BNP AM

The official blog of BNP Paribas Asset Management

Edward Lees
2 AUTHORS · Investing
24/05/2021 · 10 min read

Our thoughts on inflation – And why we just don’t buy it!

In our view, in the wake of the sell-off and reset in valuations for environmental sector stocks in the first half of the year, the fundamentals have never looked more attractive.

  • Our strategy involves a pure play environmental thematic approach, with an all-cap universe and no constraints.
  • As an investment team, we have over 20 years of experience in investing thematically together with high level of industry / technology knowledge.
  • Today, we see inflation expectations as well anchored. We argue that any rise in inflation will be temporary, paving the way for ‘lower for longer’ on interest rates.
  • In bond markets, 10-year breakeven spreads have fallen significantly over the last three days (from 2.60% to 2.45%). Being overweight US Treasury inflation-protected securities (TIPS) is, we believe, an extremely crowded trade. We expect it to significantly overshoot to the downside, which would see growth squeeze higher, everything else being equal.

Why are the fundamentals so attractive?

The sell-off earlier this year has effectively reset valuations. The price-to-earnings-to-growth ration of 0.57x for the universe of environmental stocks we invest in (with a 3-year CAGR earnings-per-share of 63.5%) compares to 1.91 and a 3-year CAGR earnings-per-share rate at 39.7% for the tech-heavy NASDAQ index.

We see pure environmental equities in wind, solar, hydrogen, electric vehicles (EV) and battery storage as under-owned. This creates, in our opinion, an asymmetric risk to the upside. Many potential investors cannot hold these stocks due to restrictions on capitalisation and/or systematic screening that fails to capture these companies.

In what respect is our strategy a pure play?

We invest in companies with environmental solutions/products and services – we do not invest in technology, financial, healthcare or retail companies with a low carbon footprint, but doing little for the environment.

Why do we have a contrarian view on inflation from here?

We see inflation expectations as well anchored currently. We would argue that the evidence suggests any rise will be temporary and pave the way for a ‘lower for longer’ world for interest rates.

The services component is large in the US consumer price index (CPI) and the sector is very price competitive.

We do not accept the idea of a new commodities 'super cycle' just because commodity prices are trading close to the highs of the 2000-2010 infrastructure boom in China. Restocking and double bookings for building inventories is, in our view, the driver of these valuations. It is not a case of structurally higher input cost pressure.

We believe there is still plenty of slack in the US labour market with little evidence of wage inflation.

Why do we see the rise in US breakeven spreads as overdone?

The trading around yesterday’s (20 May 2021) TIPS auction was, in our view, weak. This supports our argument below that the inflation trade has now 'travelled and arrived at the destination.' For us, this is the end of the line for breakevens.

Environmental stocks have been particularly vulnerable – and by far the hardest hit sector – when it comes to the reflation trade. We believe this is about to change …a whole lot.

Dislocation

Let us start with one of the most ‘unsustainable’ investing observations we have experienced for some time. The world’s largest environmental ETF with assets under management of USD 12 billion, the iShares Clean Energy ETF, started its life in 2008. In first quarter 2021, it hit an all-time record – the largest quarterly underperformance of this ETF on record relative to the USD 24 billion Energy Select Sector SPDR Fund.

In other words, stranded (energy) assets have just outperformed the transition (clean energy) economy by 43%. So far in second quarter of 2021, we are witnessing the second biggest quarterly underperformance of iShares Clean Energy relative to Energy Select Sector SPDR in history at - 20%. Yes, you guessed it, the biggest underperformance EVER over two consecutive quarters!

And this has all happened amid supportive policy commitments in the form of the Biden Infrastructure Plan, the US rejoining the Paris Climate Agreement, multiple announcements of net-zero commitments and accelerated timelines, with India recently joining in.

In addition there have been announcements of US regulatory support with extended tax incentives for wind, solar, storage, and carbon prices hitting all-time highs.

No surprise there, but the market bears remind us that when the market gets caught up in negative sentiment, investors find it hard to see the wood for the the trees. In other words, we think they risk focusing on the wrong things.

We have written at length about the outlook for the green economy. And about the companies whose business model it is to deliver environmental solutions to enable the energy transition and restore ecosystems. Our views on that subject are not the purpose of this post.

So why has this dislocation happened in environmental stocks?

Well, a perfect storm was created by:

(1) Elevated passive investor positioning in environmental stocks from December 20 through January 2021.

(2) ETF rebalancing creating havoc; but mostly it comes down to one thing…and that is inflation or rather the fear it is about to make a major comeback.

So, if we can crack the inflation debate, we can understand the future trajectory of the stock market valuations of the companies in the environmental solutions universe…

Firstly, I don’t know about you, but the vast majority of research and commentary we see is pushing inflation-is-back (and you-need-a-hedge) like never before - literally. According to our estimates, the monthly story count is the highest in 10 years.

Much has been written about inflation. The consensus on Wall (and the High) Street today is that inflation will not only overshoot as the US economy reopens, but will be structurally higher due to a 'commodities super-cycle' in conjunction with a tight labour market while there is little slack in the economy, meaning prices and wages must increase.

We do not believe higher structural inflation is ahead

Let’s start with US Federal Reserve Governor Lael Brainard, who has said that officials should be 'patient though the transitory surge.' Fed chair Jay Powell has made the same argument. While policymakers expect the Fed’s preferred measure of inflation to rise to around 2.4% this year, they forecast it will return to the Fed's 2% goal in 2022.

The huge increase in the number of participants seeking to hedge inflation risk through TIPS is a key issue for the market. These new investors relish the carry they are currently making given the market reaction to headline inflation news and this encourages others to join in.

However, as we get through summer, and if as we expect US headline inflation falls back, the going will get tougher for these investors. How they react will be critical to determining the level of breakeven inflation spreads.

We see a high chance of an overshoot on the way down as holders panic.

What about the substantially higher US CPI and PPI releases?

We had expected nothing else than a number that would imply a wide range of uncertainty and will continue to do so during the reopening phase of economies globally. However, the headline number gives little information. Insight is needed into what drove the higher CPI print. This means diving into (1) services and; (2) goods

1. Services: Indeed, 60% of the month-over-month increase in the headline number was comprised of just five components - used cars, rental cars, lodging, airfares, and food away from home. These items are indeed very much transient in nature and hence will NOT contribute to structurally higher inflation. Services companies are in a much stronger position to extract higher prices in 2021 than they were in 2019 as citizens are desperate to go out for dinners, trips and experiences. But the barrier-to-entry into the service business is low, so super-normal pricing should rapidly see new competition and drive down inflation in 2022/23. The impact of rising rents is a another key risk to inflation as this has a high multiplier effect in year 1 and in all future years (whereas an oil-price driven spike is not carried forward to future years). However, with work-from-home being more of a norm, we don’t see this as a real risk. Indeed, rents might be a deflationary risk.

2. Goods: This is where there is more divided opinion. Some argue for the emergence of a new commodities super-cycle. We remain sceptical and think price rises are down to bottlenecks. Here, the most talked-about commodity is copper.

Consider these points:

  • According to research from UBS, EV and renewables will add circa 6.5 metric tonnes of new demand for copper over the next decade. That would constitute around 25% of global demand (relative to 5% today), but most of that comes closer to 2030. Demand from China's electricity grid rollout and construction is likely to fall from 30% of current demand to much lower levels as household formation slows. China currently comprises 60% of copper demand and is growing at 8% per annum, whereas the US/EU accounts for 25% and is growing at best at 1%.Even stimulus from the rest of the world and a COVID-19 recovery are not going to move the dial on overall demand growth. US/EU stimulus is never overly copper intensive – if every petrol station in the US had an EV super charger, it still wouldn't move the dial. Of course, a COVID-19 recovery is positive for demand. However, using this to justify high copper prices today is a stretch, in our view.
  • How tight is the market? We do not see anywhere near the physical tightness in markets that normally drives this kind of price spike, but of course, prices are a signal of future tightness and clearly the market is spooked about supply issues in the second half of the year (strikes, new outbreaks of COVID-19, etc.). While not much new supply will come online this year, we do not see the market as overly short. We see 10 major copper projects coming on stream to enable supply to match the 3% growth in net new demand through to 2030.
  • On commodities such as iron ore, we could make many of the same arguments. However, here prices have been driven up by speculators rather than producers.
  • Note that our view continues to be different for oil. We believe that demand will surprise to the upside and that supply will be much harder to adjust given seven years of structural underinvestment in new exploration and decline rates in the US coming down aggressively. We still believe oil prices could rise to USD 100/barrel. We note that the correlation of oil prices and the CPI is insignificant at 0.27, but it is at 0.71 for the producer price index.

3. Labour: Finally, there seem to be sufficient slack in the labour market. This supports our view that inflation is most likely to be transitory. “It seems unlikely, frankly, that we would see inflation moving up in a persistent way that would actually move inflation expectations up while there was still significant slack in the labour market,” said Chair Powell during an April 28 press conference.

According to Bloomberg Economics, until the unemployment rate falls to below 4% -- which is broadly not expected before 2023 -- policymakers will likely regard what upward pressure there is as benign. Recent wage dynamics are consistent with still widespread slack in the labour market; however, pockets of hotter growth are showing up.

  • Faster wage inflation is concentrated among lower-earners, a trend the Fed will be inclined to support, not squelch.
  • Subdued income expectations and perceptions of future job prospects show the persistence of pandemic scars, contrasting with fears of rising inflation expectations.
  • Stepping back from the review of the data, it’s important to keep in mind that the post-pandemic equilibrium is not yet in view. Expanded unemployment benefits will continue to distort labour market conditions over the summer.
  • More speculatively, it’s possible the pandemic will trigger a broader reconsideration of the work-life-balance with workers placing greater emphasis on flexibility over salary.

Summing up, a comprehensive view of the data, and broader considerations about potential shifts in the labour market, provide us with little reason for immediate concern about rising wages sustaining elevated inflation.

A very tight US labour market before the pandemic delivered very little underlying inflation, so why would we believe tight labour markets will deliver runaway inflation after the pandemic?

It’s all relative…base effects

Finally, beware of ‘base effects’. “These base effects will contribute about 1 percentage point to headline inflation, at about 0.7% of a percentage point, to core inflation in April and May,” said Chair Powell in his April press briefing. “So, significant increases, and they’ll disappear over the following months and they’ll be transitory.”

Deflationary forces still at play

Are we really convinced that all those dis-inflationary headwinds - from disruptive technical change and globalisation - that existed in the decade before the pandemic have all dissipated?

A number of structural factors have led to global deflation over the past three decades. These include globalisation, which has given us cheaper access to supplies and labour from around the world, slowing growth and aging of the population, which reduce demand over time, along with advances in technology and the internet.

Those forces are likely to keep pushing against higher price pressures. Online shopping has become even more important during the pandemic. Reflecting the importance of technology disrupting businesses, the Dallas, Atlanta and Richmond Federal Reserves are holding a virtual conference on the subject later this month.

Thus, we can’t help being slightly bemused by the market's concern over structurally higher inflation when the biggest worry we have had for the past decade has been the lack of inflation. Inflation is not an issue per se; while rampant inflation is, we don’t see any evidence of that at all.

Indeed, we believe the bigger challenge over the long run is deflationary forces, not structurally higher inflation. By the way, if you believe in decarbonisation, the biggest deflationary effect is right in front of our noses: the sun, wind and water do not charge us for the marginal cost of a unit of energy produced, so power and energy prices will be one of the biggest actors in the deflationary rhetoric.

Alas, we think inflation expectations will continue to be re-anchored for 10-year breakeven spreads, making way for a transitory increase in headline inflation that will subside and keep interest rates lower for longer. This is constructive for risk assets broadly. In addition, we expect the continued record earnings delivery to push stock markets higher and we see sentiment catching up with what are in our view attractive fundamentals.

In conclusion, we think now is a great set up for the environmental solutions theme going into the second half of the year for the following reasons:

  • An attractive level of valuations
  • Low levels of investor participation
  • A strong underlying demand picture
  • Unwavering regulatory support
  • Unprecedented investment into the energy transition
  • Undue concerns about inflation risk
  • A market that is significantly underweight growth following the overweight reflation trade

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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