Last updated: 22:13 / Wednesday, 25 January 2017
Analysis by UBS AM

The Market Is Underpricing Inflation Risks

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The Market Is Underpricing Inflation Risks

The actions of central banks and the search for yield were once again dominant themes for investors during 2016. Says Barry Gill, Head of Active Equities at UBS AM. He believes that the wider market’s strongly consensual views about ’lower for much longer’ have been evident in a host of crowded trades across asset classes that only began to demonstrate the first signs of vulnerability in the wake of the US election.

“Within equity markets, these crowded trades include bond proxies and structured vehicles targeting isolated risk premia factors, including lower volatility. However, we believe the quantum of capital now focused on such factors presents an asymmetric risk to investors: despite recent underperformance, low volatility stocks in the US are almost as expensive as they have ever been." Explains Gill.

In his view, this strongly suggests any change in the ’lower for longer’ narrative could see both the realized return and realized volatility of these factor exposures differ significantly from the recent history that attracted investors in the first place.

Inflation risks underpriced

With a surprise Trump presidency focusing attention on the US, what and where are the disruptive forces which could further shake investors in US equities from their consensual thinking in the coming months? "When we look at the macroeconomic assumptions discounted in markets, the one key area where we see widespread complacency is inflation. A Trump presidency likely exacerbates those risks. ’Lower for much longer’ has become accepted wisdom – and a broad investor base is positioned aggressively in the expectation that inflationary forces have been slain."

But, according to Gill, this view flies in the face of several data points and emerging trends. Notwithstanding the sharp move higher in oil from its February lows, with the US economy close to full employment, they see potential for a tight labor market to squeeze wages higher still.

"And while wage growth in the official US average hourly earnings statistics currently looks modest, we do not believe this is representative of cost pressures experienced by listed companies. The Atlanta Federal Reserve Bank has created a more representative wage growth gauge which is currently running at 3.3% YoY. These higher costs are highly likely to be passed on to consumers. If they are not, margins and profitability will have to bear the brunt. Neither outcome is reflected in equity prices at the time of writing." He concludes.

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