July 2021 - Monthly House Views
The success of the vaccine rollout in many countries has allowed for the unlocking of economies and a gradual return to normalcy, particularly for the services sector, which had been battered by strictures on movement. The restart has, however, led to a spike in inflation – the headline consumer price inflation (CPI) in the US hit 5.4% in July, above the 4.9% market consensus. This has weighed on sentiment, with some fearing overheating conditions, and a potential hawkish turn in central banks’ monetary policies, particularly the Federal Reserve (Fed), which plays such a pivotal role in global capital markets.
Such fears are likely premature. The surge in inflation readings is largely driven by year-on-year base effects as prices fell dramatically for many goods and services in the throes of the pandemic. These effects will dissipate in the months ahead. Moreover, while macroeconomic fundamentals are robust, there is a slowdown in some leading indicators (e.g. manufacturing PMIs in the US and UK), which suggests global growth momentum has peaked or is close to doing so. In addition, while reopening is the dominant theme, new COVID variants and renewed localised lockdowns remain part of the economic landscape.
As a result, recent central bank meetings have continued to stress that monetary policy will remain accommodative in the short term, with most policymakers convinced the overshoot to 2% inflation targets will prove transitory. Longer term, structural inflation is usually predicated on tight labour markets, but employment remains far from pre-crisis levels. Over 7 million people who had jobs in 2019 in the US are still unemployed; in the UK, it’s over 1 million. There are other notable pockets of slack too. Roughly one in five offices in the US will be empty in 2022, according to Moody’s Analytics, with rents across the country projected to fall by 7.5% this year.
With crosscurrents between high but likely transitory inflation, the Fed delivered a masterful hawkish turn, indicating two rate hikes in 2023. This has pushed up front-end yields while long-term interest rates eased somewhat in a “flattening” of the US yield curve. This suggests the Fed successfully managed to assuage the market’s concerns about long-term inflation while keeping monetary support at record levels for the time being.
Other central banks have remained expansive. The Bank of England has downplayed concerns over a pick-up in inflation at its June meeting with near unanimity, kept interest rates at their historic low of 0.1% and maintained its bond-buying target at £895 billion. The European Central Bank maintained its dovish tone as well.
The combination of the above has helped global equities to another strong quarter. Although equity valuations look rich in absolute terms versus their own history, they are not relative to government bonds. Indeed, from a total returns perspective there is little alternative to equities over the medium term, as government bonds are all but guaranteed to deliver losses over time once inflation is factored in. Corporate bonds are not much different – the difference in yield between corporate bonds and sovereigns (known as “credit spreads”) is narrow, offering little value.
We believe the case for risk-taking is well supported given a strengthening economic backdrop and strong momentum. Nonetheless, we are wary of expensive valuations. On balance, we are moderately risk-on with a continued preference for equities but have been tilting more towards less expensive, value-oriented regions. We also continue to hold a stable of safe-haven assets, including gold, low-volatility, defensive alternatives (e.g. hedge funds) and government bonds.
- Economic regime: Our Leading Economic Macro Indicator (LEMI) suggests the global economy is in a state of expansion, which is clearly favourable for risk-taking.
- Valuations: Valuations for equities – the largest source of risk and return in most strategies – remain challenging in absolute terms. We believe central banks have little appetite to raise rates at present and inflation is likely to remain subdued over time, albeit a transitory rise is occurring. We remain tolerant of higher global equity valuations at the headline level but have been tilting our exposure towards less expensive regions and away from Growth to Value
- Momentum: Global equities are in positive momentum versus their ten-month moving average. This is supportive of increased exposure to the asset class.
- Sentiment: Sentiment is displaying signs of exuberance in some areas (e.g. rising S&P 500 net speculative positioning) but defensiveness in others (e.g. trade-weighted US Dollar strength).
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