Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.
View from the very top: expect more volatile times ahead. We are transitioning from early-cycle to mid-cycle. Both growth and inflation may have peaked in the very near-term. If vaccine rollouts globally do not accelerate, then deteriorating economic newsflow will likely do so. Downside, however, is limited by the fact that policymakers will likely remain highly proactive. For investors, it is imperative to recognise that there has been clear regime change. We’re now in an era of policymaking that relies more explicitly on the support not only of Central Banks but also Governments. If more intervention, generally, is to be expected, then this implies that the investment strategies that have worked for the past decade may not work so well for the next. Our view: no single investment style will dominate. As a result, embrace a variety of assets, seek balance and continue to diversify.
- Equities: Indices globally are close to all-time highs, supported by record year-to-date inflows and the strongest current earnings season in more than a decade. However, since mid-May, there has been a marked sector reversal. The shift away from value towards growth may endure in the near-term, particularly should macro data remain mixed. Even if some segments of the market appear overvalued, we continue to see clear attractions for equities over fixed income, particularly from a yield perspective. We favour continued exposure to a variety of styles (growth and value, quality and cyclical).
- Fixed Income/ Credit: 10-year US Treasuries currently yield 1.23%, a massive downward shift from the 1.71% peak reached in March. At the same time, the yield curve has flattened markedly. We attribute such a move not only to an unwinding of prior consensus but also to a reassessment in prospects for growth and inflation. Yields may fall further, should full economic recovery be delayed. Notwithstanding the safe haven status of fixed income, we see the space as looking less compelling than previously and advocate only limited allocations across the broader credit universe.
- FX: The significant upward move in the US Dollar over the last two months follows a period of relative weakness. The trend towards a stronger Dollar (positive for the Euro, less so for many EM currencies) may prevail for the near-term, even if concerns over America’s twin deficits (fiscal and trade) may argue for structural pressure on the Dollar over time.
- Gold: The 7.5% rise in the gold price since early March reflects the fact that real (inflation-adjusted) yields have retreated. We see a continued case for gold in investor’s portfolio and believe that it acts not only as a very good portfolio diversifier but also as a low-cost portfolio hedge (particularly in the event of potential policy error).
- Alternative Assets: Similar in some ways to gold, these assets bring clear diversification benefits to investors' portfolios. We are also attracted to the collateral-backed cashflows that these assets generate (which would offer some protection in the event of higher inflation). We expect infrastructure assets to benefit from ongoing fiscal stimulus initiatives. Elsewhere, we see merits in business models with strong balance sheets such as seniors’ housing or logistics REITS.
As most long-suffering parents know, “are we there yet?” is the perennial question asked by impatient children as they journey to their summer destinations. The same query could be posed when considering the current investment landscape, for asset allocators need to decide whether we have reached the peak. If we have arrived at a place where things are perhaps as good as they might get, then this has clear investment implications. Like many parents, the easiest approach may be to defer giving a definitive answer. “Soon” might be the most appropriate response.
The seemingly relentless upward move in equity markets belies potential turbulence beneath the surface. The euphoria created by rapid vaccine rollouts in some geographies has been subsiding, replaced by growing concerns about the durability of economic recovery. It is perhaps beginning to dawn on many that the world may not be ‘back to normal’ (if we even have a benchmark for normal now) after the summer. Although your author is clearly not an epidemiologist, if vaccine rollouts globally do not accelerate, then deteriorating economic newsflow will likely do so.
Expect some potentially volatile times ahead, exacerbated by lower traded volumes over the summer. This perhaps helps explain why the yield offered by 10-year US Treasuries has declined so rapidly – for this asset represents a clear safe haven. Of course, if Jerome Powell, Chair of the US Federal Reserve, is to be believed, then the reason behind the move in yields is simply that we have reached peak transitory inflation. Of course, an alternative perspective could be that lower yields constitute a potential indicator that the economy is cooling fast. Perhaps we’ve arrived at the peak; or, at the least, we’ve gone from early-cycle to mid-cycle.
Consider the case for peak economy. Even with better-than-anticipated corporate earnings, the resilience of the pandemic is, arguably, the major current issue for the global economy. The growth in the Delta variant may postpone a full reopening, while the consequences of the UK’s post-pandemic experiment (all prior virus restrictions have effectively been lifted) are still unknown. Jerome Powell notes that uncertainty around the economic outlook remains “elevated.” Christine Lagarde, his counterpart at the European Central Bank, describes the recovery as “fragile.”
Even without the pandemic’s resurgence, growth may have already been slowing. Industrial production (as measured by purchasing managers’ surveys) peaked in the US in May, while recent data from both Europe and China have been worse than anticipated. It is telling that China cut its reserve requirement ratios for all banks (i.e. they can lend more, effectively injecting more money into the economy). This is perhaps an indicator that the economy is cooling, or that the authorities fear it may be. Think about it as a move from reflation acceleration to reflation moderation. We’re now at the end of the of the ‘V’; the huge post-pandemic catch-up effect is behind us at the same that the one-off improvements from vaccine efficiency have passed. Vaccination rates in many countries – given that large chunks of the population seemingly do not want be vaccinated – may not be at levels akin to herd immunity. Only 47% of investors believe the economy will improve from here (per the latest Bank of America Merill Lynch Fund Manager Survey) versus 91% in March.
There is a certain irony that investors may draw comfort from the notion that a less powerful economy may not need higher interest rates in order to rein it in. Even if headline US inflation of 5.4% represents the fastest growth rate since mid-2008, the more interesting data lie below the surface. Much of the major rise seen last month can be attributed to higher prices paid for airfares and previously-owned vehicles. The rebound from reopening has affected the former while the latter is rising owing to semiconductor shortages limiting the sale of new vehicles. Strip these factors out and the inflation reading would be broadly consistent with those recorded over the last decade (per the Bureau of Labour Statistics).
A separate dynamic worth considering is that a flood of labour is set to re-enter the US market in September, as pandemic subsidies expire. Over the next two months, all states will stop paying the current $300/week supplement to unemployment benefits. This may reduce any potential upward pressure on wages. Against this background, there is an emerging consensus that the Federal Reserve might just be right – that inflation is transitory. More importantly, the Central Bank’s messaging has been quite explicit in highlighting that it won’t let inflation get out of control. Policy will be adjusted if inflation moves “materially or persistently” beyond levels consistent with its goals. Other Central Banks around the world have made similar statements.
What about equity markets; might they be at peak? For sure, it has essentially been one-way traffic in the last 18 months, supported by powerful monetary and fiscal stimulus. Year-to-date, inflows into the asset class have reached record levels (per Goldman Sachs). It’s certainly easy enough to point to potential bubble signs, whether it be increased retail investor participation, higher levels of financial leverage or the growth in SPAC (special purpose acquisition company) listings. Sure, earnings estimates have been increasing, but the current reporting season may be as good as it gets. Factset data show that the current pace of earnings growth (greater than 60% year-on-year in the US) is the fastest since 2009. Higher future expectations and the growth in the Delta variant may have an impact on results/forecasts for the next earnings season.
The counter-argument would suggest that it’s hard for stocks to fall from here since for any investors looking for yield, equities remain the only game in town (at least among mainstream, liquid asset classes). Recent action seems to suggest that ‘buy the dip’ mentality has returned to equity markets. However, we may still be close to the peak. If so, then it’s important to consider what may happen next.
It seems abundantly clear to us that policymakers are going to remain visible and proactive. This is not just to avoid the risk of a marked economic deterioration, but also because there has been a palpable regime change. Governments have a more active presence than ever before. We are in a new era of policymaking: one which relies more explicitly on the support (and intervention) of the state, in the form of not only Central Banks but also Governments. Austerity is quite clearly out. Instead, expect more policies aimed at reducing inequalities and accelerating green agendas. Such an approach is not only pro-growth longer-term, but is also likely to be supportive to higher inflation than we’ve been used to over time too.
For investors, there are two challenges. First, while it may be easy enough to accept that we might be in a near-term bubble, the harder question is to know what to do about it. The bigger debate reflects how to position most appropriately for regime change. If more intervention is only to be expected, then this implies that the strategies which have worked for investors over (at least) the last ten years may not work for so well during the next decade. Even if equities can remain the clear asset class of choice, our approach centres on the avoidance of momentum plays combined with a strategy of increased diversification. Bigger picture, our counsel is to embrace a variety of styles.
Alex Gunz, Fund Manager, Heptagon Capital
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