Q4 Update: Growing pains
The COVID-19 delta variant, inflation and central bank tapering are unnerving investors. We expect the pandemic-recovery trade to resume as inflation subsides, infection rates decline, and tapering turns out to not equal tightening. The outlook favors equities over bonds, the value factor over the growth factor and non-U.S. over U.S. stocks.
Andrew Pease
GLOBAL HEAD OF INVESTMENT STRATEGY
"The strong cycle delivers a preference for equities over bonds for at least the next 12 months, despite expensive valuations."
- Andrew Pease
INTRODUCTION
The post-lockdown recovery has transitioned from energetic youthfulness to awkward adolescence. It’s still growing, although at a slower pace, and there are worries about what happens next, particularly about monetary policy and the outlook for inflation. The inflation spike has been larger than expected, but we still think it is transitory, caused by base effects from when the U.S. consumer price index (CPI) fell during the lockdown last year and by temporary supply bottlenecks. Inflation may remain high over the remainder of 2021 but should decline in early 2022. This means that even though the U.S. Federal Reserve (Fed) is likely to begin tapering back on asset purchases before the end of the year, rate hikes are unlikely before the second half of 2023.
Another worry is the highly contagious COVID-19 delta variant. The evidence so far is that vaccines are effective in preventing serious COVID-19 infections. Vaccination rates are accelerating globally, and emerging economies are catching up with developed markets. Infection rates appear to have peaked globally in early September. This means the reopening of economies should continue over the remainder of 2021. The onset of winter in the northern hemisphere will be a test, but the rollout of booster vaccination shots should help prevent widescale renewed lockdowns.
The conclusions from our cycle, value and sentiment (CVS) investment decision-making process are broadly unchanged from our previous quarterly report. Global equities remain expensive, with the very expensive U.S. market offsetting better value elsewhere. Sentiment is slightly overbought, but not close to dangerous levels of euphoria. The strong cycle delivers a preference for equities over bonds for at least the next 12 months, despite expensive valuations. It also reinforces our preference for the value equity factor over the growth factor and for non-U.S. equities to outperform the U.S. market.
Cycle still in recovery phase
The post-lockdown recovery has been powerful, and most developed economies have seen double-digit gross domestic product (GDP) rebounds from 2020 lows. Even so, we think the cycle is still in the recovery phase, although it is maturing. Despite strong growth, there is plenty of spare capacity. This can be seen in the employment-to-population ratio for prime-age workers in the United States. The chart below shows the ratio has recovered from the pandemic lows, but only to levels reached during the relatively mild recessions in the early 1990s and 2000s. We expect the U.S. labor-market recovery should still resemble a typical post-recession recovery over the next few quarters.
U.S. employment-population ratio for prime-age workers
The U.S. recovery, however, is more advanced than that of other developed economies. The following chart shows how far GDP has recovered, relative to the pre-COVID-19 peak in 2019. GDP is 0.8% higher in the U.S., although this level is still short relative to the pre-COVID-19 trend. GDP is 2.5% below 2019 levels in the euro area and 4.5% below in the United Kingdom. We expect more cyclical upside for economic growth outside the U.S., and this should allow market leadership to rotate toward the rest of the world.
GDP in Q2 2021 relative to pre-COVID-19 peak in 2019
Two key indicators
Last quarter, we listed two indicators that should offer a guide to the Fed’s expected reaction to the inflation spike.
The first is five-year/five-year breakeven inflation expectations, based on the pricing of Treasury Inflation Protected Securities (TIPS). This is the market’s forecast for average inflation over five years in five years’ time. It tells us that investors expect inflation will average 2.17% in the five years from late 2026 to late 2031. The TIPS yields are based on the CPI, while the Fed targets inflation as measured by the personal consumption expenditure (PCE) deflator. The two move together over time, but CPI inflation is generally around 0.25% higher than PCE inflation. A breakeven rate of 2.75% would suggest the market sees PCE inflation above 2.5% in five years’ time. Market inflation expectations are currently comfortably below the Fed’s worry point.
Watchpoint indicator #1: U.S. 5-year/5-year breakeven inflation rate
The second indicator is the Atlanta Fed’s Wage Growth Tracker, and this has a less-comforting message about inflation risks. It reached 3.9% in August, which is close to the 4% threshold where we judge that the Fed will become concerned about the inflationary impact on the growth of wages. A breakdown shows that the spike has been mostly driven by wages for low-skilled, young people in the leisure and hospitality industry. This suggests the surge has been caused by temporary labor supply shortages and that wage pressures should subside as economic activity normalizes. This indicator, however, will be an important watchpoint over the next few months.
Watchpoint indicator #2: Atlanta Fed Wage Growth Tracker
"Market inflation expectations are currently comfortably below the Fed’s worry point."
- Andrew Pease
Reopening trade still makes sense
The reopening trade, which lifts long-term interest rates and favors cyclical and value stocks over technology and growth stocks, worked well for several months following the vaccine announcement last November. Value outperformed growth and yield curves steepened. The trade has reversed in recent months, however, amid fears that the delta variant might derail the economic recovery. The impact has been magnified by short covering in bond markets as investors, who have been short or underweight, have been forced by the rally to buy back into the market, pushing bond yields even lower.
The reopening trade should resume in coming months. The cyclical stocks that comprise the value factor are reporting stronger earnings upgrades than technology-heavy growth stocks, and the value factor is cheap compared to the growth factor. Financial stocks comprise the largest sector in the MSCI World Value Index, and they should benefit from further yield-curve steepening, which boosts the profitability of banks. Long-term interest rates should rise as global growth remains above trend, delta-variant fears fade, the short squeeze unwinds and central banks begin tapering back on bond purchases.
The rotation in economic growth leadership away from the United States should also help the reopening trade. The rest of the world is overweight cyclical value stocks relative to the U.S., which has a higher weight to technology stocks.
Emerging market (EM) equities have been poor performers since the vaccine announcement, but there are some encouraging signs. Initially, they were held back by the exposure to technology stocks in the MSCI Emerging Markets Index and the slow rollout of COVID-19 vaccines. More recently, they have come under pressure from the slowdown in the Chinese economy and the regulatory crackdown on Chinese tech companies. The vaccine rollout across emerging markets has accelerated and policy easing in China should soon improve the growth outlook. The path of Chinese regulation is harder to predict, but it is now largely priced in, with Chinese technology companies underperforming their global peers by nearly 50% from February 2021 through mid-September.
The resumption of the reopening trade should also result in U.S. dollar weakness. The U.S. Dollar Index (DXY) has traded sideways since the vaccine announcement. It should weaken once investors have confidence that delta-variant risks are subsiding and realize that the Fed is likely to remain dovish as inflation risks decline. The dollar typically gains during global downturns and declines in the recovery phase. Dollar weakness should support the performance of non-U.S. markets, particularly emerging markets.
The key risk is that the delta variant or similar proves resilient to vaccination or that infection rates escalate during the Northern Hemisphere winter. The evidence so far is that vaccinations are highly effective in preventing serious illness. In Israel, booster shots appear to have slowed the rate of new cases.
Another watchpoint is inflation and the response of central banks. Our expectation is that this year’s inflation spike is mostly transitory and that the major central banks, led by the Fed, are still two years from raising interest rates.
Finally, there is the risk of a sharper-than-expected slowdown in China. Credit growth has slowed this year and the purchasing managers’ indexes (PMI) have trended lower. Monetary and fiscal policy have been eased, however, and senior officials have signaled that more stimulus is on the way. China policy direction and credit trends will be an important watchpoint over coming months.
"We expect the inflation spike is mostly transitory and that the major central banks, led by the Fed, are still two years from raising interest rates."
- Andrew Pease
Regional snapshots
The U.S. economy is likely to sustain above-trend growth into 2022. However, the easiest gains appear in the rear-view mirror at the end of the third quarter as the recovery phase of the business cycle matures. This is most visible for corporate earnings, where S&P 500® Index earnings-per-share already sit 20% above their previous cyclical high.
Strong fundamentals have helped power the stock market to new highs. Early evidence that the delta-variant wave may be fading and the potential for greater vaccine access for children are positives for a more complete recovery in the quarters ahead. The Fed looks poised to start tapering its asset purchases around the end of 2021. The timing of the first rate hike will then hinge on what happens to inflation next year. Our models suggest that inflation is likely to drop back below the Fed’s 2% target in 2022. If that is correct, the Fed is likely to remain on hold into the second half of 2023.
Wage inflation is a key risk to this view. It is running unusually strong for this stage of the cycle, and record hiring intentions from businesses could exhaust spare capacity in the year ahead. We expect the 10-year U.S. Treasury yield to rise moderately from 1.37% in mid-September to 1.75% in coming months.
Fiscal stimulus negotiations continue to grab headlines in Washington, D.C. The tax provisions in these bills are likely to be the most impactful for financial markets. We estimate that higher corporate taxes could subtract about four percentage points from S&P 500 earnings growth in 2022. This could create volatility and opportunity in markets. Given our strong cyclical outlook, our bias continues to be a risk-on preference for equities over bonds for the medium-term.
Euro area growth slowed through the third quarter but looks on track for a return to above-trend growth over the fourth quarter and into 2022. Vaccination rates are high, and the euro area has more catch-up potential than other major economies, particularly the United States. The euro area is also set to receive more fiscal support than other regions, with the European Union’s pandemic recovery fund only just starting to disburse stimulus, which will provide significant support in southern Europe. Polls in advance of Germany’s federal election on Sept. 26 suggest the electorate is moving toward the left, which means the new government is likely to support expansionary fiscal policy and support a continued dovish stance by the European Central Bank (ECB).
The MSCI EMU Index, which reflects the European Economic and Monetary Union, has performed broadly in line with the S&P 500 so far in 2021. We think it has potential to outperform in coming quarters. Europe’s exposure to financials and cyclically sensitive sectors such as industrials, materials and energy, and its relatively small exposure to technology, gives it the potential to outperform as delta-variant fears subside, economic activity picks up and yield curves in Europe steepen.
As of mid-year, UK GDP was still nearly 4.5% below its pre-pandemic peak. We see plenty of scope for strong catch-up growth as borders are fully reopened and activity normalizes. Supply bottlenecks and labor shortages have triggered a sharp rise in underlying inflation and created concerns that the Bank of England (BoE) may start rate hikes in the first half of 2022. We think the BoE is unlikely to be that aggressive. We expect inflation to decline in early 2022 as supply constraints ease, which should convince the BoE to delay rate hikes.
The FTSE 100 Index is the cheapest of the major developed equity markets in late 2021, and this should help it reflect higher returns than other markets over the next decade. Around 70% of UK corporate earnings come from offshore, so one near-term risk is that further strengthening of British sterling dampens earnings growth. The other risks are mostly around policy missteps, for example, early tightening by the Bank of England.
The Japanese economy is expected to get a shot in the arm as rising vaccination rates improve mobility and reduce the risk of further lockdowns. The delay in vaccine approvals and slower rollout to this point has led to States of Emergencies, and has constrained activity in the services sector. The removal of these constraints will see the reopening of the economy and a boost to those service sectors through 2022. The economy also faces a likely positive boost from political leadership changes following the resignation of Suga – with most candidates vying for the LDP leadership in favor of more active fiscal spending, as well as an increasing focus on improving the digitisation of the Japanese economy. Japanese equities look slightly more expensive than other regions such as the UK and Europe, however earnings delivery through the fiscal year ending March 2022 is expected to be very strong. We maintain our view that the Bank of Japan will significantly lag other central banks in normalising policy.
We expect Chinese economic growth to be robust over the next 12 months, supported by a post-lockdown jump in consumer spending and incremental fiscal and monetary easing. Despite a big improvement in vaccination rates, COVID-19 outbreaks remain a risk given the Chinese government’s zero-tolerance approach. The major consumer technology companies have seen significant drops in stock prices recently due to more aggressive regulation. Some uncertainty remains around the path of future regulation, especially as it relates to technology companies, and as a result we expect investors will remain cautious on Chinese equities in the coming months. The property market, particularly property developers as recently highlighted by Evergrande’s debt crisis, remains a risk that we are monitoring closely.
Canada leads the G71 countries in terms of the vaccination rollout, which should minimize the risk of large-scale lockdowns over winter. The delta variant has taken an economic toll, however, with industry consensus projections now predicting 5% GDP growth in 2021 versus estimates of more than 6% just three months ago. Even so, growth remains above-trend and the odds of additional fiscal expenditures to support the economy have increased. This means that weaker growth due to COVID-19 is unlikely to change the Bank of Canada's (BoC) tightening bias.
Tapering of asset purchases should be complete by the end of the first quarter of 2022. BoC Governor Tiff Macklem has indicated that the reinvestment phase of the bonds held by the central bank will commence once quantitative easing has ended. This should generate an estimated C$1 billion in weekly bond purchases, down from the current pace of C$2 billion. The BoC will likely only consider shrinking its balance sheet after it has started lifting interest rates. The BoC projects that the output gap will close sometime over the second half of 2022, and that rate hikes will be considered after economic slack has disappeared. We believe that the timeline may be a tad aggressive, and a delay to 2023 for liftoff is more likely. This would better align the Canadian central bank with its American counterpart.
The Australian economy is set to return to life, with lockdowns likely to be eased in October and November. Consumer and business balance sheets continue to look healthy, which should facilitate a strong recovery. The reopening of the international border in 2022 will provide a further boost. Fiscal policy has supported the economy through the downturn, and there is potential for further stimulus in the lead-up to the federal election, which is due before the end of 2022. The Reserve Bank of Australia has begun the process of tapering its bond-purchase program, but we expect that a rise in the cash rate is unlikely until at least the second half of 2023.
New Zealand’s most recent lockdown will drag on Q3 GDP, but similar to Australia, we expect a solid rebound as the economy reopens. The government aims to provide a vaccine to all adults by the end of 2021, after which borders will gradually reopen. This will provide a boost, particularly to tourism-exposed sectors. Despite having recently put off hiking interest rates due to the recent lockdown, we expect the Reserve Bank of New Zealand will start raising rates this year. Even though they have significantly underperformed global equities this year, New Zealand equities still screen as relatively expensive compared to other regions.
"Our models for the U.S. suggest that inflation is likely to drop back below the Fed’s 2% target in 2022. If that is correct, the Fed is likely to remain on hold into the second half of 2023."
- Andrew Pease
Asset-class preferences
Our cycle, value and sentiment investment decision-making process in late September 2021 has a moderately positive medium-term view on global equities. Value is expensive across most markets except for UK equities, which are near fair value. The cycle is risk-asset supportive for the medium-term. The major economies still have spare capacity and inflation pressures appear transitory, caused by COVID-19-related supply shortages. Rate hikes by the U.S. Fed seem unlikely before the second half of 2023. Sentiment, after reaching overbought levels earlier in the year, has returned to more neutral levels.
Composite Contrarian Indicator: Sentiment shifts toward neutral
Asset performance since the beginning of 2021
"Stronger economic growth and steeper yield curves after the third-quarter slowdown should favor undervalued cyclical value stocks over expensive technology and growth stocks."
- Andrew Pease