Not every Buck is a Stag
The end of September and beginning of October witnessed the steepest sell off in risk assets this year. Global equities, which had rallied to record highs just weeks earlier, reversed notably and witnessed a 5% drawdown (peak-to-trough loss). Safe-haven assets such as government bonds offered no harbour in the storm – ironically, they may well be the cause of it. Yields surged dramatically as central banks signalled a “tapering” of quantitative easing programs, and rising rates too.
While risk asset gains remain robust over the year thus far, fears have bubbled up centred on slowing economic growth and rising prices.
China has been a principal factor. A furious regulatory crackdown on some parts of the digital economy, worth 40% of GDP by some estimates, had been underway for most of the summer. This was compounded by the collapse of Evergrande, a Chinese real estate behemoth, in early September. Evergrande is likely to cause a sharp slowdown in the broader Chinese real estate market, a major driver of domestic activity. In addition, a recent energy shortage in China has further hit sentiment. Some expect Chinese growth to halve next year from 8% this year.
This energy shortage is far from a Chinese phenomenon, and global oil prices have surged above $80 per barrel for the first time in 2018. Other commodities are at record highs. This has coincided with other shortages on all manner of goods as ports clog up with ships, disrupting “just-in-time” supply chains. Moreover, labour is widely reported to be scarce by those companies currently reporting their periodic earnings. Local idiosyncrasies exist too, such as Brexit in the UK, which has contributed to a painful lack of lorry drivers. This has all stoked inflation worries.
This combination of slowing growth and rising inflation has led to a rather cavalier usage of the word “stagflation”. Stagflation refers to a period of rising prices but slower growth. While that is technically true today, the word is meant to imply a long period of structurally weak growth and high inflation, combined with the misery of painfully high unemployment. The 1970s are a case in point. Just as not every buck is a stag, not every minor slowdown in growth and rise in price pressures is stagflation. We are nowhere near such conditions.
Demand remains buoyant
Indeed, at the root of most of today’s supply shortages is a voracious demand for goods and services. This is unequivocally good for businesses. Manufacturing Purchasing Managers' Indices (PMIs) for the US, UK and Eurozone ended the quarter buoyant at 60.7, 57.1 and 58.6, respectively (anything over 50 implies growth). While China's factory activity just dipped under 50, services returned to expansion despite all the domestic turmoil.
Consumers appear well anchored globally too. European consumer activity is at pre-pandemic levels in a sign of returning consumer confidence across the eurozone. US air travel, restaurant visits and hotel stays are robust. Moreover, US households have accumulated $3 trillion in cash during the pandemic, which provides plenty of dry powder for ongoing consumption.
The UK is suffering from a more acute supply chain crisis than many other advanced countries, partly due to an exodus of European workers in the wake of Brexit. However, in the UK too, payrolls have exceeded the pre-pandemic record. The housing market also remains strong: the average house price on Nationwide’s measure is about 13% higher than before the pandemic began. The household savings ratio of 11.7% remains well above historic levels, indicating further room for growth.
Supply chains should normalise in time
Given the “shut-down / restart” nature of the recovery, a voracious demand has been unleashed simultaneously across much of the globe. This has led directly to difficulties for some sectors and production chains. However, many of these issues – and the upward pressure on prices – are likely to be temporary. For example, shortages of microchips appear to be easing as used car prices appear to have peaked (microchips are a key component of new cars). Used cars were the single biggest driver of the elevated inflation readings in the US earlier this year.
The more important single indicator of sticky, structural, and worrying inflation is spiralling wage growth, which leads companies to raise prices, which then leads workers to demand higher wages (the negative vortex witnessed in the 1970s). Some will point to rising pay for longshoremen in the US, or of lorry drivers in the UK. However, the wider data would suggest plenty of slack in the system. Unemployment rates are still higher in advanced economies than before the pandemic. Wage pressures seem under control too: Atlanta Fed's Wage Growth Tracker shows US nominal wage growth at 3.9%, about in line with pre-pandemic levels; average weekly earnings in the UK increased 6.8%, but that is due to a flattering base effect.
More importantly, perhaps, is the Labour Force Participation Rate in the US, which is at 61.7%, well below the 63.4% at the beginning of 2020. A similar measure in the UK, the economic inactivity rate, remains at 21.1%, well above pre-pandemic levels. Clearly, potential workers are still staying home for reasons which likely include ongoing crisis-era benefits, Covid-fears and school closures. Those factors all are ending or abating, and the supply of labour will likely expand meaningfully in the weeks and months ahead.
Shipping – and container – shortages may admittedly be stickier. Demand for shipping has soared for current consumption and to beef up inventories prior to Christmas. Furthermore, carriers have opted against carrying heavier products such as wheat, which increase vessel fuel costs. As a result, American farm exports bound for China end up languishing as shippers prefer to rush them back to Asia empty to capitalize on the more lucrative, lighter China-to-US-bound route. This has led to the port in Los Angeles – a major US hub – to export three times as many empty containers as full ones. Experts think this anomaly may take six months or more to revert.
Despite shipping issues and some tightness in parts of the labour market, expected forward revenues, earnings and margins for S&P 500 companies are all at record highs, a feat difficult to achieve if cost pressures were a major headwind. Policymakers, too, have been excellent at balancing the various risks and rewards of policy support thus far. We expect tapering and subsequent rate rises will be done slowly and gradually enough to be tolerable.
We expect economic activity to remain strong over the next few quarters, particularly in the developed world, with labour markets getting back on track and still supportive financial and fiscal conditions. We also expect inflation to return to pre-pandemic levels in 2022 in most countries. This slowdown in growth and rise in inflation simply cannot be characterised as stagflation.
We believe the case for risk-taking is well supported given a robust economic backdrop and still positive momentum for risk assets (despite September’s sell off). Nonetheless, we are wary of expensive valuations. On balance, we are moderately risk-on with a continued preference for equities in most strategies. We do, however, also hold a stable of safe-haven assets to offset risks, particularly those from equities – which are expensive and supported somewhat by heady sentiment. These include cash, government bonds, gold, and defensive alternatives (e.g. low-volatility hedge funds, Tail Risk Protection Note).
As always, our decisions remain rooted in our investment process, the four pillars of which currently indicate the following:
• 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. However, as we believe central banks have little appetite to raise rates at present, we remain tolerant of higher global equity valuations.
• 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 has fallen back into neutral territory.
As ever, we are constantly monitoring markets. Should conditions change, particularly with the economic regime or signals from our valuation, momentum and sentiment framework, we will adjust our asset allocation accordingly.
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