Investors positioning for the second half of 2021 and beyond are grappling with some key uncertainties. With the US Consumer Price Index (CPI) jumping to multi-decade highs, the pathway and persistence of inflation will be critical, as will the length, strength, and mix of monetary and fiscal support in the “post-reopening” period. Meanwhile, pandemic-related disruptions in work patterns and consumption are spurring companies to make long-delayed investments in their operations and infrastructure –a marked change from what we saw after the global financial crisis (GFC).
To gauge the impact of these trends on asset markets, consider the starting point. The massive exogenous shock of the Covid-19 pandemic essentially reset the global economy and launched a new cycle – and we’re now just one year into what we expect to be a multi-year expansion. It may also have been the tipping point to reverse a 40-year policy orientation of monetary dominance. That context needs to be top of mind when considering which assets, regions, and segments are best positioned as the cycle turns.
Historically, the best returns have come at the very beginning of a cycle, when the most economically fragile segments of asset classes have their time in the sun – a tendency the current cycle has borne out, with one of the best 12-month periods of performance on record. Despite the highly unusual circumstances that preceded and triggered it, this recovery has been quite classic in terms of market behavior, though it has moved more quickly than we’ve seen in the past. If a new policy mix is ushering in new market behavior, we’re not seeing it yet.
As the cycle progresses beyond the initial burst of exuberance, the rate of growth and returns may decline but should remain positive. That is where we find ourselves now: entering a phase of sustained growth, improvements in fundamentals, and markets that continue to grind upward, but at a slower pace. This context has important implications for how we’re positioning for the period to come.
The debate about inflation in markets today tends to fall into two camps: that inflation will be “temporary,” resolving to more normal levels after a few months of running hot, or “permanent and problematic,” marking a structural shift toward higher levels in the future. Our view is that for the next nine to 18 months, inflation is going to be in between – “persistent, but eventually transitory.” Problematic prints will last longer than those in the “temporary” camp expect before ebbing back down.
Over the next five years, inflation could still turn problematic (recent flattener in the yield curve notwithstanding), yet this would require a more sustained political pivot toward fiscal dominance. While the enablers for such a policy pivot have been in place for some time, with rising inequality accompanied by a 40-year trend in the share of national income moving toward capital, the pandemic may have prompted political solutions that would involve more fiscal involvement and steering of the economy. While the odds of a pivot from monetary to fiscal dominance have risen and could manifest over the next several years, we still need more evidence to meaningfully position for such a view. Over the next nine to 18 months, our focus is on how the dynamics of reopening will influence temporary inflation.
Anyone who has witnessed a factory or transportation system reopening after extended shutdowns knows it’s an ugly process of identifying and clearing the first bottlenecks, only to discover more bottlenecks. Lined up against this norm are central banks and markets that believe most of these supply bottlenecks will clear in the fourth quarter. Maybe.
For an economy still near the beginning of its business cycle, we would characterize any firming in inflation prints off former lows as “reflationary” rather than outright inflationary and concerning. Meaningful clearing of bottlenecks in the fourth quarter would signal to us a baseline level of inflation that is marginally higher than in the prior cycle, but not excessive or problematic – a more benign “reflation regime” characterized by a healthier balance of economic conditions that manifests in firmer inflation prints, but not overly so. To us this goes hand in glove with the best scenario for risk assets, accompanied by gradual monetary and fiscal tapering.
The alternative scenario is one in which fiscal dominance becomes more deeply ingrained in the US and spreads beyond. Germany’s election is up next and could provide the second domino if it signals a greater willingness for spending on climate initiatives on top of other priorities. Then, if US Democrats hold Congress in the midterm elections, and new Federal Reserve leadership maintains or strengthens its newly found commitment to “maximum full employment,” this would likely result in a sustained high-pressure economy. Should trends move in that direction, markets would churn for an extended period fearing an upside breakout of inflation. Still, historical precedent suggests such problematic inflation requires years, if not decades, of nurturing before overheating economies and markets.
With the taper and first rate hike issues out of the way, which one would expect to result in temporary downward pressure to markets, the key risk remaining for 2021 and 2022 is that “temporary” inflation stays higher for longer, allowing reflationary forces to embed themselves and segue into longer-lasting inflation. We are already witnessing some signs of this in the US, where a structural imbalance of liquidity for the first time in over two decades is seeping into the economy, and not just markets. This is in the form of rising rents following booming housing prices, thus raising the cost of living. That, in and of itself, would not be inflationary unless wages keep up or exceed this rising cost of living.
Yet against this backdrop, emboldened workers are feeling that for the first time in their careers, the government has their back, and are leaving their jobs if not granted higher wages – or reassessing their priorities despite rising wages and leaving more frequently. Wage price spirals, of course, are the traditional ingredients to launch structural inflation. So central banks’ (and markets’) patience will run thin if bottlenecks fail to show clear signs of fading by the fourth quarter. A fork in the road is approaching, with one turn leading toward a favorable 2022, and the other toward more turbulence.
Since mid-May 2020 we have positioned more aggressively than most, given clarity provided by three pillars: 1) a fiscal response that filled the deep Covid-related hole in economic activity and cash flows, 2) a monetary thrust sufficient to bring down uncertainty premiums and discount rates, and 3) a fast-enough healthcare response, given Moderna’s May 2020 preview of favorable Phase 1 vaccine prospects. Now, with market confidence having been restored – implied by volatility falling back into longer-term norms while markets rose – we began dialing down our portfolio risk from above our norm back toward it. While we wouldn’t be surprised if bottlenecks do clear in the fourth quarter, we lack the markets’ and central banks’ conviction that they surely will.
Another reason for our shift is that one of the biggest triggers of the current recovery – massive, coordinated, and rapid fiscal and monetary policy stimulus, beyond what many observers would have thought possible – is unlikely to last forever. Granted, political trends and the related policy mix could move in that direction, entrenching crisis-based policy into longer-lasting Modern Monetary Theory (MMT)-style policy, yet many political obstacles must be cleared to position for this. The coordinated policy response is what the past 12 months have been all about. After watching the Fed sit by as the US 10-year Treasury breached 1.25%, then 1.50%, and finally 1.75%, and more recently move aggressively to keep longer-term inflationary expectations well grounded, one should question the odds of MMT – at least absent a new Fed that moves this venerable institution in a much less independent fashion.
We’ll know the new Fed constituency later this year and will watch whether all three Republicans on the Board of Governors (Powell, Clarida, and Quarles) are replaced – which would signal less independence and more coordination with the Treasury in jointly extending crisis-oriented policies into ordinary times. Otherwise, today’s policy mix and magnitudes shouldn’t be extrapolated forward. We now assign higher odds of fiscal dominance extending itself as extraordinary monetary policies ebb away. This too would require enabling elections. Without such, monetary and fiscal tapering may both crystallize in 2022.
This deck of cards is a good reason to curb one’s enthusiasm. We still see an environment that generally rewards risk-taking, but to a lesser degree. We also may be heading into a peak growth phase for the US, as Europe and Japan accelerate and most emerging market (EM) countries struggle to keep up. Such “staggered reopening”-driven growth is likely to cause global growth rates to plateau or decline somewhat, even if such deceleration proves less pronounced than in prior synchronized recoveries (and subsequent synchronized decelerations). As a result, while the market’s “peak growth” fears may be overblown, markets remain hypersensitive to changes at the margin. A global plateau or slight decline would still likely bring about market behavior that is less supportive of cyclically sensitive assets. With the Fed now signaling that it will still drain liquidity, and that this period is now in sight, there are now asset allocation implications as the deceleration unfolds.
Meanwhile, the world’s other growth engine, China, is already decelerating even if on a distinctly different policy and economic path. Chinese policymakers refrained from the kind of outsized response taken to the global financial crisis of 2008. Instead, its policies have been relatively muted and targeted. Notwithstanding demographic pressures, Chinese policymakers are increasingly comfortable with a moderate growth target and are focused on preventing stimulus excesses elsewhere from posing risks to China – largely by focusing on productivity through technological innovation as the gateway to prosperity for its aging population. A rapid technological climb is also critical for them to avoid the classic emerging market middle-income trap. China’s growth trajectory has already resumed its modest downward trend, serving as a mildly disinflationary force on the global economy.
Broadly speaking, once growth rates plateau or decline, equities and commodities are likely to offer less attractive risk-adjusted returns relative to credit assets. Credit thrives in slow but positive growth. Moreover, with supply bottlenecks having already caused inflation to spike well beyond what the Fed expected, in order to now anchor longer-run inflation expectations, the Fed has been forced to commit to removing the cookie jar earlier than expected, acting as the first hike of the cycle which usually unleashes a temporary dip in markets.
We see only a short “first hike”-oriented dip and therefore continue to steer clear of defensive equities and maintain a balance between secular growth and cyclicality – yet a balance which, early in reopening, has favored cyclicality. As the reopening ages, we have already evolved to a more equal balance on the way towards a modest secular growth tilt, valuations willing. Our approach during reopening has incorporated “front-running the vaccine.” For this reason, our convictions have been circling equities in Europe, and are now moving as well toward Japan, where vaccines are finally pouring in and rapid reopening to follow. Both Europe and Japan also offer attractive valuations with high beta to global growth, and both will benefit from the US’s fiscal thrust without needing to raise corporate taxes.
Within Europe, next up is Spanish equities, which combine attractive valuations with exposure to hard-hit segments such as tourism on a look-through basis. Our largest exposure is in European small-caps, which provide higher exposure to domestic growth. In Japan, where we think equities provide operational leverage to global growth, we view the recent Covid-related pullback as a good entry point to benefit from the vaccine rollout there.
More broadly, we slightly downgraded our view of equity risk, reflecting the difficulty in sourcing new stock ideas after valuations rose. Stock reactions to gangbuster first-quarter earnings beats tended to be muted, as earnings expectations had already risen along with stock prices over the past six months. As we enter a more normalized phase of earnings revisions, idiosyncratic company fundamentals will become even more critical to alpha generation. While revisions are becoming less of an upside driver, they are also unlikely to serve as downside catalysts. Company fundamentals remain robust, and most management teams believe we’re at the beginning of a multi-year economic up-cycle.
We don’t expect a major correction in equity markets in this tapering phase accompanied by slowing growth, but rather a more benign situation in which equities flatline or move sideways until bottlenecks eventually clear, making asset selection all the more critical.
We remain short duration. Nothing is more antagonizing to inflation expectations than full-out monetary spigots while inflation spikes. The onset of the tapering dance has now instilled confidence in the long end that the inflation expectation component of the yield curve will be addressed. Yet once tapering starts to diminish liquidity, it will slowly but surely work against the other component of the yield curve – real yields.
While the flow of quantitative easing (QE) is what matters to markets over a quarter or two, for longer periods it’s the stock of QE that matters. The extent to which negative real yields have resulted from the cumulative consequence of extended crisis-orientated QE outside of crisis conditions (before and after the pandemic) remains underappreciated. It likely trumps debt, demographics, and technology. While that’s a tough call to make, it’s clearly been the silent incremental partner to those three. Retiring QE will gradually end the chronic oversupply of capital barreling into the Treasury market, eventually shrinking the negative real rate. We remain underweight government bonds and view Treasuries as unattractive on our Capital Market Line. Treasuries are down 3% year-to-date yet remain the prime victim of reflation over time, even if the process is painfully slow.
That said, we see reasonable opportunities in credit, which we believe is well positioned to benefit from growth coming off the boil before year-end. We are seeing signs that credit could be entering into a “Goldilocks” period in the coming quarters. When looking ahead to asset class performance, one key measure – global purchasing managers’ indices (PMIs) – may offer a glimpse into what to expect. With the caveat that staggered reopening will likely produce a slower comedown for PMIs, markets still care about changes in direction. Our analysis of Institute for Supply Management (ISM) new orders data has revealed consistent patterns in asset performance that have held up over cycles historically.
As PMIs approach peak expansion and look poised to slow, we expect a shift in the top performers from equities to credit assets. In past periods when ISM new orders were coming off their boil, as they appear poised to do later in the second half, credit asset have tended to outperform (see chart).
As of 20 May 2021. Proxies for each asset class are as follows: World Equities, MSCI World Index; Developed Markets Equities, MSCI ACWI Index; EM Equities, MSCI Emerging Markets Index; US Treasuries, Bloomberg Barclays US Treasury Total Return Unhedged USD; US Investment Grade, Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged USD; US High Yield, Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged USD; US Leveraged Loans, S&P/LSTA Leveraged Loan Total Return Index; EM Corporate, J.P. Morgan Corporate EMBI Broad Diversified Composite Index Level; EM Sovereign, J.P. Morgan EMBI Global Diversified Composite; Oil, Generic First Oil Future; Copper, Generic First Copper Future. Performance shown since inception for each index. For illustrative purposes only. We are not soliciting or recommending any actions based on this material.
Among credit assets, the most attractive are in emerging markets (EM). We view these as a stable allocation because they offer positive real yields and have lagged other credit assets, which means they have further to run and provide an attractive yield contribution to return.
We continue to find Asian credit attractive, and expect the uncertainty in China around Huarong Asset Management to be resolved without broad repercussions. Nonetheless, we have reduced exposure to other Chinese credits due to unfavorable risk compensation, in favor of more attractive risk/reward in other segments of Asian credit.
After a pullback in renewable energy stocks, we expect fundamentals to confirm these stocks’ multi-year growth spurt. We remain focused on wind and solar stocks due to their price competitiveness and forthcoming government funding for capacity buildouts. We are examining related themes in areas such as “green hydrogen,” although we believe prices have outstripped realistic intermediate-term fundamental improvements. We’re also intrigued by developments in nuclear fusion, which remains the holy grail of energy solutions and appears to be making real progress.
Despite wider discussions of a commodity “supercycle,” we view commodities as another highly growth-sensitive asset class that has had a huge run. Now with growth plateauing, commodities are revealing their vulnerability. There will be more to come once supply bottlenecks do clear. We have not owned commodities recently, and now is not the time to re-enter.
Copper is the one area where we see a strong longer-term growth story and a potential supercycle, given copper’s key role in many green technologies critical to the decarbonization push. Solar power systems rely on copper to collect, store, and distribute energy, and it’s used in several components of wind energy systems and electric vehicles. That said, we would not be surprised if copper experienced a meaningful correction as early as the second half of this year, given its huge run and sensitivity to growth, along with China’s slowdown.
For more economic and investment insights, visit our 2021 Midyear Investment Outlook page.
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Last updated 3 June 2021