International | Jul 14 2021
As equity markets continue to rise, investment managers scan the world for opportunity with an eye on inflation and the commencement of tapering by the US Federal Reserve.
-Front-loaded US fiscal policy may drag on second half growth
-Fund managers offer preferences by sector and style
-The shift towards ESG strategies looks structural
-Citi expects the ASX200 to reach 7,700 by mid-2022
-Preferred Australian stocks
By Mark Woodruff
The reopening trade can be dated from the first week of November 2020, when the first successful covid-19 vaccine was announced. Since then, the best performing asset classes have been small-cap and non-US equities, global real estate investment trusts and commodities, while the Value style of investing has outperformed.
More recently, US equity markets have continued to rally with the S&P500 rising 0.5% in May and 2.2% in June.
In June, that strength was driven primarily by a strong move in the stocks making up the latest acronym, namely FAAMG (Facebook, Apple, Amazon, Microsoft and Google). These stocks account for over 20% of the S&P500’s market capitalisation.
Other markets have fared less well, as the strength/momentum of the uptrend in global equity markets has diminished. For example, Chinese equities are largely unchanged since the start of 2021, German equities have continued to edge modestly higher, while Japanese and Korean equity markets have been trending lower since February this year.
In Australia, the stock market is currently around 4.8% above its pre-covid peak, lagging behind other global markets with the MSCI AC World index 28.5% above the peak.
Globally, many assets have increased more than normal in the acceleration phase of the economic cycle. Cyclicals and growth stocks are 46% and 26% above their ten-year trend, respectively, which suggests they are vulnerable to negative surprises.
Where to from here? Naturally, the topic du jour remains the likely timing and magnitude of interest rate rises across the globe.
In the US, speculation continues as to when the Federal Reserve will start to taper the asset purchasing program. Some fund managers believe the situation is in hand, and trust the Fed is cognisant of how tapering impacted markets in 2013, and will proceed in such a way this time so as to avoid too much turbulence.
While risk assets could become volatile temporarily on the announcement of tapering, it’s thought this may not have a long-lasting impact.
Of course this looks easy in print, but at the time markets will have to assess the Fed’s average inflation-targeting framework, which by design looks past initial price increases.
Back in Australia, the Reserve Bank recently reiterated its commitment to "highly supportive monetary conditions” and suggests the target cash rate is unlikely to increase from its current level of 0.10% until 2024 at the earliest.
Before looking at how portfolio managers worldwide are adjusting their asset class exposures, let’s first examine the dynamics of this current cycle and how that may affect expectations for growth and inflation.
Dynamics of the current cycle
The current cycle has been driven by pandemic effects and explains why the manufacturing recovery was underestimated, explains Dankse Bank. As consumers could not buy services, they bought a lot more goods.
However, the easing of the pandemic leaves a lot of uncertainty about what will drive the economy. As the market underestimated the increase in goods consumption, there is a risk the market will also underestimate the reversal and see a bigger decline in goods demand than expected.
Such reversals are currently evident in the US housing market, where pandemic effects have previously dominated. There is now a sharp cooling in activity, despite rising consumer confidence and a strengthening jobs market.
Going forward, a driver for overall growth may be the higher-than-normal savings, along with the reduction in consumer debt during the pandemic.
Additionally, stronger services should underpin overall growth, as the sector has been lagging with lots of pent-up demand. Normally the manufacturing and service sectors move in accord, explains Danske B, but this time there has been quite a big divergence.
However, fiscal policy has been front-loaded in the US, which will turn into a drag on growth in the second half as the temporary income spike from stimulus cheques and enhanced benefits fades.
Inflation and tapering
After upgrades to all major regions over the last few months, Citi economists expect global real GDP to grow by an impressive 6% in 2021 and 4.2% in 2022, following the -3.5% contraction in 2020.
Rising energy prices in 2021 are expected to keep headline inflation running well above 2% in many economies, but should unwind into 2022.
However, a couple of factors will help put a lid on inflation expectations going forward, according to Dankse Bank. Firstly, we are approaching the peak in the economic cycle, which has historically mostly led to lower inflation expectations. Secondly, this peak now coincides with an expected decline in headline inflation in both the US and Germany over the next year. Finally, a more hawkish Fed during the second half should help anchor inflation expectations.
On the flipside, an upside risk is that US wage growth moves up more than expected due to labour shortages, and that the Fed falls behind the curve. However, while a tapering of bond purchases should contribute to higher yields, Dankse Bank does not expect a new "taper tantrum".
Morgan Stanley also believes the rate of change in terms of year-on-year inflation is peaking. While inflation should remain above the Fed's 2% personal consumption expenditure (PCE) target in the next two years, it should normalise from current levels.
Inflation in Europe and Japan is less pronounced, and will undershoot targets for longer, suggesting to the investment bank that any tightening from the European Central Bank and Bank of Japan will be well behind the Fed.
Sectors and styles
Dankse Bank believes we will face ‘twin peaks’ in both inflation and the manufacturing cycle over the coming quarters. This has important implications for performance across assets and within asset classes.
The bank believes this will occur when we move from the current acceleration phase of the business cycle (easy liquidity and lagging job gains, leading to muted wage pressure) to a more mature late cycle phase (central banks start a path of withdrawing liquidity, job markets gain strength and wage pressure builds).
In this latter phase, corporates also face lower growth in revenue. Nonetheless, equities should continue to rise after the peak, assures Danske.
More interestingly, it will likely be a matter of tilting the equity exposure to benefit from the (average) shift in markets, as borne out by a historical analysis performed by the bank. That is, the curve flattens and commodities pause or outright decline. Inflation expectations then co-move with commodities, the US dollar strengthens and liquidity tightens.
Largely, such cross asset moves would be consistent with a tilt to Quality and Technology in styles and sectors. The Value factor would probably underperform jointly with the commodity space.
Russell Investments, on the other hand, still likes the pandemic-recovery trade that favours equities over bonds, Value over the Growth and non-US over US stocks.
The investment advisor believes the inflation spike is mostly transitory, a combination of base effect (from when the Consumer Price Index fell during the initial lockdown last year), and temporary supply bottlenecks. It’s thought it will take until the middle of 2022 for the US economy to recover the lost output from the lockdowns and longer in other economies. Broad-based inflation pressures are unlikely until then.
Alternatively, Citi strategists think the recent pull-back in bond yields will prove temporary and they still expect the ten-year US Treasury yield to hit 2.0% into 2022, as the economic recovery gathers momentum and markets contemplate Fed tightening.
Rising yields are usually accompanied by cyclical sector outperformance, especially Financials. Technology-related stocks are also expected to hold their own if real yields stay low.
Finally, Morgan Stanley recommends investors begin to blend Value with Quality, particularly in the US and Europe, as this blended approach tends to outperform in the mid-cycle phase.
In particular, there’s a preference for Quality stocks with relatively more stable earnings along with reasonably priced Growth stocks. These both offer dependable performance in mid-cycle transitions.
In this regard, the investment bank prefers international (and Australian) healthcare stocks as opposed to technology stocks for which valuations remain rich.
Timing of tapering
Morgan Stanley expects the Fed to wait until the September FOMC meeting to signal its intention to taper asset purchases, whilst formally announcing tapering in March 2022.
The investment bank forecasts tapering to then start from April 2022 and rate hikes are likely to begin in the third quarter of 2023. This will occur after the inflation rate has been sustained at or above 2% for some time and the labour market has reached maximum employment. These moves to normalise policy are expected to come at a later stage in the recovery compared to previous cycles.
As long as the Fed retains balance sheet expansion, technical corrections in the market (not related to a downgrade in the macro outlook) will likely be bought as investors believe the “Fed put option” remains. This term encapsulates the widespread belief that the Fed will always rescue the economy and financial markets.
Morgan Stanley believes the Fed is very cognisant of how tapering impacted markets in 2013, and will do so in such a way as to avoid too much turbulence. Risk assets could become volatile temporarily on the announcement of tapering, but it's not seen as having a long-lasting impact. The Fed is only expected to proceed once inflation and growth have sufficient momentum to allow a change in policy.
Citi expects an announcement this September of -$15bn/month worth of tapering (from US$120bn/m), to start in December this year, five months earlier than the April date envisaged by Morgan Stanley. The first US rate hike is expected by Citi in December 2022.
While Morgan Stanley’s base case remains a moderate overshoot of inflation, their economists see a very real risk that inflation could enter the acceleration phase, (i.e. threaten to breach 2.5%, the Fed’s implicit tolerance threshold, from the second half of 2022).
This would likely be driven by higher wage costs. This could play out either from a faster-than-expected job market improvement or uncertainty around the natural rate of unemployment. It’s conceivable that the natural rate of unemployment has risen and sits higher than commonly perceived.
A shorter timeline of the current labour market recovery may not give workers enough time to be re-skilled and reallocated across industries. This is especially the case if the structural shifts in the labour market persist due to the pandemic. This would mean that a lower decline in unemployment would be needed to start generating noticeable wage inflation.
The combination of a neutral short-term/positive long-term view leads Morgan Stanley to continue to recommend a mild overweight to risk assets. The style preference shifts somewhat towards Quality as the cycle matures but a preference remains for Value over Growth, and overweight sectors and countries most levered to reflation on a longer-term view.
Earnings growth is expected to continue, but at a much slower pace. Valuations will also remain elevated, particularly in the US. However, risk premiums (the amount by which the return of a risky asset is expected to outperform the known return on a risk-free asset) remains relatively appealing. This is even more so now that the investment bank expects a limited rise in bond yields moving forward and cash rates are expected to remain steady for a sustained period.
Morgan Stanley considers tapering in US monetary policy as the key trigger for a correction in the short term, particularly given current elevated valuations and artificially low bond yields.
Nevertheless, with substantial cash sitting on the sidelines and a positive macro outlook, it’s believed this could potentially create a good opportunity for investors to add to equities in the medium to longer term.
Russell Investments believes global equities remain expensive, with the very expensive US market offsetting better value elsewhere. While sentiment is close to overbought, it is not near dangerous levels of euphoria. The strong cycle delivers a preference for equities over bonds for at least the next 12 months, despite expensive valuations.
Financial stocks are the largest sector in the MSCI World Value Index, and these should benefit from further yield-curve steepening, which boosts the profitability of banks. Russell expects long-term interest rates will have modest upside over the next few months as global growth continues to improve.
In terms of regions, Morgan Stanley believes the US market will likely lag in the second half of the year. The 'strong winds' of the economic recovery will create risks to margins, tax policy and high valuations.
Europe and Japan are expected to perform better, with still-strong earnings growth, less extreme valuations and less risk associated with a “hotter economy”.
Emerging markets (EM) equities sit somewhere in the middle of Morgan Stanley’s scenarios for the US (earnings growth, but at a slower pace) and Europe and Japan (still-strong earnings growth with less extreme valuations than the US).
EM equities have been laggards so far this year and Russell Investments believes they have been held back by the high weighting toward technology stocks in the emerging markets benchmark.
Additionally, there have been concerns about slowing credit growth in China and the slow rollout of covid-19 vaccines across some regions has contributed. It’s believed this should start to reverse later in the year as Chinese credit growth stabilises and vaccines become more available across emerging markets.
Citi suggests the shift towards ESG strategies is structural, and this favours Growth over Value and Europe over EM equities.
ESG inputs are becoming increasingly important for equity fund managers. Flows into ESG-focused funds are increasing and right now it is the most important theme for European equities, and becoming more important elsewhere.
Australian economy and the sharemarket
Morningstar notes the Australian economy continues to exhibit solid growth, and there are now more people employed than before the covid-19 outbreak. The slow vaccine rollout is expected to ramp up, and early signs of this are more evident following the recent lockdowns.
The RBA has maintained its accommodative stance and the investment management firm believes it will continue the quantitative easing program until the Fed begins to taper. Hence, a rise in the cash rate is still considered some way away.
The Australian economic recovery is reflected in the rapidly improving unemployment rate. It fell to 5.1% in May, its lowest level since December 2019. This is despite the federal government’s JobKeeper scheme ending in March. Unemployment is already below the Federal Budget forecasts, released in May, which envisaged an unemployment rate of 5.5% for the June 2021 quarter.
The equity market as a whole currently looks overvalued, according to Morningstar, and investors should be particularly selective when investing new capital. Nonetheless, Morningstar makes several sector and individual stock suggestions (below).