Invesco: The end of the recovery phase

Key takeaways

1. Current economic concerns focus on high inflation, peaking growth and the outlook for 2022 margins.

2. These concerns have resulted in a more conservative outlook.

3. Long-term we prefer equities over fixed income, though we’ve trimmed our equity exposure in our portfolios.

Supply chain disruptions, rising wages and upward moves in commodity and energy prices are leading to short-term inflationary pressure – and a debate as to how transitory or sticky these inflationary forces are.

Though Invesco’s Chief Economist, John Greenwood, would implore us to see them as transitory, this does not undermine his view that higher inflation is likely. His focus isn’t on these short-term drivers but on the excess monetary growth seen over the last two years, which should be an inflationary force in the US and UK.

*All data to July 2021 except Canada which is to June 2021. AU = Australia; CH = China; CN = Canada; SW = Switzerland; NZ = New Zealand; EZ = Czech Republic; JP = Japan.

Sources: Refinitiv as of 6 September 2021, and Invesco calculations.

Numerous commentators, including the Governor of the Bank of England, are adding weight to these concerns. In an interview with the Yorkshire Post, Governor Bailey indicated that the surge and stickiness of the excess inflation expected in the coming quarters is leaving the Monetary Policy Committee (MPC) between a rock and a hard place when it comes to policy.

Bailey added to his recent hawkish remarks this weekend, saying that monetary policy must address risks to inflation expectations. He commented that labour demand is stronger than expected, and that he has concerns about labour supply and demand. He also mentioned that energy costs were likely to push inflation higher.

The market already felt the November MPC was ‘live’, and these remarks appear to endorse this. Bailey’s comments can be visibly seen in the rates market reaction this morning.

Interestingly, Michael Saunders, a member of the Bank of England’s MPC, was even more vocal about the need to tighten sooner rather than later. In fact, he explicitly endorsed market pricing, pencilling in a 'full rate hike' by February (and half by December 2021). Now, there are concerns that a rate hike could happen in November and that it might be higher than the 15bps forecast.

There are also concerns that the move in Commodity prices (Bloomberg BCOM index is up over 40% year-on-year), is not only inflationary, but will squeeze household incomes. The Bank of America estimates that higher energy prices will cut global household disposable incomes by 1.5%. Indeed, past commodity price surges have been associated with subsequent recession, so it’s no surprise that stagflation is being discussed more widely.

But in the long-run, commodity prices remain depressed – close to a 50-year low in real terms. This means recent commodity price rises might not have the same impact, given the low base they’re rallying from. There have been three major commodity bull markets over the last 50-year period, each lasting between 9-11 years. So does this bounce-back in commodity prices represent the start of a longer-term bull market? We’re not convinced, but will keep a close eye on commodities because of the long-term asset allocation implications for resource sectors and EM assets.

A global outlook

Inflationary concerns have led to rising rate expectations globally, led by Gilts, with the 10-year yield rising 98bp from its 2021 low to 1.16% – the highest it’s been since May 2019.¹ This back-up in government bond yields has filtered through to credit markets, with US dollar and sterling markets hit the hardest. Globally, yields on investment grade and high yield debt are now 38bp and 48bp, respectively, above their all-time lows set earlier in the year.

Interestingly, China is bucking this rising rate expectation. Evergrande’s solvency issues and the overall leverage of the broader property sector in general (which accounts for 29% of China’s economic activity) are centre stage. This is especially true after September saw sales decline 36% year-on-year among China’s 100 largest property developers.²

These concerns and the potential knock-on effect for the wider economy are raising expectations that China will ease. We could see this in interest rate or RRR cuts but also in further infrastructure spending, mortgage loan relaxation or potential dialling down on de-carbonisation goals to boost commodity production.

Global equities (the MSCI World Index in US$ terms) are up only 1% since the end of June. But since 1970, the final quarter of the year has been the strongest. Seventy-eight percent of fourth quarter returns have been positive, with an average gain of four percent (both measures are substantially higher than in any other quarters).³

Additionally, from 2008, there is a 0.96 correlation between global equities and G4 central bank balance sheets. Though there’s a lot of discussion about tapering, contraction of G4 balance sheets is not expected till Q1 2022. Over the next two quarters, markets expect expansion of US$1.4 trillion (Fed: US$0.6 trillion | ECB: US$0.7 trillion | BoJ: US$0.1 trillion), further supporting equities.⁴

Looking ahead, the Q3 earnings season in the US will be a short-term focus, with overall S&P500 earnings expected to be up 23.2% year-on-year in Q3.⁵ After six quarters of beating earnings expectations, the focus may now shift to forward guidance for 2022 and away from the likely better than expected results for this quarter. If CEOs are more conservative, this could dent market pricing – especially after such strong moves in equity markets over the last 18 months.

It’s interesting to note that the caution we indicated a month ago has been supported by hedging activity in Europe. There has been a pick-up in volumes of index puts. In September, EU single name puts saw decade high volumes – US$3.3 billion/day traded, US$700 million/day greater than the next biggest (September 2019).

Outcomes

Covid-19 cases in Europe and the US are running around 40% below the summer high, which is great news as it’s enabled a further easing of restrictions. The outlook for markets, though, is less clear.

Statistically, equities should perform well in Q4, supported by ongoing quantitative easing. But as we suggested in last month’s outlook, there are headwinds – inflation, rising rates, peak growth and margin pressures. Though we’ve trimmed our equity exposure in our portfolios, we maintain our long-term preference for equity over fixed income.