How Investors Are Preparing for Rising Inflation

Inflation Trends and Drivers

• Recent market indicators signal a shift from the deflation observed in March 2020 to budding reflation:
  • The trade-weighted dollar has declined 11% since March.
  • Broad commodity indices have surged 33%.
  • 10-year interest rates have doubled.
  • Market-implied future inflation expectations have risen from 0.5% to over 2%.
• Key catalysts for sustained inflation in 2021 include:
  • The distribution of credible vaccines (including a potential Johnson & Johnson option within 10 days), which may trigger pent-up demand and growth exceeding expectations.
  • The unified U.S. government following the Georgia runoff, projecting higher fiscal spending.
  • A potential $750 billion fiscal package early in the Biden administration, representing 3.4% of GDP.
  • The Federal Reserve's shift to a "flexible average inflation target," allowing rates to stay lower longer to average 2% over time even if short-term inflation exceeds the target.

Investment Strategy and Asset Allocation

• Investors are increasingly seeking inflation hedges, with equities identified as a primary asset class suitable for rising inflation environments, particularly when starting from low levels.
• Market rotation is shifting away from the "low beta" and long-duration cash flow strategies favored over the last decade toward:
  • Small-cap and high-beta stocks.
  • Value-oriented stocks reliant on near-term cash flows.
  • Companies with real assets and high leverage, as inflation erodes the real value of debt.
• Large-cap technology stocks remain a core holding but face relative underperformance compared to other sectors:
  • The five largest tech companies have outperformed the broader market by 354% over the past decade.
  • The NASDAQ is projected to grow 16% in 2021, significantly lower than the expected growth of other indices.
  • The Russell 2000 small-cap index is expected to grow eight times faster than the NASDAQ in 2021.
• Despite the rotation, investors are not abandoning tech due to solid fundamentals, but rather diversifying into new cyclical opportunities that were previously scarce.

Additional Strategic Themes for 2021

• Reopening: The travel and leisure sector is positioned for a surge in demand as competition has diminished and pent-up consumer demand accumulates following over a year of restrictions.
• Renewables: The potential passage of Biden's $2 trillion climate package creates market opportunities within a sector currently characterized by low market capitalizations.
• Emerging Markets: Macro conditions including higher commodity prices, an accommodating Federal Reserve, and inflation trends are viewed as supportive for growth across Latin America, Asia, and SME (Small/Medium Enterprises) in emerging markets.