It may be time for mainstream stocks and bonds to give way to real assets.
According to Chris Brightman, CEO and chief investment officer at Research Affiliates, the U.S. economy is probably heading toward stagflation. This means that the capital markets are likely to behave as they did in the early 1980s, when soaring inflation and recession simultaneously dominated the economy.
“If I’m correct, investors will wish to reposition portfolios to protect the real value of their financial capital,” Brightman wrote in a blog post. “They [can] reduce exposure to equity beta and nominal duration by selling mainstream stocks and bonds in favor of commodities and real assets, whose prices have historically risen in response to rising inflation.”
He added that in a stagflation scenario, investors should rotate from growth stocks into value stocks, because the former rely more on future earnings. Lower-duration assets, such as value stocks, will provide better protection against rising prices and dimming economic prospects. In fact, value already beat growth by 8.8 percent in the first quarter. Brightman wrote that investors should also swap their nominal bonds into inflation-protected securities, such as TIPS.
Brightman laid out why he believes stagflation will strike the U.S. economy. For one, he predicted that there is at least a 50 percent chance that the central bank will “fail to get inflation under control soon.” The consumer price index is running at a 40-year high of 8.5 percent, but the Federal Funds rate is hovering around a mere 3 percent. Gross domestic product will also likely shrink further by the end of 2023. In fact, many allocators are already investing like they don't believe in the Fed’s promise of a soft landing.
Brightman wrote that there’s at least a one-in-three chance that both events — high inflation and a recession — will occur, creating the perfect conditions for stagflation. “In this scenario, both stock and bond prices will suffer,” he wrote.
Zhiwei Ren, portfolio manager at $34 billion Penn Mutual Asset Management, agreed that stagflation is a very possible scenario for the U.S. economy. Inflation will persist for a while, he said, especially given rising labor costs. “It’s a constant struggle for employers to hire and retain people,” he told II. “I think this is going to put [a lot of] bargaining power in employees’ hands. Everyone is talking about high inflation, so when people jump ship, they [want] bigger raises.” The asset management industry itself, for example, is facing challenges in talent retention.
Ren added that assets can be categorized into “deflation assets” and “inflation assets,” based on how they respond to changes in consumer prices. Assets in the former category — including technology stocks and long-duration bonds — generate better returns in a deflationary or low-inflation environment. In contrast, those in the latter group — commodities, energy stocks, value equities, and real assets, for example — respond better to inflation.
“Because growth stocks have done so well [over the last 10 years], there was [a lot of] money in deflation assets,” he said. “But if stagflation happens, I think money will move [in] the opposite direction.”