By Simon Tryzna, Chief Investment Officer
With summer in full swing, and states re-opening, it feels like things are getting back to normal, or at least the new normal. While COVID-19 continues to be a health risk, and variants are out there, it's been incredible seeing sporting events full, concerts back in full swing, and people just out and about enjoying summer. Yet, as well all know, markets are very much forward-looking. So while things are going relatively well at the moment, investors have already begun to project and position portfolios for the remainder of 2021 and 2022.
As part of our ongoing investment research process, I've spent the last few weeks touching base with our portfolio teams, talking to strategists, and reading countless market outlooks. The consensus is that the second half of the year will be far more challenging than the first. The majority of investors I've spoken with don't envision the Delta Variant being a significant risk moving forward, agreed that inflation is here (albeit there is a strong debate about how much of it is transitory) and that Fed actions and interest rate movement will be a significant market driver. Despite the risks outlined, the consensus is that equities still merit overweight to fixed income. While we could see an equity pullback of 10% or more, mid to long-term economic fundamentals favor growth and a risk-on trade.
Undoubtedly the biggest talking point right now is inflation and how global central banks will react to curb it. Inflation is defined as a general increase in prices and a fall in the purchasing value of money. In other words, what consumers can purchase with $10 today, may cost $12 next year. At its core, inflation is a supply and demand issue. If there is more demand for a good than supply, prices will go up until an equilibrium balance is reached.
There is no disagreement that prices have been going up this year. Almost all economists agree that some proportion of inflation is transitory – the disagreement among them is how much. The global pandemic disrupted supply chains and altered consumer behavior. These factors added to the cost of production and transportation, forcing companies to raise prices on goods. The unprecedented global stimulus has left consumers in great financial shape. On aggregate, the U.S. Consumer is sitting on $2.6T in excess savings since the beginning of the crisis, with saving rates still considerably elevated. With the global economy re-opening, consumers, with pent-up demand, began to spend. All of that led to an incredible 5% increase in the Consumer Price Index in May. That said, 55% of that increase came solely from auto sales (used & new), hotels, and transportation, even though in total, those areas make up just 3% of the index. These factors likely will not worry central banks, and as businesses scramble to expand supply, equilibrium should return. The question then becomes – how long will that take?
Speaking of central banks, "Transitory versus persistent" was the main debate at the Federal Reserve's June FOMC meeting, and recognition of the upside inflation risk accelerated the Fed's tightening path from zero interest rate hikes in 2023 to two. Many investors are reckoning with the fact that because inflation has been absent from the macroeconomic scene for so long, policymakers (particularly in developed countries) seem unsure how to manage it best. Fed Chair Jerome Powell openly admitted they do not know exactly when price pressures and bottlenecks will abate. We expect that both the Federal Reserve and the European Central Bank will announce tapering plans in the fall and be extremely careful about communicating their plans. Volatility is almost certain to occur as markets may be sensitive to any perceived change in policy support.
The one component of inflation that may stick around is wage inflation. To incentivize the labor force to come back, businesses are being forced to increase wages. Once they raise wages, it will be tough for them to lower them. Higher wages will add to operational expenses and ultimately be passed on to consumers, thus increasing prices. In addition, now making more money than before, workers will have extra cash to spend, thus increasing the demand for goods and services and pushing prices higher. Therefore, rising wages have a knock-on effect on the rest of the CPI. That said, the U.S. labor share of profits is finally getting closer to its post-World War II average, something the Fed will be very reluctant to interfere with. As a result, if wage pressures remain, the Fed is unlikely to react.
While inflation seems to be a bit of a curse word in the news these days, the reality is that moderate inflation, when backed by economic growth, is actually a positive. And, right now, all signs continue to tell us that global growth will continue this year and could very well continue in the years ahead. The U.S. Leading Economic Index saw considerable improvement, and global economists have continued to upgrade forecasts for this year and next. There continues to be pent up demand from consumers, and the Child Credit Expansion, while providing further support for the families that need it (the poorest 20% of eligible households are likely to consume the majority of these payments), will add a powerful fuel to the U.S. consumer engine. As a result, service activity has continued to pick up, small businesses are planning on going on a hiring surge, and companies are once again looking to increase capital expenditure spending.
The best-case scenario for the markets is that the growth potential is realized over a prolonged time. The resulting inflation would then be at a level higher than what investors have become accustomed to over the last 13 years. The biggest risk is that inflation reaches a high enough level to where it impedes global growth.
So what can derail this? Unfortunately, COVID-19 variants. While the absolute worst-case scenario would be another collective global lockdown, it's improbable that governments would go to that level. That said, individuals and companies could very well self-impose lockdowns to help combat the spread of the virus. Already, certain manufacturing plants in Asia are in lockdown, and the mobility data (how often consumers go out to eat, make travel directions on Google / Apple Maps, fly, etc.) has started to trend lower. In addition, the spread of variants has also already magnified the divergence between countries, as the virus spreads further and quicker in countries under-vaccinated, exacerbating the unevenness of economic performance worldwide.
Even with some of the economic risks highlighted above, investors continue to favor stocks over bonds. After the "covid" trade last year, which saw mega-cap tech stocks lead the way, the stock market performance at the beginning of this year was categorized as the "re-opening" trade, in which many names that deeply sold off last year bounced back. Their bounce, however, didn't last too long, and over the previous quarter, a re-adjustment trade was made. Now, more so than in recent months, investors have begun to pay attention to fundamentals. Much like in late 2019, investors are currently favoring quality companies with strong balance sheets that are in a position to continue to grow in this post-pandemic environment.
Growth-oriented investors believe that we are beginning another technological revolution as businesses and consumer experience digitize. This trend provides a powerful secular tailwind to a lot of growth names, particularly those companies that are deemed "disruptive." To keep margins low (especially in the face of rising labor costs), companies have continued to invest heavily in technologies to make their businesses more efficient. This has already begun to happen across major emerging markets and has been a key economic engine that only strengthened during the pandemic.
The risk for the U.S. equity market, then, is around valuations. Almost all of the teams I spoke with would agree that valuations are still high in the U.S. and look more attractive abroad. And while the U.S. market's valuation can be rationalized with strong earnings and low-interest rates, the reality is, should one of those two components change, the market could suffer. "Equities remain priced to perfection" is a comment that came up in multiple conversations. And with inflation on everyone's mind and yields & interest rates going up, there is a significant risk associated with U.S. stocks. One other thing to note – while it's still too early to tell, and there is a lot of political debate to be had – it is likely that there is an increase in corporate tax, which could weigh on corporate earnings moving forward. (It could also force companies to increase prices which could push inflation higher and force yields and interest rates to go up…)
With that backdrop, a lot of investors are now looking overseas for better risk-adjusted returns. Many have a favorable view of Europe now that their economy is starting to accelerate once more. Europe's exposure to financials and cyclically sensitive sectors (such as industrials, materials, and energy), and its relatively small exposure to technology (which would be affected by rising interest rates), give it the potential to outperform in the post-vaccine phase of the recovery. The U.K., as reflected by the FTSE 100 Index, is the cheapest of the major developed equity markets.
In emerging markets, Chinese equities have struggled over the last couple of months, in part due to increasing regulation on their technology companies and in particular, their foray into financial services. Forecasting regulation measures is a difficult task, but the underlying assumption is that most of the regulation changes are behind us for now. And while China led the Emerging Markets last year, we expect that other countries will bounce back heavily this year. Already, those countries that are net commodity exporters have benefited from the increased commodity prices. With the expectation of a global economic rebound, new infrastructure programs, and an increasing focus on environmental sustainability, capital expenditures in the developed world are set to increase. In their role as suppliers to the developed world, an uptick in capital spending in developed markets bodes well for emerging markets.
As emerging markets stabilize with more vaccines and stabilization of Chinese credit, they look incredibly attractive to investors. And while geopolitical issues persist, the reality is that most of Chinese and E.M. fund flows come from local investors, and they should continue to perform well as their respective economies continue to open and bounce back. Lastly – broader global inflation is good for emerging market equities, especially those with a high level of operating leverage. Should inflation push higher, yet be contained, it would provide a tailwind to E.M. Equities.
If rising interest rates are a risk in the stock market, it's an even bigger risk in the bond market. Higher interest rates push bond yields higher, and, as yields have an inverse relationship with bond prices, higher yields mean falling bond prices. As an example, should the 10-year treasury yield double from 1.5% over the next 2-3 years, the capital loss on the bond would be somewhere between 10-15%. At the moment, government bonds are expensive, and yields should come under upward pressure as output gaps close and central banks look to taper back asset purchases. Many teams I spoke with expect the U.S. 10-year Treasury yield to trade in a 1.5% to 2.0% range over the second half of the year.
At the moment, with yields being low, investors have flooded into the high yield and investment-grade market looking for higher yielding assets. While that segment of the bond market is considered expensive, they benefit from a positive cycle view that supports corporate profits growth. Default rates continue to decline, and demand technicals remain strong, driven by demand from Europe and Asia and U.S. pension funds seeking long-duration assets to lock in their improved funded status.
Active bond investors have begun to look to emerging market debt and certain areas of the corporate credit and securitized asset space for opportunities. All of them cite the importance of credit selection. They are mindful not to reach for securities that they deem expensive and feel like they aren't properly compensated for the risk they would be taking. Even when compared to the free-wheeling credit environment of 2007, many lenders have discarded any discipline they used to have regarding covenants, restricted payments clauses, protections against layering and subordination, mandatory payments from asset sales, etc. While it's overlooked at the moment, this credit underwriting deterioration could be a significant risk to the bond market, particularly the high yield sector, when we reach the bumpier part of the business cycle.
The one area of fixed income that looks resilient and fairly attractive is the municipal bond market. Credit risk in the muni market has diminished, and muni revenues are incredibly high. When combined with the possibility of a tax increase, many investors have looked to allocate to the muni space. Per our muni team at BlackRock, this summer, we'll have a negative $46B in net supply – in other words, there is far more demand for investors for municipal bonds than supply, which is pushing muni bond prices higher. In addition, should the infrastructure bill being proposed in Washington D.C. pass, it would provide a massive tailwind to the market. The muni market will be kept in focus and will be relied upon to help finance projects. There could be another edition of "Build America Bonds" again, which will be another positive.
Investment returns aren't possible without taking on investment risks, and in this piece, I've outlined a few key ones on investors' minds. There will be a lot of short-term noise, and every economic data point and central bank word will be heavily scrutinized. The reality, however, is that while we may experience some bumps along the way (and some could be bigger than others), there are a lot of positive economic forces out there. Those forces should allow long-term investors to maintain a risk-on viewpoint. As long-term investors, our job isn't to get caught up in the weeds but rather focus on the bigger picture and react accordingly.
As always, please don't hesitate to reach out with any comments or questions.