Economic environment: Just the way Goldilocks would have liked it

In most parts of the world today, we see a modest acceleration of growth and limited inflationary pressures. Besides geopolitical risks – Brexit, Korea, trade -– financial markets are witnessing a calm period. 
Most market indicators of risk are at benign levels, perhaps bolstered by gradually improving economic growth data and corporate earnings. 
It is during these periods of calm – or complacency depending on your viewpoint – when it’s worthwhile taking stock of potential risks in investment allocations.
We believe inflation trends remain central to the near market outlook. 
A move towards reflation – stronger growth with modestly higher inflation – remains one of our most likely economic scenarios at 35-per-cent probability. However, markets appear less convinced, with expected inflation lower than at the beginning of the year. 
The drop in inflation expectations has increased the likelihood of a muddle-through environment playing out over the next 12 months – 40 per-cent probability.
This tug-of-war between muddle-through and reflation outcomes still presents many investment opportunities. 
While equities should do well under either scenario, the backdrop is also positive for a regular income-seeking investor. 
Reduced worries of an inflation spike, and, thus, bond yield surge, mean a strategy combining income-generating assets across equity, fixed-income and hybrid assets, such as convertible bonds, preferred stock and REITs, should do well. 
We expect the strategy to deliver a 4-5-per cent yield alongside a positive total return. 
In this benign environment, the inclusion of asset classes offering a higher yield, but potentially carrying a significant interest rate risk, should be less of a concern for the global multi-asset income investor. 
An example is emerging market US dollar-denominated government bonds, which offer a 5.3-per-cent yield but are exposed to a significant interest rate risk. 
In a muddle-through situation, an investment in this asset class is attractive given the higher yield it offers over its developed market counterpart. 
Emerging market local currency-denominated bonds offer even higher yields than their dollar-denominated peers. 
The bonds perform well in a weaker dollar environment, as seen this year when the dollar’s pullback after January resulted in increased funds flowing to emerging markets.
The main risk to this strategy is sharply rising inflation, as that would force central banks to tighten monetary policy more rapidly. 
The resulting rise in bond yields could drag on fixed-income-earning assets, which represent a sizeable portion of this multi-asset income allocation. 
An analysis of previous yield moves should provide some comfort to an income-focussed investor in a gradually rising-yield environment. 
In fact, outside those periods where the Fed started its rate hiking cycle (2004) or the market thought the Fed might tighten monetary policy (2013 and 2016), pullbacks in an income-focused allocation have been limited during periods of rising yields.
If the probability barometer shifts further towards a reflationary scenario, we would look for asset classes that are less sensitive to rising interest rates. 
US high-yield bonds and floating-rate senior loans are examples of asset classes that carry a lower interest rate risk than some other areas within fixed income. 
For the moment, interest rate risk is not a significant issue for a multi-asset income investor, given the almost equal probability between the muddle-through and reflationary scenarios. 
However, knowing one’s exposure to this risk will bear fruit as and when a truly reflationary scenario takes root. 
While the bears might not be in the near vicinity, having a plan to deal with them can ensure the story faces a happy ending.

ADITYA MONAPPA is the head of asset allocation and Sportfolio solutions at Standard Chartered Private Bank.