As we write, global markets in 2021 display an unambiguous picture: Defensive assets such as gold and high grade bonds are down, while risk assets are up, led by oil and followed by stocks, gaining 4 percent in emerging markets and 2 percent in developed. Below the surface, the sector composition is equally radical: The leaderboard has shifted from the previous darlings with technology, consumer staples and healthcare replaced by energy, financials and mining.
This looks like a classic “risk-on” configuration, reflecting a more robust outlook, although the returns of cyclical assets are a bit tepid. There are however two intriguing, and maybe more sinister features. First, the volatility is considerable. The venerable US 10-year treasury yield has experienced intra-day moves of up to 40 basis points, which is definitely unusual and sent shockwaves across all markets. Second, risk markets suddenly seem to be scared for the very same reasons which triggered a massive rally less than 6 months ago: better economic prospects, starting with virus containment, kick-started by fiscal stimulus, and turbo-charged by extremely accommodative monetary policies.
This raises two questions: What has changed, and should we be worried looking forward?
The key change is obvious and we wrote about it several times: Investors’ sentiment and positioning are much more bullish now than 6 months ago. Back then, faith in the recovery was considered complacency; it is now consensual, following the double catalyst of vaccines and US elections. Sentiment reversed, under-exposed investors bought, markets rallied, retail speculation amplified, and valuations rose. In the recent weeks, the scenario gained further traction: PMIs exceeded expectations, showing that the global activity is nearing the pre-“second wave” level. It was confirmed Friday by a spectacular US job report and Sunday by buoyant trade numbers from China.
Stimulus is on: The US Senate passed President Biden’s $1,900bn plan bill, and talks have started for the next one on infrastructure. It’s only fundamental good news, but it’s happening earlier than expected. Markets hate uncertainty, and the risk of a spike in inflation takes center stage. Inflation could force central banks into a premature tightening of their support, starting with less liquidity injections (“tapering”) and ending with hikes in short-term interest rates. This would not only affect the fixed income asset class, but higher rates would push equity multiples lower, not to mention the risk of “stagflation” in the economy at some point.
So, should we be worried?
We don’t think so. As always with investments, it’s about the articulation between a level and a time horizon. There is no doubt that inflation pressures are on a sharp rise on the short-term, especially energy and food prices. It is not surprising. Stimulus is unprecedented, and a better virus control unleashes the massive pent-up demand – to illustrate, the best contributor to US job creations in February was hospitality and leisure. The virus has also created disruptions in the supply chains and various costs. Inflation could raise further in the short-term as growth booms. Central Banks have been very clear: they welcome reflation and will tolerate a temporary overshoot of their targets. But market participants are increasingly nervous and disregarded the last US treasury issuance: What if inflation goes out of control?
We see three reasons to be confident. First, the level at which interest rates would justify a severe de-rating in stock valuations is much higher than where we are today. If anything, more robust economic growth and some inflation will boost earnings even further (stocks are a nominal asset), which will mechanically reduce multiples. Second, there are mechanisms to limit the rise in interest rates, the first one being investors’ appetite: current levels are not unreasonable, and there were buyers of treasuries last year at half the current yields. Ultimately, central banks also have tools to control the yield curve by directing their purchasing programs. Thirdly, and more importantly, we do not see reasons for a sustainable rise in inflation. There was none when the unemployment rates were 2 or 3 times lower than today, and the long-term drivers of lower prices, should it be demography, technology or even globalization, are still in place.
We are closely monitoring the situation and remain well aware that markets can easily exaggerate. We may change our view, and keep an eye on food prices in particular, but we value patience and not reacting to market volatility in itself. For the time being, we stick to our positioning. We are overweight in stocks and underweight in bonds but we hold inflation sensitive assets (gold and emerging markets). Volatility will remain elevated, but as always, it is not adverse to long-term fundamental investors. If anything, should inflation fears become irrational, there may be compelling entry points in gold or in safe bonds, for the long-run. Stay safe.
© Opinion 2021
Any opinions expressed in this article are the author’s own
Disclaimer: This article is provided for informational purposes only. The content does not provide tax, legal or investment advice or opinion regarding the suitability, value or profitability of any particular security, portfolio or investment strategy. Read our full disclaimer policy here.