Expect economic expansion to endure despite rising near-term inflation

November 19, 2021

Steven Wieting

Chief Investment Strategist & Chief Economist

SUMMARY

Even if inflation moderates, the US Federal Reserve is likely to raise interest rates gradually over the coming 2 to 3 years in a climate of enduring economic expansion. However, we believe that post-COVID fiscal policy will boost demand far less than in 2020-21.

Market-based long-term US inflation expectations are well above those of the last Fed tightening cycle in 2014-18. However, they are only in line with the Fed’s inflation target. The last tightening cycle saw long-term inflation expectations plunge. That forced the Fed to rethink its approach toward reaching its goals. In today’s context, this suggests the Fed will move only gradually in the coming years unless long-term inflation expectations soar. Such memories are helping to limit upward long-term yield pressure.

The 2014-16 period has both similarities and large differences vis-à-vis today. The dollar held onto a large real and nominal gain from that period, making a disruptive rise less likely now if the Fed can raise rates only gradually in the coming few years.

One parallel concern is China’s property market, where a downturn has not yet been fully felt throughout its broader economy. Unlike in 2015, however, China’s equity and credit markets significantly discount economic weakness, making a Fed-induced sharp negative reaction less likely.

We expect crude oil to peak in coming months, but its price is unlikely to collapse 65% as it did in 2014-15. That period – one of booming US oil production – drove economic distress in some emerging markets, which is unlikely to repeat.

While we continue to be more overweight US equities than many others, non-US equities never recovered fully in valuation from the impact of Fed tightening and US dollar appreciation in the 2013-17 era. This has improved their relative return prospects for the long-term.

We’ve maintained our 6% overweight in Global Equities and 6% underweight in Fixed Income and Cash. During 2021, we’ve reduced risk assets from a peak overweight of 11%, as we see equity returns in the coming year moderating toward high-single digits. We’ve migrated holdings toward consistent dividend growers and less cyclical areas such as healthcare to drive sustainable long-term returns.

We also remain overweight of some real estate assets after the dislocations of 2020. However, forward-looking yields have moderated. As such, we continue to look at opportunities for optimizing our holdings within fixed income and equities amid changing valuation and growth opportunities. We seek to invest in leading firms within industries whose share of economic output is growing. We also seek to invest in firms that sustainably increase income distributions to shareholders.