Reflation and Risk

The article below is from our BRIEFINGS newsletter of 16 April 2021

The simultaneous pickup in economic growth and inflation—or reflation—following the hit to both during the COVID-19 pandemic has revived investors’ appetite for riskier assets. Unprecedented levels of fiscal stimulus have helped boost momentum. While stronger growth should sustain that trend into the second quarter, returns on risky assets like equities will likely slow from here, says Goldman Sachs Research’s Christian Mueller-Glissmann. We sat down with Christian to dig into his outlook across asset classes for the year to come.

Christian, how do you expect global equities to move over the next 12 months?

Christian Mueller-Glissmann: We remain broadly pro-risk in our asset allocation and are overweight equities over both a three- and a 12-month horizon. Within the asset class, we prefer non-U.S. over U.S. stocks, a position that reflects the opportunities we see in cyclical, value and short-duration equities. We have shifted from industrial to consumer cyclical sectors and themes to position for the reopening of economies.

Your Risk Appetite Indicator currently sits at an elevated level. What are the implications for investors’ asset allocation strategies?

Christian Mueller-Glissmann: Our measure of risk appetite has climbed materially since the beginning of 2021 amid the bullish shift and reflation optimism in global markets. That means adding risk from here becomes trickier and portfolios become more vulnerable to negative growth and rate shocks. Growth and reflation optimism should be able to sustain risk appetite at high levels: Our economists’ macro outlook continues to be positive, so we don’t think bullish positioning and sentiment alone have been reasons enough to reduce risk. Still, the increased risk appetite will likely act as a speed limit to equity returns.

What about other asset classes?

Christian Mueller-Glissmann: We remain bullish on commodities. Given the recent weakness in oil prices, we’ve moved to an overweight position from neutral over a three-month horizon and remain overweight over 12 months. In periods of high and rising inflation, commodities can act as a diversifier for balanced portfolios: When equities and bonds have declined together due to inflation risks, commodities have often decoupled and offered attractive carry. We remain neutral on credit and underweight on bonds. Growth optimism will likely persist and longer-dated yield levels remain low even after their recent advance, which should continue to push investors towards riskier pockets of the market.

What are investors most worried about right now?

Christian Mueller-Glissmann: We’ve been hearing concerns over the prospect of a deeper bond sell-off and larger-than-expected increase in inflation as global growth momentum accelerates. We expect fears over hawkish monetary policy and inflation risk to eventually fade. In our view, the reflation trend will likely continue in the near term. While there is potential for an inflation overshoot, a transition to a “Goldilocks” scenario into year-end— with growth still robust but the bond sell-off easing—is most consistent with our forecasts. This should eventually create opportunities to add exposure to long-duration assets and carry strategies. Until then, higher allocations to real assets such as commodities can help reduce risks from high inflation for balanced portfolios.