With the US Federal Reserve still able to control the narrative on inflation, risk assets had another good month in June. Global equities, broad commodity indices and diversified property all ended the month higher – and high-yield and corporate bonds continued to eke out positive returns. Elsewhere, and the key to this broad-based asset-price reflation, sovereign bonds rallied. This was, in large part, due to a favourable market reception of Fed policy guidance.
Guidance from the Fed’s June policy meeting was initially viewed as hawkish and caused an unsettling spike higher in government bond yields and volatility in equities. Reflecting the recent surge in inflation, the Fed projected a much higher level for Core PCE (its preferred inflation measure) for this year, with upside risk to its projections for next year.
Elsewhere, there was a marked shift in the Federal Open Market Committee (FOMC) towards favouring an earlier lift off in the key Fed-Funds rate. When the bond market eventually settled down, longer-term yields fell on the back of declining inflation expectations – whereas short-term yields rose on the prospects for a slightly less accommodative interest-rate policy.
With the market imbuing the Fed with enhanced credibility (at least until the July FOMC, when key guidance on the future tapering of bond purchases is expected) the Dollar rallied quite sharply, further boosting the Sterling returns of US assets – and the earlier weakness in global equity markets was more than reversed.
If we look below the surface of the equity markets for a moment, it’s possible to identify a tug-of-war between opposing market views.
Up until the revised interest-rate guidance from the Fed, value stocks were very much in favour, but the decline in long-term bond yields and lower inflation expectations after the latest FOMC saw growth stocks outperform. The current tension between growth and value is only likely to be resolved once the debate around inflation is itself resolved.
If it becomes clear that this year’s surge in inflation is transitory, reflecting supply-side bottlenecks, then any moderation in economic-growth momentum should see quality growth stocks perform relatively strongly as they did until the summer of last year. However, should there be a structural shift higher in inflation – and with it materially higher wage-growth and inflation expectations – then we would expect value stocks to outperform.
At this point of the cycle, and given the uncertainties around inflation and monetary policy, it makes sense to have a combination of both equity styles. Nevertheless, we maintain a slight preference for growth, reflecting our view that we will soon be over the peak of the growth, earnings and inflation cycles.
Turning to regional equity selection, Asian and emerging market returns have been disappointing in relative terms. Another wave of Covid-19 infections and low vaccination levels have been headwinds to growth. We have also seen tighter monetary policy in China, reflecting a desire to curb speculative excess, and active steps to limit the influence of some of China’s biggest internet companies. These have combined to weigh on sentiment. Notwithstanding these clear headwinds to performance, we feel the favourable valuation gap that has emerged compared with the rest of the world makes them attractive from a long-term perspective. A catalyst for outperformance is likely to be the favourable narrowing of growth differentials with Western economies over the balance of this year.
If we turn to the overall equity market outlook, at present an unusually high number of uncertainties present themselves and, reflecting this, we expect more modest 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 a little too early to become more defensively positioned.
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