for supply, as weather limited planting in many regions and interfered with the growing season. This has made services comparatively affordable and thus more attractive.

However, the shift from goods consumption back to services may take longer than expected. While airlines, hotels and restaurants make headlines, nearly half of the gap in services demand is for medical services. Some of this is likely to be from postponed elective procedures, which could rebound sharply when people feel more comfortable resuming daily life. However, people may take it longer to reach that point.

Prices do not have to fall for inflation to decelerate. Inflation measures the rate of change in prices rather than the price level. Importantly, inflation is not just a one-time change in prices, but a persistent increase. Even if prices simply rise at a slower pace, inflation will turn lower. This means that over time, goods prices and services prices will converge and that inflation will eventually fall below services inflation. Pushing goods prices inflation lower will make a big difference in overall inflation, though it will not solve the problem entirely.

One of the biggest categories of services inflation is how the consumer price index captures the cost of housing. Housing is the part of the economy most sensitive to monetary policy. Mortgage rates in the US have soared and housing prices have risen over the past few years so affordability is extremely low. Subsequently, mortgage applications have fallen sharply and sales of homes, both new and existing homes, have turned down. This suggests that home prices are likely to slow their rate of increase, which should eventually bring services inflation lower too.

To understand ongoing increases, it helps to look at inflation on a month-over-month basis. Doing so eliminates past price rises from the equation, so investors can focus on what is changing now and in the future. The best way to monitor progress toward the outcome is through a broader assessment of financial conditions. Measures and indicators such as lower equity prices, wider credit spreads and higher Treasury yields all work to slow demand by transmitting monetary policy from central banks to the economy. The current financial conditions indicate an economic slowdown is in motion and will in turn bring inflation lower. The key question over the medium term is how aggressively central banks will tighten policy once evidence of slowing growth mounts. Inflation tends to lag the cycle, staying high even after growth slows. If central banks remain aggressive during that interval, the risks of a recession rise sharply.

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Climate-Focused Portfolio Approaches

Investors gain confidence that an equity or corporate bond portfolio is invested in companies that are helping to address climate risk. To support a transition to a net-zero carbon economy, climate-aware investors monitor the carbon impact of the companies in their portfolios. However, climate issues are complex. A purely quantitative-driven process that rewards companies with lower carbon emissions is likely to prove inefficient.

A carbon footprint is the total greenhouse gas emissions (GHG) caused by an individual, event, organization, service, place, product or business activity, which is expressed as carbon dioxide equivalent. A carbon footprint measures the negative impact of a company’s operations on the environment. Some providers, such as MSCI, have created a range of carbon footprint metrics that compare the carbon characteristics of a portfolio with a benchmark.

For bond investors, the most relevant metric is the weighted average carbon intensity of a portfolio, which measures the carbon footprint of a portfolio in terms of the volume of carbon dioxide emissions per value of sales. This metric is applicable across asset classes. It is simple to calculate. It does not need the market cap or sales data required for other equity ownership-related measures and can be expressed in a score for the portfolio and a score for the benchmark.

The carbon footprint investing approach aims to identify key sustainability issues. One is whether the issuing company’s strategy is aligned with recognized carbon-reduction targets. The other is how the companies are financing their transition to net-zero carbon. It is also important to stay aware of the wider picture and whether conventional analysis adequately reflects reality.

However, a carbon footprint approach does not tell the whole story of the impact of a company. It can sometimes be misleading. For one, a carbon footprint is only a snapshot in time, which cannot look forward to allowing for companies’ carbon-reduction plans. Secondly, it cannot capture the nuances of carbon use. The GHG Protocol distinguishes between direct and indirect sources of carbon emissions; the distinctions depend on whether a company emits the carbon itself as an intrinsic part of its business or as a user of energy or further up or down the supply chain. Moreover, taking bond portfolios as an example, existing carbon intensity reporting tools do not differentiate between carbon footprints from conventional bonds and those from green bonds or other ESG-labeled bonds. These structures raise capital either for specific green projects via a green bond issue, or to support firm-wide carbon-use reduction via sustainability-linked bonds targeting key performance indicators.

Using the carbon footprint approach, companies that have a relatively large carbon footprint might be overlooked even if they are making significant contributions to decarbonization through climate solutions. Many products needed to help curb global emissions over the long term require industrial commodities, such as steel, cement, lithium and cobalt, which are energy-intensive to produce. Similarly, companies with a low carbon footprint might be included even if they rely heavily on carbon offsets. Carbon offsets help make up for the GHGs that an entity produces by allowing it to buy, sponsor or fund a carbon-reduction initiative elsewhere; however, offset projects that are not certified by reliable third parties may not be as effective as advertised.

A carbon handprint, by contrast, measures the positive impact or carbon avoided by using the products of a company. Using the carbon handprint approach, a clean energy company will be judged on the amount of zero-carbon energy generated, while a resource efficiency company is ranked on its ability to save energy for other companies or entities. Products and services that address the physical effects of climate change include drought-resistant crops, coastal infrastructure to protect cities and communities, and smart irrigation systems to improve water use efficiency. Such progress is needed in many areas, such as resource efficiency solutions, clean energy solutions, transportation solutions, agriculture solutions, food waste solutions, and recycling solutions.

The three investing principles for a carbon handprint approach are: (a) search for climate solutions across regions and sectors; (b) make sure that target companies have solid fundamentals; and (c) invest in portfolios that actively engage with their portfolio companies. By assessing carbon handprints, actively engaging with management, and conducting independent research of business fundamentals, investors can obtain the information needed to measure a company’s carbon handprint accurately and convincingly, and create a portfolio of companies with superior long-term return potential that are providing solutions to the biggest climate challenges.

Using carbon handprints to invest in climate-focused companies can also help investors create differentiated portfolios. The MSCI Climate Change Index or the MSCI Climate Paris Aligned Index, are carbon footprint measures. As a result, these popular climate benchmarks look very similar to the MSCI ACWI Index. A carbon handprint index would look very different than the broader equity benchmark.

Climate-aware investors also need to dig much deeper into the business and emission policies of each company to understand whether a low carbon footprint is truly indicative of a good environmental actor. Investors should also be clear about the key milestones as well as the end goal of the carbon-reduction journey of the companies.

Lastly, sustainably reducing carbon emissions means that companies’ strategic plans should aim to reduce their future emissions. Therefore, it is vital to identify companies that have credible climate commitments for the long run. Drawing on independent sources of expertise and transparent climate pledges, such as the Science Based Targets initiative and the Net-Zero Banking Alliance can help differentiate between companies with demonstrable long-term commitments and those who are not yet willing to walk the walk.

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Uncertainty Clouds the Outlook

An anti-goldilocks economy refers to the global economy where policymakers are confronted with a stagflationary supply shock, which is negative for growth and will tend to push up inflation further. In the current market condition, inflation is “too hot,” as evidenced by the higher energy and food prices, as well as the disrupted supply chains and trade. Globally speaking, energy and food prices have been increasing significantly since late April of 2020, while supply chains and trade flows have been lowering since May of 2020. On the other hand, economic growth is “too cold,” as indicated by the tighter financial conditions since year-end 2020 and the lower business and consumer confidence due to uncertainty.

Significant uncertainty clouds the outlook; however, the baseline development-market (DM) growth remains above trend, especially in the US, assuming a 1.5% DM real GDP growth. DM inflation, as measured by core CPI inflation, peaks at elevated levels, the target of which was 2%.

The current global markets witness greater divergence and dispersion of outcomes among countries and regions: DM exposure to Russia varies across the US, the UK, and the eurozone. Italy has approximately 21% of all outstanding loans to Russia, accounting for 2.5% of all the foreign claims (FCs) of Italian banks. Austria has nearly 14% of outstanding loans, representing 3.7% of all Australian banks’ FCs. France’s loans are also approximately 21%; however, they are just 0.7% as a share of total FCs. No other European economies have Russian FCs exceeding 0.4% of their totals. The direct impact on European banks’ balance sheets from Russia exposures will be relatively low. On the emerging-market (EM) side, looking at EM commodity exporters and importers, winners and losers are highly divergent, as indicated by the commodity trade balance as a percentage of GDP.

On volatility across equities and rates, although modest in absolute terms, equity volatility, as measured by the VIX index, has increased, especially since May of 2021. Meanwhile, rate volatility, measured by the CBOE interest rate volatility index, has picked up amidst inflation concerns.

Policymakers struggle to balance higher inflation against greater uncertainty. Higher and more broad-based inflation raises the risk that inflation expectations become unanchored. Market expectations for year-end 2022 policy rates are higher across the Fed and the key central banks; however, central banks are unlikely to ride to the rescue, increasing the risk of weaker growth or even a recession. In the US, different indicators imply that it may already be in the late cycle. Elevated inflation will continue to drive rate markets.

A decrease in demand from the Fed has raised mortgage rates and cheapened valuations. As of March 22, 2022, Agency MBS spreads have widened almost 40 basis points (b.p.) since the Fed announced its intention to taper MBS purchases, back to its cheapest levels in two years. Higher rates and wider spreads have caused mortgage rates to rise, likely lowering MBS supply, extending outstanding MBS, and increasing yield potential. As of March of 2022, the conventional 30-year mortgage rate was 4.51%.

Further on credit, spreads have retraced well above their post-pandemic tights. Investment-grade credit indices have largely recovered from the COVID-19 sell-off; however, sector dispersion remains high. The recovery trade in select resilient corporate credits that have ample liquidity, particularly hardest-hit sectors such as travel and leisure, may be poised to outperform and offer further upside to a reopening of the economy.

Lastly, the financials sector, especially banks, benefit from strong balance sheets with an average investment-grade rating, which can deliver attractive yields. As of Feb 28, 2022, the average yield for the European additional Tier 1 market was 561 b.p. and that of the global high yield market was 526 b.p.

In fact, higher rates may prove to be an attractive entry point, as index yields per unit of interest rate risk are historically low. As of Feb 28, 2022, the yield-to-duration ratio of the Bloomberg US Aggregate index was 0.35, and that of the Bloomberg Global Aggregate was 0.24. Dispersed valuations reinforce the importance of active management and selection. In the current market conditions, portfolio flexibility and liquidity are the crucial.

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Rising COVID-19 Infections in China in March

The COVID-19 infections in China have increased dramatically in March and may continue to rise in the coming days. Shenzhen, Dongguan, and Changchun, have been locked down for over a week. Shanghai has also significantly tightened its COVID-19 restrictions. In China, the number of asymptomatic cases in the current outbreak is much higher, which is likely due to a combination of the milder symptoms of omicron variants and the vaccinations that reduce the severity of the infection. On the other hand, imported cases have been comparatively high. Moreover, the fact that more provinces have been affected is posing a greater challenge in controlling the outbreak.

People are speculating that China may relax its zero-COVID policy; in fact, the highest health authority in China recently urged regions experiencing severe outbreaks to control the epidemic quickly by taking strict measures. Difficulties in getting most of the population vaccinated effectively via a booster shot present further constraints around relaxing the zero-COVID policy.

Looking at indicators, traffic congestion and subway passenger volume may be affected by the imposed restrictions as well as individual risk aversion. Meanwhile, daily coal consumption provides color on industrial activity. These three measures dropped notably during the past outbreaks of COVID-19 and are showing negative effects. Purchasing Managers’ Indices further indicate that activities held up relatively well in both January and February; however, they may weaken in March. The path of economic growth in 2022 will largely depend on how quickly China controls the outbreak and how much additional policy support it has in place to counteract the hit to its growth.

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Value Discount

Value stocks outperformed through mid-February this year as investors repriced expensive growth stocks. Mounting inflation and rising interest rates are creating conditions for broader value recovery, particularly for companies with solid business fundamentals. Style return patterns have been erratic over 2021, where returns of global value stocks and growth stocks flip-flopped, and both cohorts ended the year with similar gains. During the sell-off in January 2022, value stocks outperformed growth stocks by a wide margin, as evidenced by the fact that the MSCI World Value Index fell by 0.6% through February 15, while the MSCI World Growth Index dropped by 10.1%, in US-dollar terms.

Inflation is changing the game. With investors and central banks acknowledging that inflation will stay higher for longer than initially expected, interest rates are poised to continue rising, which should benefit value stocks, even as it raises challenges for equity investors. Rising rates tend to compress valuation multiples of all stocks; growth stocks are particularly vulnerable, while value stocks are generally more resilient.

Despite their recent outperformance, value stocks still trade at a near-record discount to growth peers. As of January 31, 2022, the price-to-forward earnings ratio of the MSCI World Value was 50% lower than that of the MSCI World Growth. Investors might think this discount implies that value stocks are impaired. The three indicators of profitability, earnings expectations, and balance sheet strength, however, show that value-stock fundamentals rank near historic highs relative to growth stocks.

In recent years, multiples of growth stocks have benefited from the falling-rate environment as well as investor demand for high-flying growth companies. Many of these companies have long-term potential but weak current cash flows. This, together with fears of a prolonged economic slump, filed a massive valuation gap between growth stocks and value stocks. However, these trends are ripe for reversal. Since 2009, valuations of growth stocks have been tightly linked to the real yield of the 10-year US Treasury. As real yields fell, growth stocks valuations rose in near lockstep. Over the same period, valuations of global value stocks were relatively stable.

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