Investment Update Q3 2021: Is the post-COVID rebound peaking?
Tougher times may lie ahead, but we believe the cyclical rally has further to run.
This year is on track to be a stunningly good one for growth – both in terms of economic output (GDP) and company profits. Of course, that’s largely a function of 2020 being so stunningly bad. Nevertheless, the rebound’s speed has continued to exceed expectations, even as the easing of social restrictions continues to lag.
Global and US GDP are likely already back above their pre-COVID high watermark; on some measures, cyclical parts of the stock market have enjoyed an unprecedented run relative to defensive segments. The prudent investor must ask whether we should start to position for tougher times.
Our analysis suggests it would be premature to do so now. We expect global leading economic indicators (LEIs) to remain broadly range-bound at today’s elevated levels until late 2021. We reach this conclusion by looking at their historic relationship with interest rates, bond yields and other monetary measures. And because we believe today’s nascent capital expenditure cycle, the rebuilding of depleted inventories and the ongoing resumption of spending on consumer services will continue to keep them buoyed. Especially as growth becomes more geographically synchronous, with Europe, Japan and the UK joining the US reopening party.
“The rebound’s speed has continued to exceed expectations… we expect global leading economic indicators to remain elevated until late 2021.”
After that, we expect high economic growth rates to decelerate throughout 2022, but to stay above the historic norm thanks to a continuation of loose financial conditions and stimulatory fiscal policy. Growth rates in countries that suffered the largest contractions in 2020, such as the UK, will likely stay a little more elevated as they have further to ‘bounce back’. However, many of these countries operated job retention or furlough schemes (as opposed to the income-replacement policies of the US, for example) and there is some uncertainty over what their closure might do to employment, corporate defaults and consumer confidence.
Once our favoured indicators do start to decline, we expect a change of investment strategy to be warranted. Investors sometimes fail to understand that there are conditions where more cyclical, ‘risk on’ parts of the market tend to underperform even when LEIs are signalling very strong growth: and that’s if they are signalling growth to be a little less strong than they were before. We hope it goes without saying that we will remain vigilant that the reversal doesn’t occur before 2022.
Is inflation here to stay?
We do not agree with theories of runaway inflation, currently a hot topic among market commentators. To summarise briefly, the main reason for the spikes we are seeing today is that prices were abnormally low a year ago, and the rate at which they have risen since has been exacerbated by COVID-related dislocations in spending, employment, production and logistics.
We have been warning about a very uncomfortable spring since early this year (read here at greater length why we expect inflation to fade, as you can in a forthcoming article in InvestmentInsights). And yet inflation in the US has risen by more than our already above-consensus expectations. Still, half of the month-on-month increase in the latest US inflation figures for May – which caused mild volatility in financial markets when they were released– was due to a small number of COVID-affected sectors, such as household construction materials and furnishings, recreational goods and used vehicles. Lumber prices have recently fallen by about a third, which should presage an easing of pressures here, while used car inflation may have peaked too if auction prices serve as a lead indicator (as they have in the past). A broader, more important point to note is that COVID-beneficiary sectors make up a larger share of the inflation basket than COVID-recovery sectors (such as air fares, clothing and hotels), and the passing of inflation in the former to inflation in the latter will therefore act to decelerate overall Consumer Price Index inflation.
For inflation to spiral, wage inflation must accelerate perpetually, and inflation expectations must untether from the 2% rate embedded by independent central bank regimes over the last 30 years. Our favoured gauge of US wages has been decelerating recently. While the speed of the growth recovery has exceeded expectations, the speed of the employment recovery has not. In the US there are still more than seven million fewer people in work than before the pandemic. We do expect evidence of skills shortages to push wage inflation a little higher over the remainder of the year, but not to a de-stabilising degree.
Inflation expectations extracted from a broad swathe of gauges - with different look-ahead horizons, drawn from different samples of the population and relating to different measures of inflation – still haven’t broken out above the normal range of the last 25 years. Some – although not all – measures of consumers’ short-term inflation expectations have broken out, such as the one compiled by the University of Michigan. Among the many measures of expectations, these have some of the worst ‘track records’ as forecasts. Moreover, unlike in the 1970s to early 1990s, rising prices seem to be destroying demand. The same University of Michigan survey asks respondents if they think it’s a good time to buy a house, furniture and a car or truck. Worried that prices would be even higher tomorrow, the proportion of consumers who said it was a good time to buy throughout was never greater than in the 1970s to early 1990s whenever their inflation expectations rose. Today, consumers are worried about high inflation, but an unusually large majority of them think it’s consequently a terrible time to buy these big-ticket items.
In short, we believe that unusually high rates of US inflation will be transitory. Transitory is a rather imprecise word that’s worth clarifying. We don’t mean that inflation will be back on target by year end. Instead, we see it peaking in the next month or two, before falling back toward 2% throughout 2022. In the UK it’s a little different: inflation is likely to peak at a lower level, in part because of the appreciation of the pound and because of structural headwinds to the UK. It may take a little longer to get to that peak, perhaps early 2022, because of things like the extension of the temporary VAT cut on hospitality spending. We would be surprised if UK core inflation (excluding volatile food and energy prices) makes it to 2.5%.
"Once our favoured indicators start to decline, a change of investment strategy might be warranted. But we’re not there yet."
Our outlook is of course more sanguine than the prognosticators of runaway prices. But we still think it’s highly likely that US inflation will average above 2% over the next two years, in stark contrast to the sub-2% average of the last decade. This itself is a profound change that all investors should take note of, one that is likely to influence leadership within equity markets even if it should leave aggregate market returns broadly untroubled.
Tempering the taper talk
The earnings underlying equity markets are typically a good hedge against inflation. US and UK companies still delivered profit growth over and above the rate of inflation during the 1970s and 1980s, when inflation averaged four to six times what we expect for the next two years. But while earnings tend to be able to cope with inflation, equity market valuations can suffer if the inflation-adjusted (‘real’) rates used to discount tomorrow’s earnings into today’s prices also rise. Our analysis suggests valuations have already built in a buffer against an increase of about half a percentage point in real rates. Nevertheless, all eyes are on the Federal Reserve (Fed) as it starts to talk about reining in its easy monetary stance.
We expect the Fed to begin tapering bond purchases (quantitative easing) in December, signalling it well ahead of time. We do not expect this to be a market moving event. The original ‘taper tantrum’ in May 2013 induced considerable volatility because it took the market somewhat by surprise. Today, all investors are talking about the prospect of tapering – although the Fed is adamant it is only “talking about talking about” tapering, to any sensible person this is the same thing! It is difficult to envisage such a well flagged event causing similar volatility. It’s possible a speedier or earlier tapering than anticipated could cause an equity sell-off, but unlikely one greater than 10%. Even in 2013, developed markets were back above water in less than two months. The risk of a 10% correction in equity markets is ever-present: these happen almost invariably each year. Trying to time them is extremely difficult and, as long-term investors, we think it makes sense only to underweight equities if we see an elevated risk of something more severe that would take longer to recover from.
There are many reasons why the Fed is likely to continue buying bonds long after it starts to taper its purchases. It has a mandate to smooth both inflation and employment, and we’ve had something of a jobless recovery. As Fed chair Jerome Powell recently noted, the unemployment rate is still over 9% if you include the people that have dropped out of the labour force since COVID. Fed policy makers have also repeatedly mentioned a more inclusive range of labour market indicators than it’s considered in the past, such as the unemployment rates of minority groups. These have a long way to go before they return to pre-COVID levels. The Fed’s favoured price index is back above where it would have been if inflation had come in at an annualised rate of 2% since Feb 2020. If the Fed’s new Flexible Average Inflation Targeting (FAIT) policy is designed to make up for past misses, then mission accomplished, perhaps. Yet the terms of FAIT were left suitably vague. Inflation has been undershooting since the financial crisis and the price level remains some 5% below where it would have been had inflation consistently achieved the 2% target since April 2009.
We think the Fed is likely to use the current environment as an excuse to continue making up for the missing inflation of the past – that was a huge worry for policy makers because of the risk of entrenching low inflation expectations and, therefore, ultra-low interest rates. Indeed, chair Powell has said that the Fed welcomes market-based expectations rising back to pre-financial crisis norms. Markets were roiled a little after the last policy meeting when some officials revised up their projections for interest rates, with the median projection showing two 0.25% hikes in 2023. However, Mr Powell was at pains to point out that this was not a plan or a roadmap – indeed, many of these officials don’t have a vote - and he suggested the Fed may proceed even more cautiously.
Although we still expect bond yields to rise as they are at odds with the US economy’s fundamentals, the Fed’s dovishness should limit the extent of the increase in yields.
Certain about uncertainties
All that said, can we say that we fully understand the consequences of the unprecedented degree of money creation during the pandemic? No, we can’t. As investors we must acknowledge that the degree of uncertainty around the inflation outlook is larger than anything investors have had to face for the best part of a decade (and arguably three). That also creates considerable uncertainty around the outlook for bond yields and valuations. Inflation risks over the next 18 months are skewed to the upside relative to our base case – which is something we’re positioned for in and of itself.
We are looking to individual stocks whose business models might enjoy greater inflation resilience. We have also upgraded our outlook for market segments that tend to do well when inflation expectations or bond yields rise, which have performed strongly this year. These are often found in so-called ‘value’ (i.e. cheaper) indices, and particularly in financials and energy.
Regular readers will know that we resisted leaning toward value early on in the recovery from the pandemic, preferring quality, but cyclical, companies. What’s changed? First, cyclicals have enjoyed what on some measures has been their strongest run of relative outperformance on record, while value has only more recently started to outperform growth after a long period of underperformance. As we highlighted in the opening section, we don’t expect cyclicals to give that back until leading macro indicators roll over in the new year. But if we are wrong about the timing, value stocks may give us greater protection – value factors and cyclicality can decouple at such moments. Second, the risks to the post-COVID reopening have dissipated, while risks from rising real yields and inflation have risen substantially.
Europe’s sweet spot?
Everything discussed so far leads us to a more constructive view on Europe. For the first time in many years, we believe tactical considerations net off positively against Europe’s structural headwinds. After a botched start, Europe’s vaccination programme has caught up substantially on the US and the UK. The region will likely reach herd immunity just two or three months behind – although since that’s uncomfortably close to winter, we still have some concerns. As European economies are finally reopening, its leading indicators have more scope to continue to rise further, benefiting its cyclical sectors. Earnings momentum is very strong, on some measures the strongest in the world – and our first outlook of the year said that we need to seek out the best earnings momentum given the headwinds to valuations (e.g. prices relative to earnings).
"Earnings momentum will be key given the headwinds to valuations, particularly from inflation risks."
As global yields and inflation risks rise, Europe’s outsized and relatively cheap bank and energy sectors are likely to continue to do well. To be sure, COVID could cause non-performing loans to build up and exacerbate structural problems in the banking sector. But this is a risk for the medium term, after government support schemes have ended, and not something that is likely to hurt investors this year. Domestic inflation risks that could weigh on profit margins, such as higher wages, are much more muted – European surveys do not indicate skill shortages as US surveys do.
A few political risks on the horizon have diminished. Germany will elect a new government on 26 September, but the risk of a firmly left-wing alliance between the Greens and the SPD and the Left Party is receding – they only got a combined 37% of votes in the latest poll. It’s still possible the Greens and the SPD might partner with the FDP, but it’s difficult to see how that would work in practice given that the FDP has very free-market, neo-liberal economic policies – the resulting policy vacuum would likely benefit equity markets. Current Chancellor Angela Merkel’s CDU/CSU alliance is steadily winning votes from the FDP, which means that a CDU/CSU-Green coalition or a CDU/CSU-Green-SPD “Grosse Koalition” is most likely. Broadly speaking, that means something similar to the status quo.
In Italy the not-so-long-ago renegade Deputy Prime Minister Matteo Salvini is taking his party away from nationalistic, anti-EU populism and strengthening ties with more mainstream right and centre-right parties. That substantially reduces risks around the next Italian elections, which have been known to rile investors before. These will occur at some point in 2022 or 2023.
Emerging markets under pressure
We expect emerging market (EM) growth rates to continue to disappoint in 2021 due to lagging vaccination programmes, less generous government policies and lacklustre consumer behaviour, particularly in China. Some emerging markets are suffering an immiserating combination of falling growth and rising inflation. And because US interest rates are important for dollar-based trade and corporate financing in emerging markets, the risk of higher than expected US bond yields is, paradoxically, a greater risk to EM financial assets than many developed market counterparts.
The Chinese Communist Party begins a run of anniversary celebrations, starting with the centenary of its founding this year; while its leaders have met their targets for growth and social prosperity, they cannot afford to allow major financial instability as the economy gets to grips with a structural slowdown. As a consequence, China has tightened policy this year as part of an ongoing crackdown on financial risk. The degree of tightening has surprised investors. We think there is more risk that China tightens too much than there is that it will reverse course.
China must also wait to see just how far the Biden administration will go in resuming its predecessor’s hawkishness. Since before the presidential election, we have highlighted how similar Biden is to Trump on China. A number of anti-China bills are making their way through Congress, and the new US Trade Representative is stating that the previous administration’s measures won’t be removed without careful consideration. Can you imagine Biden allowing statements like that from any other branch of the executive? China and its investors may need to wait nervously for a while longer.
Call it ‘re-globalisation’
With Donald Trump gone, the leaders of the G7 nations tried to convince the world that internationalism was back when they met in Cornwall in June. We’re fans of internationalism: it fosters market size, competition and the sharing of ideas and capital which is of paramount importance for productivity, prosperity and profits. However, there was a lot of rhetoric and we suspect we won’t see much to back it up. The ‘green belt and road’ initiative, for example, that’s intended to combat China’s global infrastructure drive had no numbers attached – we suspect we won’t see many zeros.
With a lot of smoke and mirrors going on with Western cooperation, particularly around trade (the EU is still technically a national security threat – Biden hasn’t reversed Trump’s decision), some commentators continue to talk about de-globalisation. We’re not convinced by this narrative. Globalisation is driven by technology, which, short of North Korean-style autocracy, only flows in one direction. Political and economic institutions can act or be incentivised to act to slow down globalisation or to speed it up, but that’s different to undoing it altogether. In other words, anti-globalisation is not the same as de-globalisation. By way of example, some academic work previewed by the Federal Reserve Bank of New York in June found that the US trade deficit with China narrowed by half as much as the US data claims because of Chinese companies’ savvy efforts to evade US tariffs.
"With Donald Trump gone, the leaders of the G7 nations tried to convince the world that internationalism was back when they met in Cornwall in June."
However, as the G7 leaders tried to coalesce around a need to combat China, it’s clear that the loci of globalisation is shifting. It’s shifting spatially from being driven by the West to being driven by the East, and shifting from trade in goods (which peaked as a percentage of global GDP over a decade ago) towards trade in services (which is yet to really break out), as well as the globalisation of information and infrastructure. We’re calling it ‘re-globalisation’, not de-globalisation.
Compare, for example, President Xi Jinping’s speech at the Boao Forum for Asia in April to anything said in Cornwall. A paean to multilateralism and economic openness, it read like an old speech by internationalists like former German Chancellor Gerhard Schroeder or former Chancellor of the Exchequer George Osborne. Of course, any political speech must be read with healthy scepticism, but the point is that the world is bifurcating into American and Chinese spheres of influence. We are surprised how little attention the signing of the Regional Comprehensive Economic Partnership (RCEP)received last year. We think future economic historians may come to see it as just as pivotal a moment as the COVID pandemic. RCEP is the biggest trade deal in history, bringing together 15 low-, middle- and high-income countries, all in the eastern hemisphere, which comprise a third of global GDP. More evidence that globalisation is shifting loci and not disappearing. Cross-border relations are becoming more complex, but not necessarily less interconnected.
Investors must try to understand these dynamics as they will have profound consequences on the flow of capital. One likely outcome is that investing in Asian development is likely to mean looking for Asia-domiciled assets more than at any point in the past. Western companies trying to grow in both hemispheres may find life harder than it has been for the last 20 years. This is a subject we’ll return to when we think the structural tailwinds start to offset the tactical headwinds for EM returns once again.
Are we there yet?
It’s clear that the global economic recovery has gathered momentum since the start of the year and that it’s broadened out to encompass more geographies and economic sectors. But we believe the recovery trajectory has further to run, which is why we believe better valued cyclical themes could have further to run.
We are keenly aware that tougher times may lie ahead, particularly if immediate inflationary pressures prove more stubborn than we currently expect. We believe earnings momentum will be key, given the headwinds to valuations. In particular, as global yields and inflation risks rise, Europe’s relatively cheap bank and energy sectors are likely to continue to do well.
Meanwhile, we will be keeping a close lookout for any risks that our favoured leading indicators might start to decline. It’s at that point – but not before – that a change of investment strategy might be warranted.