23 Jul 2021
30 June 2021 | Clive Emery, Fund Manager
Inflation trends have been a key focus for the first half of 2021; however, we see growth being the key for the rest of the year.
The extent to which markets have adapted to higher inflation expectations was demonstrated by their reaction to the recent US headline and core CPI annual inflation rates of 5.0% and 3.8%, respectively, the latter being the highest rate since 1993.1
Instead of yields rising, US 10-year Treasury yields fell by 20 basis points and equities saw a reversal of leadership with growth/defensive areas leading and financials/materials the biggest underperformers.1
Though the debate on inflation will continue, there are few upcoming data releases to help settle the issue of whether higher inflation is a temporary phenomenon or something more permanent. The implication is that central bankers may have to start focussing on strong GDP growth rates.
This shift has been illustrated by a range of Fed speakers over recent weeks. Notably, Bill Dudley, the New York Fed chair from 2009-2019, recently wrote that: “Not only will the Fed have to raise rates, but rates are likely to go much higher than investors anticipate”.2
He pointed out that US Federal Reserve (Fed) officials’ latest economic projections, showed that a Fed Funds rate consistent with 2% long-run inflation would be somewhere between 2% and 3%.2
The Fed, in Dudley’s view, will likely have to take rates considerably higher than neutral before its tightening cycle is done.
The markets do not currently seem to be putting much weight on Dudley’s views. Given that Fed chair Janet Yellen was also suggesting that higher rates would be a positive for the US, this is a little surprising. Even more so, given that the World Bank’s latest forecast of 2021 global GDP growth is the strongest for 80 years at 5.6%.3
Another key factor as we head into the second half of the year is the ongoing China-US geopolitical rivalry.
The US Senate passed the sweeping Innovation and Competition Act, which aims to counter China, particularly in areas of technology (including artificial intelligence, quantum computing and semiconductors). However, only 19 Republicans supported the bill, a somewhat lower-than-expected margin, which indicates some unease about the expansion of active US industrial policy.
The White House released the findings of its review of supply chain vulnerabilities that lays out recommendations across a broad swath of sectors, from electrical vehicles and semiconductors to pharmaceuticals, virtually all with China as the primary concern. Concrete steps will depend in part on synchronization with funding provided in Congress’s China package.
Meanwhile, tensions over Taiwan continue. China criticized the provocative nature of the brief (three hour) visit to Taiwan by three US senators to announce a donation of 750,000 vaccine doses. Beijing also criticized US Secretary of State Antony Blinken’s reference to potential trade talks with Taipei, and Japan Prime Minister Suga’s referral to Taiwan as a country.
China on its part has passed, with unusual haste, an anti-foreign sanctions law. This provides a legal basis for China to target anyone that sanctions or criticizes the country over issues such as Beijing’s stance on Xinjiang, Tibet, Hong Kong, Taiwan, maritime territorial claims, and the origins of Covid-19. Foreign and domestic firms will thus face a more complicated legal and political calculus.
We have recently seen new all-time highs in many equity markets with the MSCI ACWI up 12.7% year-to-date while US and European equities are up 13.8% and 16.7% respectively. Europe has outperformed the US in 70% of weeks year-to-date, a development that has contributed to greater flows from the US into the European markets.1
Given the strong growth rates forecasted, our preference remains for equities and other ‘risk-on’ assets.
The S&P 500 rally has been largely supported by earnings over last year. The market was on 22x forward earnings a year ago and is close to the same multiple today.1 Although US earnings revisions appear to have peaked, there has been a recent broadening out of the sectoral pattern of earnings upgrades. This suggests they have not necessarily peaked, which could further support markets.
US earnings revision ratio
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S&P500 PE ranges
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Although 10-year US Treasury and UK gilt yields are off their recent highs, this has been a bad year for longer-dated Treasuries. The year-to-date annualised loss in 30-year US Treasuries of 29% is the worst in a hundred years.1 However, we think the recent rally will likely be short lived and continue to have an underweight to sovereigns as a result.
In credit, investment grade debt has recently outperformed high yield globally. Investment grade spreads of 91 bp are close to their 87 bp post-Global Financial Crisis low.1
Although the absolute level of high yield yields is at a new low (4.5%), however, spreads (350bp versus a post-GFC low of 311bp) suggest there is still some scope for compression, and absolute yields when compared to government bonds are still attractive.1
A strong growth outlook means our focus will remain on risk assets and equities. However, we will continue to challenge the permanence of the growth outlook given conundrums like US retail sales being 20% above pre-Covid levels, despite unemployment being 8 million higher.1
Footnotes
1 Source: Bloomberg as at 11 June 2021.
2 Bill Dudley, ‘Markets are in for an interest rate surprise’, Bloomberg, 10 May 2021, https://www.bloomberg.com/opinion/articles/2021-05-10/markets-are-in-for-an-interest-rate-surprise.
3 ‘Global Recovery Strong but Uneven as Many Developing Countries Struggle with the Pandemic’s Lasting Effects’, The World Bank, 8 June 2021, https://www.worldbank.org/en/archive/news/press-release/2021/06/08/world-bank-global-economic-prospects-2021.
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Data as at 11 June 2021, unless otherwise stated.
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