Stock markets look forward. Investors do not base their decisions on how they think the global economy is performing today, but where it will be in nine months or so.
That explains why equities did so well in 2020, with the MSCI World Index ending the year up 15.9 per cent despite the chaos inflicted by Covid-19.
Investors were looking beyond the pandemic to when the coronavirus is beaten and the global economy is firing on all cylinders again.
They continue to keep their eyes on the horizon, even as mutant strains of Covid-19 force another wave of lockdowns, and vaccine rollout programmes suffer early teething problems. So what do they see there? The return of inflation.
That may seem ridiculous today, with price growth stagnant and interest rates negative in many countries. Inflation remains stubbornly low at just 1.17 per cent in the US and 0.6 per cent in the UK, while in the eurozone it is negative at -0.3 per cent.
That is still well below central bankers’ target rates of 2 per cent, but if those vaccines work then watch out, things might just take off.
Central bankers and politicians have injected jet fuel into the financial system via trillions of dollars worth of fiscal and monetary stimulus. If vaccines bring us closer to herd immunity and liberated consumers spend their pent-up savings, it could catch fire.
Peter Garnry, head of equity strategy at Saxo Bank, says there is another reason why inflation may be about to make a comeback.
You could call it reverse globalisation.
For the past 30 or 40 years, globalisation has squeezed price and wage growth, as China and other emerging countries flooded global markets with cheap goods and plentiful labour.
Mr Garnry says the trend started to reverse before the pandemic, as US President Donald Trump launched a trade war with China that was designed to support its growing economic power and bring manufacturing back to the US rustbelt.
This process, known as reshoring, has been accelerated by the pandemic, which has disrupted global supply chains and encouraged companies to bring manufacturing back home to mitigate risks.
Mr Garnry says globalisation brought 40 years of lower prices and higher company profit margins. “This trend has run out of steam and the world will now see higher inflation as a result.”
This would mark a radical change after decades of deflation and turn the financial world upside down.
There’s another reason why inflation could soon have its day. Politicians and central bankers will welcome it. It may be their only option to erode the record-breaking debts countries have built up during the pandemic.
Total US debt has now spiralled to around $19 trillion, roughly the same size as the nation’s gross domestic product, while China has a debt-to-GDP ratio of 250 per cent.
Kristina Hooper, chief global market strategist at fund manager Invesco, says the US has been here before. “It was able to dramatically reduce high debt-to-GDP levels through inflation in the 1960s and 1970s.”
Chaddy Kirbaj, vice director at Swissquote Bank in Dubai, says inflation is coming, just not yet. “Today’s loose monetary and fiscal policy will continue until the economic recovery is sustainable and inflation finally makes a comeback.”
It is currently held in check by the suspension of normal economic activity, with “trade, logistics, tourism and consumer spending” on hold, he says.
Mr Kirbaj says that may not last. “I am optimistic and cautiously bullish about the global economy in 2021, and this could trigger higher inflation in China and the US.”
President-elect Joe Biden now has control of the US Senate, after the Democratic Party’s victories in the two Georgia run-offs, and analysts say this should free him to inject further stimulus into the US economy.
That should also drive growth and inflation.
So what does all this mean for your money?
Mr Garnry says a reflationary environment favours shares over bonds. “We believe investors should tilt towards emerging markets, and consider European equities if the continent can roll out the vaccine fast enough.”
US technology stocks may underperform after years of runaway success, especially if Mr Biden slaps new regulations on Big Tech, he adds.
Guy Foster, chief strategist at wealth manager Brewin Dolphin, also expects US tech to underperform, along with government bonds and the US dollar.
By contrast, smaller companies should do well, as will commodity prices, gold and inflation-linked bonds, Mr Foster says, as these protect the value of investors’ wealth from the eroding impact of inflation.
Mr Kirbaj suggests investors target stocks in sectors such as Chinese consumption, retail demand, renewable energy and e-mobility, the umbrella term for electric and hydrogen-fuelled vehicles, and driverless cars.
Property could go either way. Real estate is often seen as a protection against inflation, but Mr Kirbaj warns that after years of rising house prices, the sector holds “considerable risk if the recovery doesn’t materialise in 2021”.
Ms Hooper also has mixed views. “Higher inflation should also be positive for real estate, so long as interest rates remain relatively low.”
She expects the post-Covid-19 recovery to favour cyclical stocks, commodities and emerging markets.
Vijay Valecha, chief investment officer at Century Financial in Dubai, says the reflation trade is already under way as long-term US inflation expectations pick up and Mr Biden’s stimulus programmes will accelerate that.
Investors can play this by investing in low-cost exchange-traded funds targeting equities. “The reflation trade should be bullish for iShares US Infrastructure ETF, as Mr Biden’s latest stimulus package should boost infrastructure funding,” he says.
Mr Valecha says higher inflation should eventually push up interest rates and this will boost financial service companies, as they can take advantage by increasing their net interest margins, the difference between what they pay savers and charge borrowers.
Investors could invest in that trend with the Financial Select Sector SPDR Fund, which invests in US financial services companies, Mr Valecha says.
Most analysts expect 2021 to be a tough year for the US dollar, including Ugo Lancioni, head of global currency at fund manager Neuberger Berman. “Growing confidence in the recovery will reduce the dollar’s safe-haven premium and bring the currency’s value into line with its low yield. Shorting the US dollar is the most consensus trade I can remember for a long time.”
This would be bad news for UAE expats and residents with overseas commitments, as their dollar-linked dirhams will fall in value relative to other countries.
Mr Lancioni believes that emerging market currencies could rise further, along with emerging market equities and bonds.
“We have upgraded our view on the euro, given its positive gearing to global economic activity and the recent clarity on both Brexit and the European Union’s common budgetary response to the coronavirus crisis.”
Mr Lancioni also like commodities. “They have lagged the weaker US dollar so far, and have room to appreciate even before inflation rises.”
Mr Valecha also expects energy and commodity prices to continue their recovery, and tips iShares Global Energy ETF and Invesco DB Commodity Index Tracking Fund as a way to benefit.
He says the weaker US dollar is bullish for large US companies that derive most of their sales from the rest of the world. Schwab US Large-Cap Growth ETF (SCHG) and Vanguard Large-Cap ETF (VV) are a good way to play this trend, Mr Valecha says.
Inflation isn’t here yet, but it is coming.
Emerging markets, financials, green energy and commodities look set to be the major beneficiaries. Gold and property may rise, too.
The outlook for cash remains as grim as ever. Politicians and central bankers may be willing to let inflation run wild for a time, rather than rein it back in with higher interest rates. Some things just don’t change.