Inflation and rotation: Investors must prepare for a recession

While there are signs that inflation may be starting to cool after reaching a 40-year high in May,[1] there is a broad consensus that rising prices will be with us for some time. U.S. Treasury Secretary Janet Yellen recently acknowledged that she had been mistaken in previously describing inflation as “transitory.”

Yellen and many others had not anticipated that Covid-19’s lingering effects on supply chains would be exacerbated by the ongoing impact of the war in Ukraine on food and energy prices. In this new reality, the World Bank is warning of a heightened risk of global “stagflation” – a term that became prominent in the 1970s to describe a period of high inflation accompanied by weak or negative growth.

There is some cause for optimism. The U.S. core personal consumption expenditures (PCE) price index – which excludes volatile food and energy prices to give a clearer indication of persistent price pressures – moderated in March and April after peaking in February. Most economists expect inflation to remain elevated for a while, though, and certainly considerably higher than the 1.5% to 2% range that had become normal before the pandemic.[2]

Importantly, there are broader factors contributing to persistent price pressures than the post-pandemic rebound in consumption and supply chain glitches.[3] First is the reversal of globalization amid rising tariffs and efforts to diversify supply chains, which has made imports more expensive. Second is the fact that the working-age population in China – often described as the world’s factory – has been shrinking steadily since 2011 as the country’s population ages.[4] Third are the costs associated with the transition to net zero emissions as the world seeks to limit climate change. Finally, in the U.S. in particular, a housing shortage is also pushing up prices.

Inflation opportunity

These factors are fanning the flames of persistent inflation, which is fuelling expectations of sharper interest rate hikes.[5] That, in turn, has increased the likelihood of recession. The U.S. Federal Reserve puts the probability of a recession over the next four quarters at slightly more than 50%.[6] And 70% of economists polled by the Financial Times and the University of Chicago Booth School of Business said a recession would strike by 2023.[7]

But these same inflationary factors also provide clues as to how investors might adjust their portfolios to weather that increasingly likely economic downturn.

The quest for supply chain resilience and China’s declining labor force, for instance, could be an opportunity for Vietnam and other Southeast Asian nations to pick up China’s slack.

Suppliers of healthcare as well as technology that enhances workforce productivity also stand to benefit from the broader trend towards aging populations. And though traditional energy stocks may have performed well over the past year while clean energy plays have declined in tandem with the growth stocks more broadly, that may give way to a resurgence of investment in renewables as the focus on climate goals recovers.

Other sectors traditionally viewed as resistant to inflation include dividend-paying utilities along with consumer staples, discount retailers and the logistics companies that serve them. Banks, mortgage lenders and insurance companies may also profit from rising interest rates.

Investors may also be tempted to increase their exposure to private real estate, betting on long-term demand for bricks and mortar as a hedge against inflation. But that comes with the caveat that mortgages are becoming more expensive, increasing the chances of a housing market correction.

Taking a broader, longer view

Moreover, investors may take this opportunity to reconsider geographical diversification. To be sure, where the US economy goes, much of the rest of the world follows, and the World Bank has adjusted its growth expectations across the board. But economies in Southeast Asia, South Asia, the Middle East and North Africa are still expected to register fairly robust growth in 2022 and 2023.[8]

Whatever an investors’ current positions, it often pays to take the long view and remain invested during downturns rather than selling and returning to the market at some point in the future.[9]

Securities-backed financing can offer an efficient and cost-effective way for investors to diversify their exposures in a changed environment while retaining the upside potential of their core holdings. Borrowing at a low and fixed cost can also be an attractive strategy in an inflationary environment, as borrowers repay less in real terms.

Today’s inflationary environment and the looming prospect of a recession certainly increases risks, but nimble investors can also identify undervalued assets – whether in equity markets or elsewhere – during times of dislocation. Securities-backed financing can help sophisticated investors capitalise on those opportunities.











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