How might supply chain disruptions and inflation affect market returns

Optimism around the reopening experienced during the spring and summer months has faded. In its place are questions around what the next few quarters will bring as pandemic-driven distortions persists and inflation remains elevated.

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How long will these disruptions last?

At the heart of the issue is uncertainty around how long these disruptions, in all their forms, will last. The emergence of Omicron, the newest coronavirus variant, introduced yet more uncertainty into the macroenvironment, but it’s too early to have a clear sense of how the new virus strain might affect the growth picture. 

On the employment front, the roll-off of key unemployment benefits in North America could provide some answers around job scarcity in the next one to two quarters. Port blockages and restrictive policies in some countries make normalizing supply chains—and, by extension, prices—harder to discern. It’s clear, in our opinion, that the length of these disruptions will have a profound impact on forecasts: The sooner the resolution, the more benign the medium-term outlook; conversely, the longer these issues drag on, the greater the likelihood of more permanent scarring in overall growth. 

Over the longer term, we maintain that we’re likely to experience modest growth and monetary policy normalization. This expected return to stability and a rising interest-rate environment remain generally favorable to risk assets, with government bonds providing the least attractive return profile.

Opportunistic perspectives
Short-term asset allocation view (6–12 months)

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Source: Manulife Investment Management’s asset allocation team, October 2021. No forecasts are guaranteed. An underweight reading indicates the potential for an asset to underperform its class or subclass on a risk-adjusted basis. An overweight reading indicates the potential for an asset to outperform its class or subclass on a risk-adjusted basis. A neutral reading indicates the potential for performance in line with the asset’s historical averages.

 

Sizable distortions persist

Supply chain disruptions are more pronounced than expected at this stage, creating ongoing scarcity of supply in everything from cars to labor. By extension, what had been considered transitory upward inflationary pressure is proving more persistent than most base-case scenarios—ours included.

However, it’s worth noting that there’s probably limited read-through to shifts in monetary policy stances: Inflation driven by supply-side dynamics such as chip shortages or incremental pressure placed on energy prices (e.g., due to droughts) is unlikely to be affected by tighter policy. That said, the risk is that a scarcity of supply in certain areas could begin to weigh on growth. 

Once we get past these distortions, the medium-term outlook is sanguine

Looking beyond the current uncertainties, we ultimately expect that an economic paradigm similar to what we experienced before the pandemic will reassert itself; that means modest but stable growth for an extended period, albeit with a slightly higher inflation profile. Against a backdrop of broad-based but gradual monetary policy tightening, this environment should remain broadly conducive for risk assets to outperform. Unfortunately, the timeline for this pattern to emerge appears to have been pushed back by a quarter or two as higher prices and shortages caused by supply chain disruptions are proving more persistent than anticipated.

Strategic perspectives
Long-term asset allocation view (3–5 years)

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Source: Manulife Investment Management’s asset allocation team, October 2021. No forecasts are guaranteed. An underweight reading indicates the potential for an asset to underperform its class or subclass on a risk-adjusted basis. An overweight reading indicates the potential for an asset to outperform its class or subclass on a risk-adjusted basis. A neutral reading indicates the potential for performance in line with the asset’s historical averages.
 

Key central banks have started down the path to normalization

In the spring, the question facing central banks was when the first steps toward normalization would occur. Now, reducing the pace of quantitative easing (tapering) is a foregone conclusion at several key central banks, and attention has firmly moved toward when conventional policy tightening (interest-rate increases) might begin. Market expectations are that the U.S. Federal Reserve (Fed) and the Bank of Canada will begin their tightening cycles around the middle of 2022. The Bank of England has already started, and the European Central Bank likely has a longer timeframe still, while there’s no evidence of meaningful removal of accommodation at the Bank of Japan.

There are, however, risks to this view: First, should the aforementioned macro disruptions persist, a weaker growth profile during the first half of 2022 could convince central banks to make a dovish pivot; alternatively, any rapid retreat in inflation would similarly alleviate pressure to normalize. Second, the recent announcement of Fed Chair Jerome Powell’s reappointment provides a measure of stability; however, there are still three senior positions to fill at the Fed, and the choice of appointments could influence policy in the coming years. 

The search for yield will be as important as ever

Despite our belief that interest rates will gradually rise, they’re likely to stay near historical lows and struggle to exceed prepandemic levels over the next few years. With negligible expected returns in the fixed-income space, particularly in global government debt, asset classes that would provide additional yield are likely to remain in favor with investors. This is especially true for asset classes that can also provide diversification benefits. This perspective underpins some of our higher-conviction views, such as our overweight stance on emerging-market debt. It also explains why we have an improved outlook on certain alternative assets, such as global natural resources