Inflation has been defeated - but is deflation coming?

GAM Investments’ Andrea Quapp believes the current environment is favourable for risk assets as the situation is better than the mood. She explains why, despite the challenges still facing financial markets and geopolitics, fleeing into government bonds may not be a good idea at the moment.

09 August 2023

Some investors are rubbing their eyes in wonder. The sharpest monetary policy braking manoeuvre of the past 40 years seems to have passed by so far without any major dislocation of stock markets or for consumers. Above all, the US economy has been prospering thus far; there is full employment, labour is scarce and consumer spending is rising. The US S&P 500 Index has gained close to 20% since the beginning of the year, and almost 30% since the low in autumn 2022.

For once, equities will not be prone to weakness at the end of the economic cycle, as new themes such as investment in climate protection and alternative energies, the emergence of artificial intelligence (AI) and gigantic economic stimulus programmes in the major economic blocs of the US, EU and China should ensure that stock markets continue to prosper. An easing of inflation makes the end of the cycle of interest rate hikes appear within reach. However, the inverse yield curve – where interest rates at the short end are higher than at the long end – unsettles bond and real estate investors, as this constellation often points to a recession.

Asset allocation takes government investment programmes into account

Financial markets typically only panic when participants are surprised. There has been no shortage of events in the recent past that could have triggered such a panic. But markets have not let themselves be unsettled by the aftermath of the pandemic, sharply rising inflation and resulting central bank action, Russia's war in Ukraine and the deterioration of the situation between China and the West, as well as the creeping pace of the economy in the People's Republic – or trusted in the intervention of the state and central banks.

Even the fear of recession could not dampen optimism. Investors weighted the flourishing labour market and stable consumption higher than the sharp rise in inflation and the deteriorating situation in industry. Now a large part of the trough seems to have been passed without the expected upheavals, especially for the stock markets. An emerging upswing in the semiconductor sector, large government investments in sustainable energy production and infrastructure, and the fact that AI promises a new tech cycle, open up a promising environment for equity investments.

Inverse yield curves as a warning signal

Experience has been lost in the bond market. After the yields of safe government bonds had only tended to fall since the 1980s, many less experienced participants are overwhelmed by the completely changed environment of the past few months. After heavy intervention by central banks in response to the sharp rise in inflation, the cycle of increases is likely to be at or near its zenith. Government bonds with yields of 4% (US Treasuries), 3% in Germany and 1% for Swiss instruments offer competitive returns. However, entry opportunities are diminishing as we think sharp price swings are likely to be a thing of the past.

In this market phase, the textbook recommends increasing duration. But inflation, which remains persistently high as commodities, food and wages continue to rise, would militate against such a strategy.

New equity themes weather the storm

The biggest surprise of the year so far may well be the strong performance of the stock markets. For the US in particular, it was one of the strongest half year performances in history. Time and again it is pointed out that the US stock markets are driven by a few very large technology stocks such as Nvidia, Apple, Tesla and Amazon. In the fight against climate change and with the intention of reducing dependence on China, the US government has put together a superlative economic stimulus package that will give a boost to new sectors and industries and their shares.

What is surprising is that the purchasing managers' indices (PMIs) – considered reliable leading indicators – in the US, Europe and Switzerland have slumped significantly in recent months. In the industrial sector, they have been signaling a contraction in all three regions for several weeks. The rule of thumb is to start building up equity exposure again when the PMIs are below the growth threshold, because the greatest slowdown is already over and the leading indicators are already trending upwards again. Here, too, it is apparent that the cyclical equity correction is likely to fail to materialise.

Only residential properties are an alternative

Because the risk-free interest rate has reached an interesting level again, alternative investments are losing some of their appeal. Investments in Swiss residential real estate, though, are a weighty exception. Due to an increase in the reference interest rate for the first time since 2008, half of the households will see their rents rise. This is bad news for tenants, but good news for landlords and thus also for real estate funds and investment foundations. The supply of residential properties continues to grow more slowly than the resident population. This leads to excess demand for single-family homes and condominiums.

The situation is quite different for office properties after the pandemic. Occupancy is a quarter lower than before the Covid pandemic – plus a hidden vacancy rate of at least 20%. Digitisation has made many simple office jobs obsolete in recent years. In the future, another third of office jobs are predicted to fall victim to AI.

Other alternative investments, both with higher risks and without, such as gold, or uncertain earnings prospects are becoming less attractive in the current interest rate environment. A weakening global economy is also weighing on commodity prices. Saudi Arabia and OPEC were only able to counteract this for a short time by cutting oil production. Investors should not be fooled by the advance of the world's largest asset manager into the crypto sector. Blackrock has filed an application with the US Securities and Exchange Commission for a Bitcoin ETF. Financial institutions like to offer what customers demand. This does not change the fact that in our view Bitcoin remains a digital entry in a decentralised database with no intrinsic value and little acceptance as a means of payment.