Pictured from left to right: Talib Sheikh, Head of Strategy, Mark Richards, Strategist and Matthew Morgan, Product Specialist, Multi-Asset team at Jupiter Asset Management

By Jonas Wäingelin, NordicInvestor

After several decades of (successful) inflation fighting, the challenge facing central banks has inverted: the principal problem now is the lack of inflation, which recently prompted the US Federal Reserve (Fed) to announce a remarkable strategic turnaround. With its announcement to pursue Flexible Average Inflation Targeting (FAIT) in future, the Fed has essentially hinted that it will do whatever it takes to deliver full employment, even if it means inflation being above the 2% target for a period of time.

By introducing FAIT, the Fed has effectively acknowledged that the economy can sustain a higher employment level than previously thought without risking inflation – and thus effectively admitted that 2018’s rate hikes were a mistake. For Talib Sheikh and his team, this is a significant change to the Fed’s interpretation of its mandate, with notable consequences for investors. There are many that will look – with good reason – to the significant deflationary pressures out there. For us, though, the key takeaway is that this announcement frees the Fed to keep its foot on the gas for much longer than it could previously,” he says. “This is a big change and a leap into the unknown.”

Higher inflation in a lower-for-longer environment?

While the pandemic has caused a deflationary shock to the global economy, Sheikh sees structural reasons that could drive inflation higher over the longer term. “The retreat of globalisation, making China less able to export deflation round the world, and as companies look to renationalise supply chains, can potentially put upward pressure on costs and prices, while insolvencies from the crisis can lead to better pricing power for the survivors,” says Mark Richards. In addition, this is the first time in many years that fiscal and monetary policy have been pushing in the same direction, showing little appetite for a return to the years of fiscal austerity.

He believes that consumer inflation expectations are key: “If employees are happy to accept lower wages in return for keeping jobs, we risk a deflationary spiral of the like we saw in Japan from the 1990s onwards.” Conversely, he adds, in many instances fiscal transfers have boosted disposable income above pre-crisis levels and could help to facilitate a rise in inflation expectations. Public opinion may also pressure governments into wage rises for key low-paid sectors of the economy. Given the fact that the banking system is far better capitalised than it was in 2008, and supported by government credit guarantee schemes, Sheikh and his team also do not expect the supply of credit to weaken materially enough to have a deflationary effect.

Consequences for investors

“No-one can say for sure whether the forces of inflation or deflation will win out, when or by how much,” Sheikh says. “Crucially, though, the Fed is now significantly less constrained in keeping liquidity flowing into markets than it used to be. This will materially alter the balance in favour of higher inflation in the longer term.”

According to the Jupiter expert, the short-term consequences are already unfolding. At less than -1%, real interest rates are at all-time lows. The dollar has depreciated significantly, US treasury yields have sold off and curves have steepened across the globe.

Over the longer term, if the Fed succeeds with FAIT and economies can break out of the disinflationary trend these consequences can be profound. According to Sheikh, a likely loser is Europe: “The ECB doesn’t enjoy unified political support or have anything like the Fed’s freedom of action at the moment, so the euro can continue to strengthen. Therefore, on a relative basis we continue to prefer US equities. A weaker dollar in turn is supportive for more cyclical Asian markets.”

Within markets, reflation could start to unwind the long-term trends that have dominated equity markets. Indeed, the pace of outperformance for quality/growth companies (especially in technology), which have been supported by very low real rates for a long time, has slowed over the summer. However, Sheikh and his team think it’s too early to call for a reversal, and note that there are other structural forces behind the strength of technology in particular. “We continue to have a quality/growth bias to portfolios, but a more moderate one, and we are looking to add more cyclicality where we can find it for the right price,” Sheikh says, adding that ongoing accommodative policy and the threat of inflation could also continue to support the price of both precious and industrial commodities.

Flexibility and adaptability will be key

“We believe our Flexible Macro strategy, which recently marked its first anniversary, is well suited for this new environment, which will require flexibility and adaptability as it develops”, says Matthew Morgan. The absolute return strategy, which targets a return of +5% above the rate paid on cash deposits over a market cycle, with risk around half of equities and a low correlation to other asset classes, uses a range of drivers to seek returns including traditional macro forces, thematic trends, and opportunistic strategies. The team implements ideas using focused equity baskets, government bonds, ETFs, listed futures and options, and FX. The strategy seeks to offer growth, alpha, and diversification based on a highly flexible approach driven by a macro-based investment process.

The strategy has a structural preference for quality/growth equities and technology in a liquidity-driven world with weak fundamentals, says Matthew. Given the possibility of modestly higher inflation as economies recover over the medium term, the team holds basic resources and economic reopening baskets, as well as exposure to Asian equity markets. The expectation of ongoing very loose policy leads to low duration and short US dollar in the portfolio. To help diversify the portfolio the team holds gold and silver, which it expects to continue to be supported by central banks suppressing real rates. It still sees structural forces driving emerging market credit as an asset class and has EU peripheral bond exposure. The team expects volatility to remain elevated and therefore is using all the flexibility at its disposal to navigate this very unusual period in markets.