Having spent most of 2021 debating inflation and the associated impact on the global economy, monetary policy, and financial markets, many have recently moved their focus to the topic of stagflation.
As a blend of stagnation and inflation, stagflation refers to an economic environment where inflation persists at a high level while economic growth is lower than expected and unemployment remains stubbornly high.
To frame this stagflation concern as simply as possible, inflation has largely been surprising to the upside, while growth has been surprising to the downside.
It represents a vexing problem for policy makers and a noxious backdrop for investors as fears of stagflation have the potential to drive sustained risk aversion in the markets, which will weigh on both beta performance and absolute returns for hedge fund strategies.
Factors including a spike in energy prices and supply constraints that contribute to slowing growth have been taken by investors as a warning to prepare for lasting inflation. The financial press has drawn comparisons to the stagflationary decade of the 1970s.
On top of this, investors point to the dysfunction in Washington on fiscal spending and the potential for another battle over raising the debt ceiling later this year as headwinds for growth in the US, while they nervously eye Chinese regulatory intervention and trouble with leveraged real estate companies in China as structural impediments for economic growth.
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More so than anything derived specifically from data, O’Connor thinks it is these fears of policy mistakes in the US and China that are contributing the economic stagnation concern to existing inflation pressures and allowing investors to conclude that stagflation is on the horizon.
While we should never summarily dismiss any type of risk, especially one as worrisome as stagflation, we think this risk is over-hyped right now and see an environment in the fourth quarter broadly conducive to risk.
Fuller perspective on China growth headwinds
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We believe that investors worried about stagflation are extrapolating recent regulatory intervention by Chinese officials in controlling data usage, pricing controls and business model changes in some industries, and deleveraging of real estate developers and rationalization of real estate price appreciation to conclude that China’s growth will abruptly downshift.
To accept this structurally lower growth case, one would have to believe that China’s policy agenda marks an abandonment of both the entrepreneurial culture and market-oriented reform policies that have driven the unprecedented economic success and political influence that China now enjoys.
Put simply, China is in too strong a fiscal position to accept substantial economic or domestic market disruption, and we believe they will strike the right policy balance, particularly ahead of the 20th National Congress of the Chinese Communist Party coming up next year.
US political dysfunction vs. expectations
While there can be no denying hyper-partisanship and ongoing dysfunction in the US political system, we believe there is simply too much at risk, and significant bipartisan support for bolstering the nation’s infrastructure, for cooler heads to not prevail in getting both the debt ceiling raised as well as a meaningful infrastructure spending bill passed.
More importantly though, all these political theatrics have downgraded economic data expectations for the fourth quarter, which we think sets the stage for positive economic surprises over the coming quarter and in line with traditional seasonality.
We often remind investors that it is hardly ever the absolute economic data that moves markets, but instead it is the economic data relative to expectations that drives risk changes.
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Re-examining market inflation expectations
More so than anything derived specifically from data, we think it is these fears of policy mistakes in the US and China that are contributing the economic stagnation concern to existing inflation pressures and allowing investors to conclude that stagflation is on the horizon
Even though inflation risks are well discounted and understood by not just market participants but also consumers, it is premature to just accept higher inflation as a given. Despite this feeling of consensus around inflation expectations rising and worries about stagflation emerging, we do not see equity markets positioned that way.
In fact, a more fulsome look at economic data points may indicate some relief may be on the horizon.
Expectations vs. reality
In short, in our view for stagflation to become an economic reality, one would have to believe that three distinct conditions will be met:
• Inflation will continue unabated and is unrelated to rebalancing required as we emerge from the COVID crisis globally.
• The political partisanship in the US will prevent both the needed increase in the debt ceiling and any substantial infrastructure spending.
• China’s policy agenda and approach have fundamentally changed and mark an abandonment of both the entrepreneurial culture and market-oriented reforms that have driven the unprecedented economic success and political influence that China now enjoys.
We think these are each unlikely on an individual basis and entirely implausible in aggregate.
Nonetheless, in managing our hedge fund portfolios, O’Connor does not disregard the market’s fear of stagflation, even if we think it’s only temporal. In the short-term, investor psychology and positioning often play as big a role as fundamentals in driving performance.
In the recent past, we saw an immediate, aggressive reaction to markets as the news of the new Omicron Covid-19 variant hit. However, markets recalibrated and settled as the risk was assessed.
We have always kept our hedge fund portfolios liquid to allow us to nimbly adapt to these fast-changing macroeconomic and financial market conditions. We find that ability to respond quickly to short-term market risks and opportunities, without losing perspective on the longer-term corporate finance, economic fundamentals, and capital allocation trends can drive strong financial outcomes.
As 2021 shapes up to be another important year in the ongoing transformation of many hedge funds, we expect these stagflation fears to gradually dissipate and that investors who have been de-risking to guard against that economic environment will find themselves chasing performance and re-risking in this quarter. The broader economic and market landscape also looks set to continue to be one that is broadly conducive for investment and opportunities.
The Covid-19 developments will continue to play havoc with our full return to office, but we are expecting things to be substantially more flexible early in 2022, and the investment teams at O’Connor will be eager to reconnect with each other and continue to execute for investors.
Kevin Russell is chief investment officer and global head of UBS O’Connor, a multi-strategy hedge fund manager within UBS Asset Management.
Photo by m. on Unsplash
