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Our investment professionals share and challenge each other’s views, creating a diverse marketplace of ideas for the Wellington Blog.

In a June 2021 white paper, A source-based approach to managing inflation risk, co-authored by our colleague Adam Berger, we laid out what we believe are the five most likely sources of higher inflation over the coming decade. One of them was climate risk or, more specifically, the potential for input price shocks caused by the ongoing trend of global climate change. Since this inflation source may not be on many investors’ radar, we’d like to revisit why we think climate change is inflationary and suggest strategies to help reduce the threat to client portfolios.

The relationship between climate change and inflation

  • Overview: A price shock to a systemically important input price will tend to spur higher inflation as businesses pass it on to consumers, leading to “cost-push” inflation. While this has historically been due to geopolitical forces driving oil prices, we believe the impact of climate change on a range of commodities will be…
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SUSTAINABILITY
Samouilhan_Nick
Nick Samouilhan
PhD, CFA, FRM
Multi-Asset Strategist
Singapore
Joy Perry
Joy Perry
Investment Director
Boston, MA

After a lengthy absence, inflation has finally returned to the US, but for how long depends on who you ask. Many observers, including the US Federal Reserve (Fed), continue to expect today’s inflationary pressures to be more or less “transitory” in nature. Market pricing suggests that many investors share that belief.

However, here are five reasons why I believe US inflation could prove to be far more enduring than widely expected by the Fed and market participants.

  1. A still-early economic cycle: The US economic cycle is still in its very early stages, as shown by the recent high level of…
MACRO
Brij Khurana
Brij Khurana
Fixed Income Portfolio Manager
Boston

In my opinion, the answer to the question above is “less than most people expect.” I think life will return to “normal” in ways that may be hard to imagine amid worries about the Delta variant. Early in the pandemic, my colleague Eunhak Bae wrote the following about living through 9/11 in New York City: “In the immediate aftermath, it seemed like no one would ever fly on a plane again. That obviously turned out not to be true. Today, it may feel like the world has changed for good. But I believe humans are blessed with selective memories and a desire to revert to what they know, so people will once more buy things, go see things, and congregate to share experiences.” When I first read those words, I thought the reversion to normal would happen much more quickly than it did, but I still think that’s our destination, perhaps within the next six – 12 months.

Why inflation will be an exception

The big change I foresee is in inflation, which has been unusually low for an extended time (1.4% over the decade ended December 2021 and 1.6% for the trailing 15 years). We have seen in past crises that economic stimulus tends to be harder to…

In light of some notable events over the past several weeks — China’s domestic regulatory actions, the Biden administration’s recent six-month milestone, and the US foreign policy debacle in Afghanistan — I thought now would be an opportune time to provide my latest take on the state of US-China relations.

Putting regulation in context

As many of my colleagues have observed, the recent regulatory moves by Beijing are mainly China-focused and not driven by global geopolitics or US policy shifts. That being said, there are some key takeaways here from my broader geopolitical perspective. For example, I think policymakers in both China and the US have begun to view their domestic policy decisions through the lens of the rising “great-power” competition between…

There is a sense that the world is slowly “getting back to normal,” after more than a year of COVID-induced economic lockdowns and other restrictions. Unfortunately, many countries — and even some parts of the US — are still grappling with more contagious and virulent strains of the virus (e.g., the so-called “Delta variant”) and troublingly low COVID vaccination rates. We are not out of the woods yet. But broadly speaking, the global economy has been recovering with the aid of accommodative fiscal and monetary policy, supporting the strong performance of risk assets and the ongoing rotation from growth- to value-oriented exposures.

The threat of rising inflation is a bogeyman now. Amid supply/demand imbalances in labor and other factors, we believe inflationary pressures are likely to persist in the period ahead. Against this backdrop, our investment outlook remains largely pro-risk, but is tempered to some degree by what we see as…

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MARKETS
Nanette Abuhoff Jacobson
Nanette Abuhoff Jacobson
Global Investment and Multi-Asset Strategist
Boston
Daniel Cook headshot
Daniel Cook
CFA
Investment Strategy Analyst

I believe that regional differences in COVID vaccination rates, government policy goals, and the ensuing trade-offs have led to a global economy that can now broadly (and imperfectly) be divided into three distinct ”blocks,” each moving at very different speeds and via very different catalysts: 1) the ”boosters”; 2) the COVID “racers”; and 3) the ”reformers” (Figure 1).

In my view, investors should track the dynamics of each block separately in order to successfully navigate the current phase of the global economic recovery. All three will also affect the markets to varying degrees and with varying effects.

Figure 1

The three blocks of the global economy

Block 1: The ”boosters”

The countries in this group have made substantial progress on vaccine provision, which has increasingly allowed them to…

MACRO
Samouilhan_Nick
Nick Samouilhan
PhD, CFA, FRM
Multi-Asset Strategist
Singapore

As credit spreads have compressed to post-global financial crisis tights, and with bond yields hovering near all-time lows, I believe the total and excess return prospects for investment-grade fixed income look rather grim. Tight valuations, coupled with some looming risks on the horizon (the COVID Delta variant, inflationary pressures, fading fiscal stimulus, and China’s slowdown), may present an opportunity to “take some chips off the table,” so to speak. I recommend reducing both credit and interest-rate risk in many investor portfolios.

The technical backdrop remains strong

Investment-grade credit has been well-supported by strong demand from non-US investors and the domestic pension community. For overseas investors, US credit is still their best option on the yield “menu” (made even more attractive on a currency-hedged basis), given lower prevailing yields across most other developed markets. Many defined benefit pension plans have been…

MACRO
MARKETS
Connor Fitzgerald
Connor Fitzgerald
Fixed Income Portfolio Manager
Boston

On 23 July 2021, Chinese regulators announced sweeping changes to China’s after-school tutoring (AST) industry, forcing AST companies to transform into nonprofit entities, banning foreign capital flows into the industry, and barring public stock listings for these firms. Following the announcement, the market capitalizations of China’s largest AST players plummeted to around 10% of their trailing 12-month highs.

But take a step back for a moment: Government regulation of Chinese industries is not new by any means. The AST policy move is consistent with the goals of China’s past regulatory actions and had even been foreshadowed through various channels during the first half of 2021.

Here’s a distillation of our China and emerging market (EM) equity specialists’ latest views on this turn of events — including why investors shouldn’t…

MACRO
MARKETS
Graham Proud
Graham Proud
Investment Director

Figure 1 highlights the six-month trailing correlation between the S&P 500 Index and the 10-year US Treasury bond as of 20 July 2021. This stock-bond correlation has shot up over the past six months or so from near all-time lows to its highest levels since before the 2008 global financial crisis. What does it mean?

Figure 1

Six-month stock-bond correlation

First, one caveat: The equity-bond correlation can be volatile, particularly amid fears of monetary policy tightening — for instance, a sharp spike around the…

MACRO
MARKETS
Nick Petrucelli
Nick Petrucelli
CFA
Portfolio Manager
Boston

The Chinese government’s aggressive regulatory crackdown on the country’s private technology companies (most recently, the online education sector) has shaken investor sentiment toward a range of Chinese assets, causing China’s equity and bond markets alike to swoon in recent days. The crackdown comes as Chinese policymakers embark on the delicate balancing act of redefining the role of private enterprise in China, versus the often-competing objectives of the nation’s common prosperity and social responsibility.

Here’s a distillation of our global fixed income and emerging markets debt teams’ latest views on some of the potential investment implications.

Fixed income investment implications

China equities and sovereign bonds, along with the Chinese currency, abruptly sold off in unison following the government’s latest regulatory actions during the week of July 26. But most Chinese household wealth is still mainly invested in…

MACRO
MARKETS
Jitu Naidu
Investment Communications Manager
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President Joe Biden’s June 3 executive order (EO) is in my view another important milestone in the long-term deterioration of US-China bilateral relations. The order, which takes effect August 2, aims to limit US investors’ ability to fund Chinese companies seen as supporting China’s military-industrial complex. It builds on the Trump administration’s executive actions but is broader in approach, clearer in detail, and more market friendly. 

Under the terms of the EO, the list of targeted Chinese companies increases from 44 to 59. As expected, the focus is on emerging or frontier technologies critical to military power, such as avionics, advanced communications, nuclear, and space. However, while this EO largely represents a continuation of Trump’s policy, it has a new focus on Chinese surveillance and human rights issues, which is consistent with the Biden administration’s general approach to…

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Thomas Mucha
Thomas Mucha
Geopolitical Strategist
Boston

The global macro discourse has shifted over the past few months to a debate around “good” versus “bad” inflation. I think there is a better way to frame it. In my view, as we look ahead, the question should be: will we see a continuation of the status quo or are we on the verge of a regime change? I think there is a high chance it will be the latter.

Over the past 20 years, there have been a number of instances when inflation has jumped higher. Often this has been due to higher energy costs, occasionally a response to strong demand and sometimes tax changes. Each time, the jump has proved short-lived, but has acted as a tax on consumers, eroding the purchasing power of households by squeezing real wages. In response, consumer spending has slowed, and the economy has cooled. In effect, these temporary bouts of inflation acted as an automatic stabiliser on the economy. Was that bad inflation? For households, yes — but not for…

MACRO

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John Butler
John Butler
Macro Strategist
London

“We suggest that a budget constraint be replaced by an inflation constraint.”
— Three MMT economists in a 2019 letter to the Financial Times

MMT in a nutshell

Modern Monetary Theory (MMT) is often dismissed as a fringe concept regarding unlimited government spending, but it’s a bit more nuanced than that. Basically, MMT holds that a nation’s budget doesn’t (or shouldn’t) really constrain spending because the government can always print more money if needed. Thus, it’s the “real” economy — the production, purchase, and flow of goods and services — that truly matters.

Taking it a step further, the government can theoretically spend as much as it wants to until said spending begins to create excess demand, thereby generating inflation, at which point the government should…

MACRO
MARKETS

ARCHIVED

Nick Petrucelli
Nick Petrucelli
CFA
Portfolio Manager
Boston

Based on the most recent available data, March 2021 was the first month ever in which Chinese imports exceeded US imports (Figure 1). China was already the world’s largest trader overall (imports plus exports), but this latest development now also makes it the largest source of both global demand (imports) and global supply (exports). This is a notable milestone and perhaps another step toward China eventually surpassing the US as the world’s biggest economy (which, as I observed in my February 2021 blog post, could occur as early as 2028).

The strong import number, together with a weaker-than-expected export number and the potential for further export weakness as the world normalizes, could put some near-term pressure on…

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Santiago Millan headshot
Santiago Millán
CFA
Macro Strategist
Hong Kong

Every quarter, the Wisdom of Wellington team surveys around 100 of our Wellington colleagues across different investment disciplines and locations to get their views on what we see as the key macro questions of the day. The results can pinpoint where the firm’s views differ from the consensus and can also reveal important shifts in our collective thinking.

In January’s survey, we asked which risks the market was most complacent about. This quarter, we followed up by asking respondents to rank which upside risks the market should be focusing on (Figure 1). The number two upside risk was the potential release of pent-up savings amassed during the pandemic, which has already been the subject of widespread comment. But the top-ranked upside risk — of a structural boom in capital expenditure (capex) — has attracted far less comment. Many of our macro thinkers believe that the market is underestimating the potential for a lasting increase in capex fueled by investment in green initiatives and infrastructure…

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Benjamin Cooper
Ben Cooper
CFA
Multi-Asset Strategist
London

The US Federal Reserve’s (Fed’s) message on inflation is clear: Higher domestic inflation is likely in the period ahead, but it should be “temporary” in nature. This begs several questions, among them: What exactly does “temporary” mean? Which price increases, if any, could be longer lasting? And if higher inflation proves to be “stickier” than anticipated, how should investors position their portfolios?

The Fed’s latest forecast is for the Consumer Price Index (CPI) to rise to 2.6% this year (which it already hit in March), before settling back down to just over 2% in 2022 and 2023. Likewise, market expectations (as observed in recent “breakeven” inflation rates) are for US inflation to pick up in the near term and then come down longer term. Yet I am hearing from some of my analyst colleagues that many areas of the economy are facing stubborn supply shortages and upward price pressures, including freight, semiconductors, housing, raw materials, and labor.

Thus, in my view, the risk is that higher inflation may have a longer-than-expected “tail” before…

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Nanette Abuhoff Jacobson
Nanette Abuhoff Jacobson
Global Investment and Multi-Asset Strategist
Boston

As discussed in my latest white paper, An allocator’s agenda for a reflating world, I’m concerned that many asset allocators seem to remain stubbornly positioned for a world of falling bond yields, declining inflation, and low economic growth. In my view, this is largely due to what I call a persistent “status-quo bias,” rather than much in the way of active positioning for the realities of today’s evolving global landscape.

As a result, I believe many clients have portfolio positioning that is ill-equipped to successfully navigate the potentially reflationary period ahead. The remedy? While I certainly don’t recommend a wholesale shift to all “reflationary” assets, I think one important item on every allocator’s “to-do” list should be…

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Samouilhan_Nick
Nick Samouilhan
PhD, CFA, FRM
Multi-Asset Strategist
Singapore

The recent flurry of US sanctions leveled against Russia has aggravated frictions between the two nations and cast a long shadow of doubt on the Russian equity market.

Russian President Vladmir Putin more or less forced US President Biden’s hand when he deployed an EU-estimated 150,000 troops to the Ukrainian border. However, pressure had already been mounting for the US to get tougher on Russia following the country’s unprecedented SolarWinds hacking operation and its largely unsuccessful attempts to interfere in the 2020 US presidential election.

The “new normal” for US-Russia relations

Based on these troubling incidents, it seems we have entered a “new normal” in US-Russia relations and should expect risk premiums in Russia’s equity market to…

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Jamie Rice
Jamie Rice
CFA
Equity Portfolio Manager
Boston
Thomas Mucha
Thomas Mucha
Geopolitical Strategist
Boston

The Wellington Global Cycle Index1 points to an upturn in global economic activity but, in my view, even that positive prognosis is underestimating the bounce that’s ahead. Over the next six months, I predict that growth numbers almost everywhere will be exceptionally strong.

Where we differ from consensus

Almost all analysts now have the same broad roadmap for 2021 as we have — strong growth, with a gradual rise in inflation through the second half of 2021. All list the same set of risks: upside risks are attached to a full household-savings unwind and another round of fiscal support, while downside risks are attached to public health. All assume US growth leadership. What is striking is how there is actually very little discussion of inflation.

As economies reopen, it will be difficult for the market to distinguish between…

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John Butler
John Butler
Macro Strategist
London

The US military defines a “complex catastrophe” as a “natural or man-made incident […] which results in cascading failures of multiple, interdependent, critical, life-sustaining infrastructure sectors and causes extraordinary levels of mass casualties, damage, or disruption severely affecting the population, environment, economy, public health, national morale, response efforts, and/or government functions.”1

Working with Wellington’s Climate Research Team, our Global Macro Team is studying the macro, market, and geopolitical implications of climate change. We see climate change as a complex catastrophe in the making, with the potential to exacerbate geopolitical instability and multiply threats to economic and national security. Governments, including the US, China, and European Union, are beginning to treat climate change as a structural peril. Under the Biden administration, climate change has…

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Thomas Mucha
Thomas Mucha
Geopolitical Strategist
Boston
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