The success of the vaccine rollout in the developed world, coupled with the strong pent-up demand for goods and services as economies reopen, has created boom-like conditions in many regions. As a result, we have the strongest global growth seen since the 1960s and the biggest increase in corporate earnings since 2009. This combination has helped generate strong equity returns across most regions and sectors.
Despite market anxiety about higher inflation and the potential withdrawal of monetary-stimulus measures in the US later this year, the strongly pro-cyclical fiscal and monetary policy stance under the Biden administration has been a tailwind for US equities. Elsewhere, European and UK stock markets have benefitted from the better global growth dynamic, reflecting their higher weight in cyclical sectors – notably energy, industrials and financials.
Asian and emerging markets have generally reached the mid-point of the year in positive territory, but their returns have been disappointing in relative terms. Another wave of Covid-19 infections and low vaccination rates have been headwinds to growth. We have seen tighter monetary policy in China reflecting a desire to curb speculative excess, which has also weighed on market sentiment in emerging markets generally.
Whilst equity investors have been generally satisfied with their returns, bond investors will have been disappointed. This year’s rise in bond yields has generated negative returns in most markets and sectors. The strength of this year’s rebound in growth has been breathtaking, whilst the pickup in inflation, particularly in the US, has been eye-catching.
Whilst a lot of the upwards pressure on inflation is likely to reflect short-term supply bottlenecks, which will ultimately ease when the global economy finally returns to a more normal footing, there are genuine worries that inflation may ultimately settle at an uncomfortably high level. Were this to occur, the level of yields on offer in the market is still too low to afford much protection to bond investors. If one then adds the prospect of the Federal Reserve reducing its monetary support for the economy via a reduced pace of bond purchases as we head toward the end of this year, there is a risk that bond yields could rise materially higher from here.
This scenario will also be of interest to equity investors. This is because, in general, low bond yields over recent years have been a key support for higher equity valuations. This is particularly true in secular growth sectors – technology, health, and consumer staples – where there is less cyclicality in corporate earnings. A significant rise in bond yields would increase the discount rate investors apply to these earnings and, as a result, valuations would come down. Other sectors, notably financials, might fare relatively better in this rising-rate environment but, in the round, it would prove challenging for equity markets.
Our base scenario for the balance of this year is that the US central bank will be able to guide the market to anticipate reduced bond purchases without excessive market disruption. In addition, we also expect that moderating inflationary pressures should allow the Fed to delay hiking its key (Fed Funds) policy rate until the fourth quarter of next year. However, we are mindful of the risk that inflation remains stickier than the markets are comfortable with and, as a result, we see the bond market force the Fed’s hand by driving up market interest rates in a rapid and disorderly fashion.
Another risk we need to consider is whether markets are in danger of becoming euphoric, reflecting excessive optimism on the outlook as economies reopen. Were we to see a sharper-than-expected deceleration of economic activity – either reflecting the continued impact of Covid-19 and/or withdrawal of central bank policy support as we head towards year end, then investors are likely to have much less enthusiasm for the recovery plays in their portfolios. In this environment, we could see financials, industrials, retail, travel, and leisure reverse some of their recent outperformance.
An unusually high number of uncertainties currently present themselves and, reflecting this, we expect more modest investment returns in the second half of this year. However, given that we have yet to see the peak in economic activity and corporate earnings momentum, we feel it is too early to become more defensively positioned.
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Uncertainties persist, but the Fed should keep control
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