Investment Brief – June 2021
Reflection on Inflection
Through May, it became clearer that markets have reached an inflection point, that is, at least for the moment leading to a potential significant inflection point away from the past 15 years investment style. Ironically, it took COVID19 to create anything close to levels of inflation that many a central bank had hoped for. Therefore, it is also rather strange that there is concern building in the market about inflation somehow. After all, is this just what everyone wanted, granted we would have preferred not to have had the tragedy of a global pandemic to bring it about.
Here are a few thoughts on where we find ourselves:
- Finally, the central bankers got just the support from fiscal policy that was so lacking in the past. It was very evident in recent years that economies could not achieve inflation with low to negative interest rates alone. The world needed a burst of excess demand for goods and services, not as we had an excess demand for assets.
- Asset prices until the COVID crisis reflected where we were rather than where policymakers were trying to take us.We wanted to have ‘normal’ inflation – call it 2%, but we got very low inflation or deflation and extremely low interest rates in both real and nominal terms. Growth stocks massively outperformed value stocks, and bonds were in a near-permanent bull market.
- The emergence of a real inflation threat forces asset allocators to make material changes to how they allocate assets. Strategic asset allocation post the global financial crisis was growth equities and bond credit. Strategic asset allocation in an inflation world is value equities, commodities, selective real estate, infrastructure/selective utilities.
The case for a material inflection point is supported by further evidence of inflation moving well beyond market expectations. Secondly, President Biden announced a significant fiscal impulse beyond the end of this year.
After dipping to a low of 1.3% last year, global core inflation has increased back to 2.6% in the four months of this year.JP Morgan economists expect global core inflation to rise 2.5% for the year as a whole putting in a half a percentage point higher than the average of 2018 nineteen. US core inflation is expected to be close to 3% marking the fastest annual increase in prices since 1995.
Recent data releases have shown far more inflation than economists had expected. The Fed’s preferred measure of inflation, the PCE deflator (personal consumption expenditure), saw core inflation (excluding food and energy) at an annualised 3.1% in April. The headline rate rose to 3.6%, a substantial spike from 1.4% in January.
Chart 1: US Personal Consumption Expenditure Core inflation (YoY)
The upward pressures on inflation are very evident in the commodity market, where in the past month, coffee prices were up 16%, onions 15%, maize 12% and iron ore 8%.
We suspect that economists won’t shift from the ‘transitory inflation’ label to current inflation trends until they see clear evidence of wage inflation.The jury is still out on whether we have a material increase in wages at hand. However, recent data has shown more wage inflation and the shortages of labour in the United States. The recent Fed’s beige book – a survey across the US of overall economic conditions commented, “Overall, wage growth was moderate, and a growing number of firms offered signing bonuses and increased starting wages to attract and retain workers. Contacts expected that labor demand will remain strong, but supply constrained, in the months ahead,”.
One driver of global inflation seems to be brewing – a weaker dollar. If the Federal Reserve commits to keeping short-term interest rates anchored at zero beyond the rate rises in other parts of the world, the dollar could come under sustained pressure. The Reserve Bank of New Zealand recently broke ranks to suggest raising rates earlier than previously thought. The market senses the Bank of England is itching to raise rates – hence the recent sharp rise in sterling against the dollar.
The last major inflation shock to the global economy was in the 1970s, when US inflation rose from 2.7% in 1972 to 12.2% in 1974. Then, the devaluation of the USD precipitated a chain of events that was a significant shock to the global economy. Of course, we don’t envisage such disruption as seen in the 1970s, but it is important to recognise that macro factors can sometimes go way beyond the norms of recent experience.
Bottom line – the world is facing more inflation than we have seen for some years. We are more in the camp that believes inflation could hang around and indeed potentially accelerate still further such that it warrants a different way of thinking about asset allocation. Greater commodity exposure and a bias to value stocks is the way to start.
May was a month where equity markets seemed to struggle a bit for direction. Inflation numbers from the US and some other countries began to show that the economic recovery post-Covid may bring inflation to go along with economic growth.
The gains in the MSCI World Index were driven by Europe and value sectors in the US market, as evidenced by the outperformance of the Dow Jones for the month. The tech-heavy Nasdaq index fell 1.5%. At the sector level, the notable outperformance was delivered by the Energy and Materials, gaining 5.8% and 5.0%, respectively. Financials were close behind with 4.8%.
Bond returns for the month were stable for the most part, with the best performance coming from the local-currency Emerging Market, which was up 2.0% on the back of a recovery in the value of many local currencies against the USD this month. Bond yields at the Treasury level were a bit lower over the month, helping the overall market post some modest gains after a challenging start to the year when yields were rising quickly.
There were gains across the board for commodities, except platinum, which dropped 3.1%. Gold and silver saw 6.8% and 5.4% gains, respectively, possibly beginning to price in some inflation risk. The gains registered by commodities and the signs seen in supply chains worldwide are the primary catalysts for both the strong performance of the more cyclical equity sectors.
Table 1: Bond and precious metal returns (%)
|1 Month||3 Months||12 Months||YTD||Yield|
|Global Bond Agg Index||0.6||0.3||4.3||-2.5||1.10%|
|Global High Yield Index||1.0||2.1||14.6||2.1||3.85%|
|US Investment Grade ($)||0.2||0.2||4.0||-2.4||2.30%|
|Emerging market ($)||1.0||1.3||7.1||-1.2||3.90%|
|Dollar Trade weighted||-1.0||-1.0||-7.5||0.1||-|
Table 2: Equity markets returns (%)
|Equities||1 Month||3 Months||12 Months||YTD||P/E(F)||Div Yield|
|Asia ex Japan||MSCI||2.4||-1.8||41.1||6.4||16.5||1.7%|
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