Monthly macro update – June 2021
Snapshot of views
Inflation is materializing, but it remains our base case that this is transitory and driven primarily by COVID-related short-term supply and demand issues. Unemployment remains elevated and as supply constraints alleviate prices are falling rapidly (see: lumber). Long-term inflation expectations, as priced in the markets for government bonds and inflation swaps, remain consistent with stated central bank objectives. We do expect upward pressure on yields as economies normalize, but that is more likely to be a function of rising real yields vs. rising inflation expectations. Monetary policy is likely to remain very supportive through at least 2023, though exceptionally strong economic data could cause this timeline to accelerate.
Property prices soar, but "bubble" talk is premature
Residential property prices are booming all around the world, especially in suburbs, exurbs and vacation destinations. The drivers need little explaining: high COVID-related savings rates for many, pent up demand and preference for more space have all been tailwinds. But we view talk of housing bubbles as somewhat unfounded. Purchases do not appear to be speculative and mortgage standards have not loosened significantly. Instead, we believe we are seeing a shift forward of demand, and as we approach a post-COVID world, we expect price growth to normalize. Also, commercial property prices aren’t benefiting in the same way, with many retail and second tier office properties seeing weak demand.
Inflation comes home to roost
US inflation picked up over May, with consumer prices rising nearly 5% year on year. This jump, a rate not seen since the Financial Crisis, prompted a rise in bond yields and a sell-off in tech (a continuation of themes we saw earlier this year). While this may have sparked fear among investors, we maintain our view that inflation spikes are likely to be temporary, caused by a COVID-driven supply and demand imbalance. For example, in the housing and lumber market, pent up housing demand and supply bottlenecks saw lumber prices soar by 85%, but are now normalizing as supply chains reopen.
As discussed previously, for inflation to rise sustainably we would need to see lower unemployment and upwards wage growth pressure. To put this in context, US unemployment is still significantly higher than pre-Covid levels. Should unemployment decline to pre-pandemic levels, there are many more reasons for this spike in inflation to prove transitory. Wage inflation, led by strong labor demand, will face deflationary headwinds of productivity growth driven by technology, while the tapering of US stimulus and headwinds to commodity prices in China will also contribute. Subsequently, we may not see the rise in labor costs required to cause higher inflation. The below chart illustrates this, with US Core inflation predicted to normalize to c.2% in 2022 in line with current US labor costs.
Source: Bloomberg 06/03/21
Where do bond yields go next?
While high inflation has materialized in data of late, the government bond yield market has been factoring in rising inflation for some time, shown by the rise in inflation breakevens1 and bond yields below. Government bonds remain crucial in the valuation of other assets, most notably through the discount effect of future cash flows, and hence have a ripple effect on other asset class performance. But bond yields have stabilized of late, so where will they go from here? Central banks have managed to put some downward pressure on yields by publicly reiterating their commitment not to respond prematurely to short term inflation, but we are already seeing some tapering in China with developed markets likely to follow over the next 12 months. With this in mind, our base case remains that we will see further upwards pressure on bond yields later in the year. We expect policymakers to continue to support economies for some time yet but are also cognizant that strong economic data could result in stimulus being withdrawn sooner than anticipated. If this materializes, we could see a much sharper rise in bond yields which act as a headwind to higher growth areas of the equity market. As this withdrawal of stimulus moves nearer, we advocate trimming allocations to areas of the market which could suffer in a rising rate environment.
Source: Bloomberg 06/03/21
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.
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS.
R&M investment consulting
From asset allocation and fund manager selection to risk management and ongoing governance support – we understand that your world is complex.
We tailor our advice to your needs.