2nd Quarter 2021 Investment Review & Outlook

Major Asset Class Returns for Q2 2021 in GBP Terms.

Global Equity Sector Returns for 2Q21, GBP.

(Source: Bloomberg)

Market Review

As we say ‘adieu’ to the first half of 2021, one word neatly defines the prevailing financial market landscape: calm. Against a backdrop of a synchronised global recovery and unprecedented levels of monetary and fiscal stimulus, investors have seen fit to look through selective data surprises, and a (very) brief Fed tapering scare in June, to power headline equity markets, led by the US, to record highs. At the time of writing, bonds have recovered from March levels that were spooking risk assets, whilst the VIX (a volatility index that provides a gauge of investor fear) remains at very subdued levels.

Heading into the summer months, the covid vaccine rollout continues in earnest. According to the most recent data, 24.3% of the world’s population has received at least one dose of a COVID-19 vaccine, with 3.22 billion doses administered globally. In the US, approximately 43% of the population is fully vaccinated, while in the UK the number stands at just under 50%. Europe is now delivering its own much-improved rollout, following a disastrous initial effort plagued by supply shortfalls, that prompted a highly politicised blame game over responsibility.

European governments are now instigating aggressive vaccination campaigns, re-doubled pro-vaccine messaging efforts and, most critically, have received a flood supply from vaccine makers. In the past week, Italy, Germany and Spain have all overtaken the US programme, dubbed ‘Operation Warp Speed’, in terms of the percentage of the population that has received at least one shot against COVID-19. As of June 30 2021, Italy, Spain and Germany have success rates of between 54% and 56%, the result of formidable efforts.

Japan remains a laggard, hobbled by an unfeasibly slow rollout, a chronic shortage of doctors and nurses and the fact the country must import all the required vaccines. Japan’s fully vaccinated rate is running at just over 8% of its population. With just weeks to go until the lighting of the ceremonial torch, the country is now rushing to protect as many as possible ahead of the Tokyo Olympics. That, and an horrific plunge in opinion polls (numbers plummeted to record lows of 33% during May), appear to have stirred Prime Minister Yoshihide Suga and his Cabinet from their slumber.

New, more contagious variants are spreading (‘Delta’ is currently front and centre ) but, encouragingly, existing vaccines appear to demonstrate a robust defence against these strains. This implies that reopening should continue across the major developed economies through the second half of this year, though it remains unlikely that the journey from A to B will be a straight line. These developments have also re-focused markets’ attention on the strength of the economic rebound, the implications for inflation, and the timing of central banks moves to taper asset purchases and, eventually, raise interest rates.

Inflation

The terms ’transitory’ and ‘structural’ have made their way seamlessly into the financial lexicon during 2021 to describe the outlook for types of inflation.

The latest June 9th headline US Consumer Price Index (CPI) print might have been considered a significantly negative event, reinforcing the argument for ‘structural’ or longer-term inflation. In absolute and relative terms, and, more importantly, relative to expectations, the number exceeded aggregate forecasts. And yet despite CPI touching 5% for the first time since the oil price spike of 2008, the S&P Index closed out June at a fresh all-time high, whilst the Nasdaq Index once again breached the 14,000 level. 10-year US Treasury yields, after initially spiking, reversed sharply through the month to close at 1.45%, some 29 basis points lower than the March 2021 cycle high:

(Source: FactSet)

Looking out, we are keeping a close eye on two sets of indicators for whether the spectre of inflation might yet return to spook Chairman Powell’s Federal Reserve, and, by extension, financial markets.

The first is the central bank’s preferred longer term inflation metric, the 5-year, 5-year forward inflation expectations rate, which measures the expected inflation rate over the five-year period that begins five years from now. Forward looking inflation expectations have risen sharply from the covid-induced low of 0.86% on March 19 2020, touching 2.38% on May 11 2021, the highest level since October 2014. The measure currently sits at 2.17%, some 21 basis points below the current cycle high:

(Source: FactSet)

Warren Pies at 3Fourteen Research points out that ‘’inflation is always and everywhere a psychological phenomenon.” Data analysis can take us so far, but true inflation episodes have invariably been accompanied by a shift in group psychology. On this point, Federal Reserve Vice Chairman Richard Clarida has indicated that the Fed will be guided by market-driven inflation expectations and by surveys of inflation expectations which should be monitored carefully.

These include the University of Michigan’s consumer sentiment survey, with the latest June reading showing that one-year mean inflation expectations are currently 4%, whilst the three-month moving average (included to filter out short-term noise) also rose to 4%, the highest level since June 2011. Similarly, the New York Fed’s latest Survey of Consumer Expectations showed median year-ahead inflation expectations surging from 3.4% in May to 4.0% in June, breaking through levels last seen in September 2013.

These levels, if sustained, would begin to make things uncomfortable for Chairman Powell given the outstanding levels of US (and the rest of G7) debt.

Re-opening

We are still in the relatively early recovery stages of the cycle following the lockdown-induced global recession. The ‘re-opening trade’ can be traced back clearly to November 9th 2020, the date interim analysis showed Pfizer/BioNTech’s vaccine candidate to have 90% efficacy in protecting people from transmission of the virus. Asset class returns since that date have been as follows:

Select Asset Class Returns, 9th November 2020 to 30 June 2021 in GBP terms

Global Sector Returns, 9 November 2020 to 30 June 2021, GBP.

(Source: Bloomberg)

A reasonable summary would be that the asset classes which performed poorly during lockdown have been the big winners in the post vaccine rollout phase.

‘Value’ style investments are heavily skewed to cyclical sectors (for example materials, industrials, financials), and these companies are reporting stronger earnings upgrades in aggregate than technology-heavy ‘growth’ stocks (which prospered during the lockdown period). In addition, value stocks continue to trade at a substantial valuation discount to growth stocks. Much will depend on how the growth and inflation outlook unfolds relative to current expectations.

Regional Round Up

In the United States, current consensus expectations for real GDP growth are around 7% in 2021, which would, if realised, point to the strongest growth in the US economy since 1984. Corporate earnings continue to surprise. S&P 500 earnings growth shattered analysts’ expectations (year-on-year profit growth of +52% versus +24% expected) in the first quarter of 2021 and will likely need to deliver similar performance again with second quarter results to justify prevailing valuation metrics.

US inflation is undoubtedly rising strongly, driven by supercharged demand (stimulus cheques being transferred directly to households) and disrupted supply (bottlenecks and pandemic impact). The reaction of bonds in the second half of June however points towards a possible moderation of inflationary pressures back towards the Fed’s target over the medium term.

Europe is now enjoying a robust recovery, and the region should benefit from a more harmonised re-opening of economies in 2H21. Direct financial transfers, notably from the EU Recovery Fund, will have the greatest impact in Southern Europe, where grants and loans comprise approximately 12% of Italian and Spanish, and 19% of Greece’s, GDP levels. This is meaningful. Consensus GDP expectations for the EU are currently around 5%. The region’s exposure to financials and cyclically sensitive sectors including industrials, materials and energy bode well for a strong second half.

The UK’s recovery from Brexit and the pandemic should power strong GDP, and materially better corporate profitability. The FTSE benchmark’s skew towards materials and financials is also favourable at this juncture as the UK pushes to return to ‘full reopening’ in the coming weeks.

Emerging markets have remained laggards since the vaccine announcements. Several factors have combined to generate significant headwinds to investment, among them a high technology weighting amongst benchmarks, concerns about slowing credit growth, heavy-handed regulatory oversight in China, and the stop-start rollout of vaccines.

Most importantly, huge pockets of Asia (India, and, more recently, Indonesia, Taiwan and Korea) and Brazil have been fighting severe second wave eruptions of the COVID-virus and respective mutations. Whilst it remains too early to declare victory, some semblance of Chinese stabilisation and a sharp reduction in 7-day average infection rates (and therefore hospitalisations and deaths) across the region as vaccines become more readily available and distributed can be expected.

Finally, the Japanese Government’s abject leadership of the COVID-19 rollout programme has reversed. With a renewed vaccine push underway ahead of the Olympics (Japan is now targeting 1 million administered doses per day), a decent economic recovery during the second half of the year can be expected, boosted by strong global capital expenditure and improving domestic demand.

Asset Allocation & Positioning Summary

• Booming stock and housing markets combined with unprecedented levels of monetary and fiscal stimulus efforts from global governments have boosted consumer and household balance sheets.
• TEAM enters the 3rd quarter of 2021 advocating a healthy allocation to global equities, real assets (US infrastructure, global property, gold) and alternative income streams, securities that exhibit traditional bond characteristics and that, in our view, offer a far greater prospect of real returns in the current environment.
• Whilst we lean more favourably towards the ‘transitory’ inflation camp, we acknowledge that evidence of sharper, more persistent price pressures remain a risk. Watch wage growth, inflation breakeven rates and inflation expectation surveys.
• Additional risks we are monitoring include, but are not limited to, a slowing Chinese economy, re-surging covid variants (and associated lockdowns) and shifting global weather patterns, including the current US drought, which could meaningfully impact food and energy prices.

Craig Farley, Chief Investment Officer

30 June 2021