Monthly macro update – August 2021
Snapshot of views
Throughout the year, our base case has been that pandemic-driven inflation will be transitory. Despite continued high short-term inflation readings, long-term inflation as priced by the markets continues to moderate to what we believe to be fair value of closer to 2% (for the US). We recognize that higher long-term inflation is a risk, and we position portfolios to reflect that as a risk, rather than an expectation.
Moderating (although still strong) growth expectations have removed a tailwind for cyclical sectors (such as energy and consumer discretionary). This, paired with the strong performance cyclicals since Q4 2020, has led us to downgrade our views on cyclical sectors. We remain positive on equities generally, especially relative to credit, and will continue to be selective within equities to take advantage of sector and style opportunities over the coming year. For now, however, we believe a balanced style and sector allocation is appropriate.
Within equities, Chinese companies are facing several challenges, notably a regulatory crackdown on the technology sector. However, while harsh regulations can be detrimental to those targeted, they can also have unintended indirect effects, which present opportunities in those sectors or companies that are pulled down in tandem. Emerging market equities is an area we are watching closely for signs that the current China-driven selloff may be over-done.
From inflation fears to moderating growth
The adage “there are decades where nothing happens; and there are weeks where decades happen” seems appropriate for the fast-moving economic environment we find ourselves in. Over just a matter of weeks, investors have moved from inflation fears to focusing on moderating economic growth.
Throughout the year our base case has been that inflation will be transitory, driven by supply bottlenecks, and despite recent data continuing to be elevated, market inflation expectations now mirror this view. Looking at a wider range of inflation measures also supports this view – the chart below shows the median component of US inflation, effectively highlighting whether inflation is widespread or isolated to specific sectors. Note how current median inflation remains near the historical average, in contrast to the elevated headline numbers which are being reported. However, we are mindful that risks remain. As such, we continue to advocate less exposure to bonds sensitive to rising interest rates which may materialize from policy makers preventing higher inflation. This is reflected in our downgrade of off risk bonds.
Source: Bloomberg, Inflation is US CPI year on year change, 08/05/21
Tailwinds for cyclicals subside
As we move beyond peak economic growth and transition closer towards a pre-pandemic environment, what implications does this have for markets? While we still expect economic growth to be strong, expectations have moderated. The fall in government bond yields over the past months reflects these lower growth expectations. However, we still expect the longer-term trajectory of yields to be upwards, although to remain low relative to historical levels. Pre-pandemic, low bond yields and slowing growth coincided with a sustained period of outperformance of quality/growth-style companies over value style companies, and there is a possibility we see these conditions return over the coming year. The accommodative conditions for cyclical sectors and regions that we have seen throughout the year are also subsiding, while performance year to date has been strong. With this in mind, we have reduced our preference for cyclical sectors and regions in our asset class views. We remain positive on equities, especially relative to credit, and will continue to be selective within equities to take advantage of sector and style opportunities over the coming year. For now, however, we believe a balanced style and sector allocation is best placed to deliver returns.
Source: Bloomberg, Russel 1000 growth/value index, 08/10/21
China's regulatory crackdown may create opportunities
Early in 2020, we advocated targeted allocations to domestic Chinese companies. Over a year later, we believe there may again be opportunities to benefit from a targeted approach, as Chinese companies face a series of challenges which are creating short term volatility. These challenges include rising Covid-19 cases amidst a less effective vaccine, but also the strict regulatory crackdown on technology companies. We think there are interesting implications of the latter. The willingness of the Chinese government to intervene in markets to achieve its policy goals, although perhaps not surprising, is likely to lead to heightened volatility. While harsh regulations can be detrimental to those targeted (in this case large technology companies), they can also present opportunities in those sectors or companies that are unintentionally pulled down in tandem. It highlights the importance of a dynamic emerging markets allocation, as well as the need for diversification. These idiosyncratic issues can have sharp consequences for specific companies, which in this case represent large segments of the equity market; but at a portfolio level the impact is far less severe if part of a well-diversified allocation.
Source: Bloomberg, 08/05/21
Investment advisory services are provided by River and Mercantile LLC, an investment advisor registered with the US Securities and Exchange Commission. It is a subsidiary of River and Mercantile Group PLC, a U.K. corporation.
The information and opinions contained in this document do not constitute investment advice and is provided for background purposes only. References to specific securities are provided solely as illustrative examples of the River and Mercantile LLC analytical methods, and are not a recommendation to buy or sell such securities. This information is subject to updating and verification. Portions of this presentation are based on data provided by third parties whom River and Mercantile LLC deems to be reliable; however, River and Mercantile LLC cannot guarantee the accuracy and completeness of the information.
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