June 2021 - Monthly House Views
The Price Is Right
In markets, there is from time to time a single data point that garners intense, widespread scrutiny and reflects the zeitgeist of the moment. In the immediate aftermath of the Great Financial Crisis, it was US house prices. During the Eurozone crisis, it was credit default swaps – a tool to hedge default risk – on periphery borrowers and banks. A year ago, it was the daily number of new confirmed COVID-19 cases. Today, it is inflation, in particular in the US.
This topic has emerged as a key concern for several reasons. Money supply growth has reached historical highs at over 20% year-on-year (YoY) ever since May 2020; growth in hourly earnings has averaged 4.6% YoY since January 2020; commodity prices have surged 62% over the past twelve months; supply bottlenecks (for example, in semi-conductors) have fuelled fears of overheating; and fiscal spending plans announced since last December amount to over 30% of US GDP.
Rapid progress in vaccinations has fuelled hopes that the pandemic will soon be over – over 50% of the US population has received at least one dose of a vaccine and mobility measures show that traffic related to retail and recreation are almost back to normal. This has bolstered business confidence. The IHS Markit US Composite Purchasing Managers Index (PMI) hit an all-time high of 68.7 in May 2021 as it registered the steepest upturn in business activity since data collection began in October 2009. Rates of new business growth were the fastest on record in both the manufacturing and service sectors.
Therefore, unsurprisingly, some market participants have begun to fret about rising prices, as witnessed by market expectations for US inflation. Swap contracts for five-year expected inflation in five years time (5Y5Y) have risen from lows of 1.22% in March 2020 to 2.52% today, while 10-year breakevens (another measure of the market’s expectations for inflation) touched a recent peak of 2.53% over the same period.
This matters because inflation expectations have enormous influence over monetary policy, bond yields and equity market valuations. Bond prices have tumbled as ten-year Treasury yields rose from 0.51% last August to 1.64% and the iShares 20+ ETF of long-duration bonds has fallen 20.5% over the period. For equity investors, short-dated Treasury yields are often used as the risk-free rate when discounting the net present value of future cash flows – this means that Growth stocks (where high valuations rely on earnings growth many years into the future) are particularly vulnerable to rising rates.
However, we should note that these inflationary worries are largely a US phenomenon. Market expectations for inflation have risen in the Eurozone, but not to the same extent – 5Y5Y swaps have risen from the March 2020 crisis low of 0.72% to 1.64% but remain well below the European Central Bank’s (ECB) 2% target. And the Bloomberg consensus of private forecasts sees Eurozone headline inflation peaking at 1.7% in 2021 before easing back to 1.3% next year. In China, both headline and core inflation are below 1% - and the country is much further ahead in its recovery from the pandemic than its Western counterparts.
As we noted last month, this year should see higher prices as economies reopen and pent-up consumer demand is unleashed, but this should prove transitory. Gaps between actual and potential output still gape wide and there is enormous slack in the labour market, as well as huge underutilised capacity in commercial real estate. In addition, ageing populations, supply-chain efficiency and technology-driven productivity gains will exert lasting disinflationary pressures. We believe that these factors will push inflation lower again in 2022.
We remain sanguine and believe it unlikely that base interest rates will rise for many months to come, if not years. Moreover, we remain risk-on. As always, we are guided by the four pillars of our investment process:
- 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. Eight of the ten underlying forward indicators of economic growth remain positive which is reflective of a broad and powerful economic backdrop.
- Valuations: Valuations for equities – the largest source of risk and return in most strategies – remain challenging in absolute terms. Heightened valuations have been further challenged by increased inflation expectations, which raises the spectre of rates rising. However, as discussed above, 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 may well occur. 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 remains neutral.
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
In accordance with the applicable regulation, we inform the reader that this material is qualified as a marketing document. CA884/Apr2021