For some time now, our base case has been that we are unlikely to see an aggressive and sustained surge in inflation to levels significantly higher than the Fed’s long term 2% target beyond 2021, although the transition to a post-pandemic world of faster growth, higher government spending and less dispersed supply chains means inflation could stay elevated at or moderately above central banks’ target.
So far, we see the data bearing out our thesis. Post the Fed’s hawkish pivot in June, US forward inflation expectations have declined. US spot inflation trended higher in the month of June as both the headline and core consumer price index (CPI) rose by 0.9% versus the previous month of May, which suggests that the uptrend is not yet levelling off.
While the inflation print for June did slightly surprise to the upside, the data remained consistent with the outlook for transitory inflation. The categories that saw significant price gains were narrow, and were caused by the surge in demand associated with re-opening (travel, dining out) and the disruptions in supply of semiconductors for the car industry. As the supply conditions in these affected industries normalize, these price pressures are expected to cool.
Over the next 12 months, with rates expected to stay ultra-low and inflation not getting out of hand, we see the post-pandemic bull market remaining broadly intact, although investors should be prudent not to rule out the risk of a short-term correction in a bull market, which is historically not unusual.
Though there is scope for further price appreciation with earnings growth, the overall risk-reward naturally becomes less compelling with significantly higher prices. We have not seen a meaningful correction in more than a year, which could set the market up for the risk of a sharp correction should the economic data ahead be less rosy than expected or if there is an unanticipated external shock.
This is especially so as the market enters a transitional period of reassessing the growth outlook as we navigate post-peak growth and stimulus.
Some of this wariness is being reflected in the recent significant decline in long term US Treasury yields. Bond markets are highly sensitive to growth uncertainties and tend to lead equity markets.
US 10-year Treasury yield fell sharply shortly after the release of the June ISM survey which showed that services activity eased off from its all-time peak in the previous month of May.
Part of this sharp move is rightly attributed to a host of technical factors (short-covering, reduced supply of US Treasury sales, rebalancing by pension funds, etc), but the magnitude of this sustained move beyond what can be attributed to technical factors alone suggests investor doubt around heightened risks to the current recovery coming from the uptick in Covid-19 infections related to the virus variants, slowing economic momentum in China, questions around the Fed’s reaction function and so on.
The delta variant continues to make inroads into more countries – an additional 15 countries reported cases with the delta variant for the week ending 11 July (source: WHO) and the share of delta variant cases are rising across Europe where we are seeing an uptick in infection.
While we acknowledge rising tail-risks related to Covid-19 virus variants, our base case is that this would not derail the long term economic recovery as vaccinations are effective in reducing the severity of the virus so far, with hospitalisation and fatality rates rising much more slowly than those seen last year.
One bright spot is that the risk of a market correction has been reduced with Chinese policy makers moving to inject liquidity in response to the soft patch in economic data, although historically the policy support takes effect with some lag.
On 9 July, Chinese policymakers surprised with a 50bps cut to the reserve requirement ratio (RRR) for all banks. While expectations have been building for monetary policy easing following several months of data confirming that the Chinese economy has entered into a soft patch, the scope of the RRR cut (for all, rather than selected group of banks) was wider than expected.
Given that the market will be navigating an environment where growth and policy stimulus remain positive but are moderating from peak levels, we believe that the outlook for returns on risk assets over the next 12 months remains positive but significantly lower than the last 12 months, and we are mindful of the risk of a short-term correction in the bull market.
Looking ahead, we see the performance of cyclical sectors in equities, such as financials, industrials, materials, energy and real estate, remaining supported as inflation data stays buoyant in 2021.
But as we begin a transition into the mid-cycle phase, we expect a rotation from cyclicals/value to quality/growth. In this scenario, we expect profitable companies with solid earnings growth prospects that are resilient to regulatory threats, such as those in high growth technology and infrastructure sectors related to key themes such as e-commerce, rise of the cloud, the Internet of Things, artificial intelligence, robotics, renewable energy and smart cities, to play key roles in driving portfolio returns.Disclaimer applicable to recommendation
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