Carnegie’s global outlook following the pandemic

The stock market upturn has been impressive, but there is no lack of threats to corporate profits. In the meantime, stimulus programmes are being withdrawn. Which is more important – the pace or the direction?

The Federal Reserve building, Washington, US
The Federal Reserve building, Washington, US 

Inflation is here, and higher than expected. Inflation-proof the portfolio with real assets, banks, robotification and companies with pricing power: they are the likely winners in an environment of higher cost pressure.

Growth in the world economy has peaked, we are approaching the apex of central bank liquidity injections and COVID-19 is still an uncertainty factor. Investors are moving into rougher terrain. Growth should remain above trend and is more likely to be subdued by supply issues than demand factors. The semiconductor famine is still ongoing, freight costs are sky-high, companies are having a hard time finding workers, and wages are accelerating.

Demand is likely to hold up, supported by budget stimulus packages, corporate investments and recovery in the service sector. On the other hand, the tax take on capital gains and labour has begun to rise in the UK and (soon) in the US. Growth is subsiding in China; the country is wrestling with over-indebtedness in the property sector and we have recently been hearing surprisingly harsh rebukes of business. Large central banks are easing up on the liquidity pedal, while smaller ones are already raising their reference rates. The stock market has taken this with equanimity thus far – a tapering without a tantrum. The economic impact of the pandemic will be determined by the race between vaccines and virus variants.

Hot stock and bond markets are probably approaching a correction phase. The risk of rising long rates in the US is intensifying since Congress has agreed to raise the debt ceiling and the Fed is putting the brakes on its asset purchases. The central banks’ toolbox is orientated towards the demand side, and eliminating labour supply bottlenecks is getting trickier.

Returns can still be found through stock-picking companies that can set their own prices and are not exposed to risks in unpredictable supply chains. Profits recovered dramatically in 2021 and persistent (single-digit) profit growth in 2022 is entirely possible in the light of issued economic growth projections. The virus is still generating uncertainty with Americans and Europeans heading indoors as winter approaches. High stock valuations and investor optimism imply significant risk of disappointments.

Carnegie Private Banking pocketed profits and reduced its overweight towards equities – at which point Nasdaq Stockholm had risen by about 30 percent this year. Other attractive investment opportunities are scarce in an environment characterised by minimal bond rates, low credit spreads and higher inflation. In ‘the return of inflation’ section, later in this article, we analyse these challenges and present a few investments in real assets.

The return of inflation increases incentives to protect assets against higher inflation. This favours real assets, including real estate and infrastructure, along with companies that can pass on rising costs to the end customer. Exposure to energy commodities and base metals is also of interest.

Is the positive scenario intact?
Basically, several of the positive drivers are still in play. The economy is chugging along nicely and a lot of curves are pointing upwards. The year 2021 is looking like it will be very good from a growth perspective and the signs are also positive for the outlooks in 2022. Listed company profits are thus expected to grow next year as well. Still, we cannot get away from the fact that profit and macroeconomic momentum have probably peaked, meaning the acceleration rate is likely to slow. The reasons are that expectations have risen during the year and there should not be the same pent-up need for many goods and services next year. The stock market thrives when data outcomes are better than expected and forecasts can be revised upwards.

We are seeing a similar pattern when it comes to stimulus packages. The central banks, with the US Fed leading the pack, are continuing to make the financial markets happy with liquidity, but that notwithstanding, the plan is to gradually slow the pace. The pundits are writing at great length about how this tapering is supposed to be a threat to the stock market, but we can count on the banks to move very cautiously to avoid unwanted market turbulence. However, we cannot ignore that the next step is likely to be incremental reductions of the liquidity injections, and thus a little less of the good stuff. The fact that we have reached a peak in our base scenario regarding growth, the profit growth rate and liquidity makes us a bit more careful heading into the autumn and winter. If we also consider that the stock market is relatively highly valued and there have been no major corrections since October 2020, a vague sense of unease creeps in. Some investors have no doubt had enough time to get used to the pace over the last year and have begun to underestimate the risks of equity investments.

China: A new cause for concern
There are other factors clouding the picture right now. The trend in China is often difficult to read. At present, we are witnessing some kind of economic slowdown combined with stricter regulations on certain industries and companies. China has been a key growth engine for the global economy, and if the country’s economy were to slow down more permanently, that would, by extension, mean problems for many other regions. Governments usually launch various stimulus packages as soon as the economy shows signs of weakening, but China is now aiming to curtail the economic significance of the real estate sector.

Downshifting before a bump
Our positive view on the stock market during the year was based on a strong economic trend, rising profits and massive liquidity injections trumping high valuations, certain bubble tendencies, inflation risks and the commonly moderate returns in the summer months of the year. We are now becoming a little more cautious, simply because we believe we have passed the peak and that risk/reward will be slightly poorer from here on out, meaning that the potential for further upturns is not much greater than for corrections. It should be noted, however, that we are not averse to equities.

2021 is looking like it will be very good from a growth perspective and the signs are also positive for the outlooks in 2022

Carnegie Private Banking is maintaining a small overweight against foreign equities. The reason is that the low interest rate level is still providing strong support for share prices. There is no doubt that TINA (there is no alternative) still applies. Although we can trace some upwards pressure on interest rates in the autumn, it would take fairly large upturns for this to be a problem. As we see it, the biggest risk over the next year is that the central banks will misstep in the tapering process, resulting in turbulence in the fixed income market.

We have placed the cash we freed up by lowering the equity weight in alternative investments. We still prefer this asset class over fixed income investments. Our forecast for rising rates combined with low credit spreads in corporate bonds indicates limited return potential going forward and this curbs our enthusiasm. Nevertheless, fixed income instruments serve a certain function as diversification in a well-diversified portfolio. We see somewhat better potential for return in alternative investments, where our uncorrelated strategies have worked well in the past year.

The return of inflation
Inflation is here – higher than expected and perhaps not as transitory as the central banks believe it will be. The US inflation rate has settled at an annual rate above five percent since May and inflation in the eurozone stepped up to three percent in August. At present, the inflation rate in Sweden is almost 2.5 percent.

US President, Joe Biden

The central banks have been trying to counter low inflation and growth since the financial crisis of 2008 by setting low and sometimes negative rates. In the past, holdings of cash and short nominal government bonds have been key instruments for managing risk and have produced positive real return. Today, such exposures cause a loss in purchasing power.

Regardless of whether or not inflation is here to stay, the central banks’ ‘kidnapping’ of nominal bonds makes asset allocation even more challenging. How should equity risk be balanced without digging into capital? Inflation-adjusted bonds have not been much help either because real interest rates have been low, often negative. There are, however, several indirect ways to protect capital against higher inflation. In our alternative portfolio, we are increasing the exposure to real assets including real estate and infrastructure. On the stock exchange, inflation can benefit certain sectors with pricing power, rising wages can work in the favour of companies in robotification, and bank stocks are likely winners if inflation results in rising interest rates.

Navigating in the rear-view mirror
Central banks in the western world believe the current rise in inflation is temporary, without saying how long ‘temporary’ is. The Fed has been trying to nudge inflation upwards for decades. Along the way, it has also changed the inflation measure from the consumer price index (CPI) to the personal consumption expenditure (PCE) deflator. The calculation of housing costs has also been changed. Since 2020, the Fed has changed its policy from the inflation target of two percent to average inflation targeting of two percent.

The biggest risk over the next year is that the central banks will misstep in the tapering process, resulting in turbulence in the fixed income market

The ECB also changed its policy as of this year and now follows a symmetrical inflation target of two percent, where the bank accepts up and down deviations. The aim of the new Fed and ECB inflation targets is for inflation to exceed the target for a period to compensate for earlier shortfalls. In addition, both central banks have purchased even more securities in response to the liquidity shortfall that followed the pandemic. This time, they did not buy only government bonds, but also bought housing bonds. The ECB and the Riksbank have also purchased corporate bonds.


Three winners in the face of higher inflation
1) Pricing power: Companies with a monopolistic position, less price-sensitive goods or a market-leading position are winners. When materials and purchasing costs rise in industry and consumer durables, the winners are the companies that can pass on these costs to the end customer.

2) The financial sector: Banks usually benefit in an environment of rising inflation and rising interest rates, especially when the interest curve gets steeper. Net interest income increases when the banks raise their lending rates. The banks are also interesting right now because they are raising dividends, which can compensate for higher inflation.

3) Robotification: Companies in automation and robotification are the winners when there are cost increases related to labour shortages (as we are now seeing in the US and China). This applies particularly when compared to labour-intensive manufacturing companies.


The support purchase programmes have reduced the supply and driven up the prices of government bonds, which has made investors look increasingly further out on the risk and reward curve. This has resulted in a lowering of the entire yield curve, which has lowered the discount factor for standardised valuation models and thereby contributed to the inflation we have seen in risk assets (especially in growth companies) over the past 10 years. The Fed has explicitly stated that the bank is now acting based on outcomes and not projections – reactively instead of proactively, in other words. Navigating by what can be seen in the rear-view mirror implies a risk that the Fed will react too late, when higher inflation has already become entrenched.

Deglobalisation and demographics
Inflation has fallen over the past 30 years in pace with rising globalisation as well as technological progress and digitalisation. It is hard to say whether these factors will become less counter-inflationary going forward, but globalisation is now taking a few steps back, not least due to chilly relations between the US and China. Global supply chains are being renationalised – including for subsidy reasons, like when US President Joe Biden’s electric vehicle initiatives focus on ‘all-American electric cars.’

Some also believe that the demographic effects of ageing populations have moderated inflation, as in the case of Japan’s ‘lost decade’ of deflation. Here as well, we are seeing a change. An increasingly older population can cause labour shortages and drive up inflation if automation and productivity do not increase to a corresponding extent.

China, which has added millions of workers to the total global workforce over the past 30 years, is one example. The country’s one-child policy was formally repealed in 2016 and three children are now accepted. But the labour supply is shrinking dramatically and the threat of moving production to China is not going to relieve wage pressure in the western world like it used to.

Major virus effects – but more than that
An analysis of the CPI in the US shows that the latest price increases have been driven mainly by Covid-sensitive goods. If the vaccination programmes also help global supply chains recover, there may be justification for the belief that the current increase in the inflation rate is only a temporary supply shock.

In our alternative portfolio, we are increasing the exposure to real assets including real estate and infrastructure

But a lot of things are getting more expensive and, even excluding pandemic-driven price hikes, US inflation is already above two percent. Energy prices and wage growth are both accelerating. The latter is problematic because wages are significantly more resilient on the downside than commodity prices. There is risk that trade barriers and reduced globalisation combined with expansionary monetary policy will raise the structural inflation rate.

The pandemic: a reflationary crisis
Crises have often been deflationary over the past 40 years. They have been of a financial nature, where bubbles have arisen in asset prices that later burst – such as the financial crisis in Japan, the Swedish banking crisis, the dotcom crash and the financial crisis of 2008. Inflation has often been pushed down due to weak demand when household and business indebtedness have been reduced.

Developments during the pandemic were not caused by economic imbalances. The pandemic has affected the supply side by impacting supply chains and freight prices, causing a component shortage and forcing production shutdowns. Demand has been stimulated by major financial and monetary policy support, which is why the pandemic has instead had a reflationary effect.

Finance Minister of Sweden, Magdalena Andersson

Four causes of inflation
Different asset classes are helped or hindered by inflation to varying degrees. The drivers underlying the inflation are the critical factors. We primarily see four separate (but closely interlinked) inflationary factors:

1. Supply of goods and services:
Controlled by the costs of taking goods to market. A supply-driven inflation shock may be due to wage growth or price increases in constituent goods, such as base metals or oil – there was runaway inflation in the 1970s in the wake of the oil crisis. Technological advances that make goods and production cheaper and more efficient help lower inflation – the chip manufacturing and robotification of the past 30 years, for example.

2. Demand for goods and services:
Controlled by individuals’ needs, budgets and willingness to pay. Inflation is often driven by demand outstripping supply, which sometimes takes time to increase – by building housing, for one such example. An expansionary monetary and fiscal policy has increased demand for housing, primarily in the US, where house prices are up 20 percent on an annual basis (Sweden: 13 percent). Price upturns of nearly 10 percent have been recorded for the OECD as a whole.

3. Money supply:
American economist Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon.” In a nutshell, this means that prices, and economic activity by extension, are directly proportional to the supply of money in circulation. This was the basis for how former Fed chair Paul Volcker chose to deal with the runaway inflation of the 1980s: by suddenly hiking the benchmark interest rate to reduce the money supply.

4. Expectations:
Americans were persuaded that the Fed was willing to take all necessary measures to get the price trend under control, which was critical to Volcker’s success. If households and businesses expect prices to be higher in a year’s time, they plan their finances accordingly by either bringing forward or postponing certain consumption and investment decisions. Wage earners who believe prices are going to go up demand higher wages to keep as much of their purchasing power as possible.


A better climate comes at a price
Greenflation refers to higher costs due to climate action. Some believe the oil price may remain high for a long time due to strong political resistance to new extraction of oil. Demand and prices for aluminium and copper, the two most important metals for electrification and green transition, have risen sharply. New extraction of these metals has impact on the environment, which can trigger protests from environmental groups and government intervention. Mines in Alaska and smelting plants in China (which produces 60 percent of all the aluminium in the world) have been forced to shut down or limit production. The prices of natural gas and electricity are currently exploding in Europe – before the arrival of winter. One reason is that Europe has scrapped coal power and shut down nuclear power plants and renewable energy is not meeting demand. Emission allowances have surged. Russia has cut its gas exports to Europe – the Russians might need the gas for themselves, or they might be aiming to hasten the opening of the Nord Stream gas pipeline that runs between Russia and Germany.


Inflationary environment investments
We have actually not seen a lot of inflation in central bank measurements since the financial crisis, but we have seen enormous asset price inflation, including in real estate, equities and, above all, bonds. Although there is little to suggest that consumer inflation is going to skyrocket to 1970s levels, more investors and managers are presumably abandoning the view that inflation is ‘extinct’ or ‘dead.’ For the first time in a very long time, we can expect somewhat higher inflation in the next few years.

The central banks are presently indicating that they will begin dismantling the current support purchase plans this year and might begin raising interest rates somewhat in 2023. This will have varying impact on asset prices.

Cash and long nominal bonds are called ‘junk investments’ by some because they reduce the holder’s purchasing power, but should, as in the past, be more resilient in the face of a possible major stock market downturn.

Natural resources and commodities: Inflation often goes hand-in-hand with rising commodity prices. The best protection is found in commodities such as energy commodities (oil and natural gas) and base metals (steel, copper, aluminium). Broad exposure to commodities also protects against inflation. The exposure can be obtained through both broad-based and niched ETFs, but also through certain specialised hedge funds.

Commodity producers: Producers of commodities and materials, such as mining and energy companies, benefit from higher commodity prices – they profit immediately when the goods they sell get more expensive. Exposure is obtained via individual equities or sector ETFs.

Real estate: Directly owned real estate has historically provided good protection against rising inflation. Higher prices for building materials increase the building replacement cost and makes it more difficult for new supply to reach the market. Higher inflation thus makes existing properties more attractive. Real estate assets with long leases, such as commercial office and industrial properties, are often automatically adjusted for inflation. There is some sluggishness in residential properties, but a certain level of protection against inflation is achieved as long as rents are regularly renegotiated. Higher interest rates are a risk for properties with a high loan-to-value ratio, but property owners with long-term loans at fixed rates run less interest rate risk. Nominal loans can also be repaid using ‘inflated’ money (SEK). As long as interest rates do not rise too quickly, real estate should provide good protection against inflation in general. Exposure to real estate is obtained by purchasing shares in property companies. Directly owned real estate provides more direct protection against inflation, but it is more difficult for private individuals to obtain exposure here.

There is risk that trade barriers and reduced globalisation combined with expansionary monetary policy will raise the structural inflation rate

Infrastructure: Infrastructure assets share many inflation-proofing characteristics with real estate assets, such as value growth through higher replacement costs, but also higher income from their utilisation. For example, through government regulation, electricity networks have built-in inflation and interest rate components in their pricing structures. Infrastructure assets are even more difficult for investors to obtain exposure to – it is easier to buy a rental property than it is to buy an electricity network.

Alternative strategies for managers who do not exclusively invest in the traditional asset classes (equities and fixed income securities) should have equally good chances to generate returns regardless of whether inflation is high or low. Global macro strategies, for example, can take both short and long exposure in fixed income investments, currencies and commodities. Relative value strategies, which exploit mispricing among the same or similar assets and are not dependent on price changes, are another alternative.