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Portfolio cash levels revisited on stagflation risk

With markets upgrading the probability of a stagflationary environment, Europe’s asset allocators assess whether to scale down portfolio risk


David Burrows

Are growing market fears of stagflation – that is, an environment of high inflation, high unemployment and stagnant demand – sufficient reason for investors to take some risk off the table and allocate a greater portion of their portfolios to cash?

Robeco is one asset manager to have switched more of its portfolio away from credits and into cash, says Peter van der Welle, a strategist with the group’s multi-asset team. Stagflation is particularly negative for corporate bonds, he notes, since inflation eats into their returns while a worsening economy increases the likelihood issuers will default.

“With markets upgrading the probability of a stagflationary outcome for the global economy, we believe now is the right time to tactically reduce risk by overweighting cash relative to credit markets until the stagflationary fears blow over,” says van der Welle.

Positive outlook

BNP Paribas chief market strategist Daniel Morris agrees reducing risk a little at this point makes good sense. “We have already reduced our allocation to risk over the previous couple of months in anticipation of volatility in September and October,” he says. “We are still modestly overweight equities currently, however, as we believe the medium-term outlook is still positive.

Morris adds: “Covid infections are falling, activity is recovering and central banks remain supportive, even if the degree of support is falling. The short-term pressures that markets are facing – inflation, supply chain concerns and labour market bottlenecks – will eventually work themselves out.”

Contemplating the wider economic outlook over the next six to 12 months, Robeco’s van der Welle suggests stagflationary fears may prove overdone and a more upbeat macro sentiment could re-emerge. “In all, we prefer to tactically scale down portfolio risk to weather stagflationary turbulence for as long as it lasts,” he says. “But we do see potential in an overweight in equities versus high yield trade once markets build a clearer view on the macro outlook for 2022.”

Priced in?

For his part, Fouad Mehadi, senior investment strategist, multi-asset at NN IP, says that, while there has been a lot of talk about stagflation, there is no evidence the market is actually pricing in that scenario. “The only thing we are seeing are inflation expectations rising, as proxied by inflation break-evens, which are impacted by higher energy prices,” he continues.

“We do not see any evidence in market pricing telling us the market is sharply revising growth expectations downwards. As such, it seems somewhat premature to ‘stash more cash’. We also find risk sentiment still to be resilient except for the recent market jitters, which do actually not have a strong fundamental basis.”

As Mehadi explains, the NN IP multi-asset team has neutralised its last remaining high yield credit exposure due to the widening in high yield credit spreads in Europe, which he says have mainly come about due to weaker equity markets and heavy seasonal supply.

“We are waiting for a nice entry point as this recent spread-widening offers future opportunities for spread-tightening as risk sentiment picks up further,” he continues. “This has nothing to do with positioning due to stagflation.

“Currently, there is no reason to expect a recession in the US and Europe. Yes – growth could come down significantly from very elevated levels, but overall demand is still very strong. High headline inflation could persist for a couple of more months but this does not mean we should be pricing in stagflation all of a sudden.”

Real economy

According to Kuros Associates CEO Tancredi Cordero, the likelihood of current inflation rates sending the economy into a recession is low, indicating stagflation is an unlikely scenario for 2022. “At the end of the day, we are still recovering from the Covid crisis, and the economy still has room to recover its pre-pandemic growth trajectory,” he argues. “That said, we know that, these days, the stockmarket is one thing and the real economy is a much different one.

“We are approaching a crossroads for equity markets in the West. Accordingly, should the sell-off of September continue well into October, we would see a compelling case to take a good chunk of money off the table and park it into equity-uncorrelated investment opportunities or in cash.”

Nevertheless, Cordero still believes secular innovation trends are “utterly deflationary” in nature and globalisation will continue to be a deflationary force for years to come. “Growing wages, higher housing prices and excess savings have historically been major drivers of inflation,” he concedes. “However, in a world where the gig and sharing economy are exploding and where consumers are virtually best-price-omniscient thanks to the internet, we see a very strong case for stagflation not to occur in the end.”

Kevin Thozet, an investment committee member at Carmignac, suggests a number of possible scenarios. On the inflation front, he stresses inflation forecasting is a particularly delicate exercise yet adds, over the coming quarters and year, headline inflation is expected to remain well above the 2% bar.

Energy inflation should also remain at high levels in most of 2022, and while bottlenecks should gradually loosen, inflationary pressures could persist to varying degrees, depending on the region – as well as on the reactions of local economic policy.

Growth prospects

On the growth side, Thozet accepts the point that excess savings in the US are huge and could well help limit any slowdown. He also points out that Chinese authorities have the necessary leeway to shift their policy mix should the economic outlook worsen down the road; while Europe could also enjoy a more resilient growth trajectory with the approach of key election years and the creation of a Next Generation EU war-chest – both of which have the potential to encourage fiscal profligacy.

For now, though, says Thozet, this constitutes an alternative scenario. “Indeed, the reality of the environment we are going through is that of downward revisions in growth expectations with the lack of positive news on the US fiscal front – along with the potential for more fiscal orthodoxy post mid-term elections.

“There is the combination of a cyclical slowdown and a more structural one linked to deleveraging in China along with the energy shock all pointing towards a lower growth environment which – for now – advocates our preference for visible growth stocks and robust portfolio construction.”

Thozet concludes 2022 could be the year that could actually see the economy slowing down and, at the same time, growing above its potential – mainly in the US – and observes: “That is a context that would require both flexibility and humility in the forming of market views.”