By Tim Sharp, Hottinger & Co.
The success of the vaccine roll-out in western economies seems to have checked the economic impact of the increased cases of the Delta variant with increasing evidence that the relationship between new cases and hospitalisations and deaths has been disrupted, while the developing world where vaccination penetration remains low, risks remain elevated[i]. This has caused some jitters in financial markets that the removal of restrictions may be delayed with the inevitable effect on global growth.
The IMF released its latest report this week on global growth, warning that limited access to vaccines risks hindering the global recovery by splitting the world into two blocs. However, by cutting the forecast for emerging markets and increasing the forecast for the developed world the overall global growth forecast remained at 6% for 2021. The UK gained the biggest uplift to 7% with the economic impact of the rise of the Delta Variant in the developed world difficult to calculate. The second risk is that inflation may prove to be more persistent than currently anticipated prompting a more aggressive central bank reaction[ii].
Interestingly, fund flows into fixed income have overtaken equity flows year-to-date in July, according to Barclays, although equity flows are also still positive. The level of Treasury holdings on bank balance sheets has soared in line with the savings rate and there has been a public warning from a consortium of 30 private and public sector experts including Timothy Geithner, Larry Summers, and Mervyn King regarding the stability of Treasury markets. Recommendations include a single marketplace, and a mechanism by which the Fed can provide participants with a short-term swap for cash to provide liquidity that can dry up at times of extreme stress as was seen in March 2020[iii].
The US Treasury ten-year continues to ignore the current strength of inflation preferring to believe that temporary supply bottlenecks are the route cause, due to an uneven reopening, with the yield dropping to 1.24%. Moreover, there are signs that some pressures are easing with prices in lumber and other raw materials lower, and the semi-conductor shortage working its way through in the auto sector[iv]. It would appear that markets have suffered a growth shock rather than fears surrounding elevated inflation which has expressed itself in a curve flattening as long duration bonds reflect global growth fears.
Morgan Stanley challenges the notion that global growth is weakening instead seeing a strong economic recovery underway. They believe second quarter US GDP is going to be approximately 12% and continue to estimate global growth for 2021 of 6.5%i. We continue to believe that despite the recent value to growth rotation, the movement towards stocks with stable earnings, strong cash flow generation and robust balance sheets will provide an element of consistency and protection to valuations.
Second quarter earnings have started strongly with Absolute Strategy Research (ASR) predicting 55% year-on-year gains although guidance remains key for investors particularly when valuations are so stretched[v]. Interestingly US Treasury thirty-year yields have dropped to 1.89% while the S&P500 dividend yield is 1.76% and until bond markets start reacting more consistently to the expected path to higher inflation this will help underpin equities. Most notable to us has been the strong results from the global banking sector which has seen loan reserves reduced following unexpected corporate strength during the pandemic, the resumption of dividend payments in many regions, and strong revenue gains. We believe that a strong performance from banks will further underpin equity markets and add to investor confidence.
The outperformance of US equities has been related to the strength of the US dollar over the last two months, in our opinion, and the rise of long-term growth stocks as bond yields have fallen. The S&P 500 gained another 2.3% in July versus 1.7% for the MSCI World Index. If the rotation back into growth stocks proves to be a short-term reaction to the rise in Covid-19 cases, then we would expect to see European equities come back to the forefront. The EU’s Next Generation Recovery Fund sees 71% of spending aimed at key green and digital transmission investments which are expected to have long term productivity enhancementsiv.
Fears of global slowdown, rising coronavirus cases, weaker commodity prices, a Chinese Producer Price Index inflation rate of 9% and a stronger dollar, was not a comfortable environment for developing markets although the difference between commodity exporters and importers saw Latin America outperform Asia and the broader index albeit to the downside[vi]. Declines in Chinese internet stocks such as Alibaba, and Tencent have been significant as Chinese regulators continue to step up their oversight and plan heavy penalties in the technology, private education and food delivery sectors causing anxiety amongst investors[vii]. This also leaked into the heavily debt-laden real estate sector where the authorities are trying to cool demand with new restrictions. We believe a renewal of the long-term trends including a return to dollar weakness should see emerging markets recover once more.
Following last month’s research into corporate debt markets we believe corporate credit spreads offer little value to investors with added duration risk, and in line with our views on the relative attraction of emerging market currencies we see emerging market local currency debt as an area of fixed income that still offers opportunities to investors. The expected path of developed market government bond yields and the expectations of a continuation in the steepening of the curve leaves investors looking to reduce bond exposure in the interim. We continue to favour the relative valuation of developed equity markets and the strengths of quality stocks particularly in the UK and Europe. The flash GDP release for the Euro Area rose by 2% quarter-on-quarter in the second quarter well above consensus expectations of 1.5% marking the beginning of a cyclical rebound that could see pre-crisis levels by the fourth quarter[viii].
[i] Morgan Stanley – Summer Doldrums _ Where Do We Stand? – July 25, 2021
[ii] IMF World Economic Outlook – Fault lines widen in the global recovery – July 2021
[iii] Financial Times – Flawed $22tn US debt market a threat to stability, warn grandees – Colby Smith, July 29,2021
[iv] Absolute Strategy Research – Investment Committee Briefing – July 1, 2021
[v] Absolute Strategy Research – Supply Constraints and Inflation Favour Cyclical Stocks – July 15, 2021
[vi] Comparison of MSCI Indices on the Refinitiv platform by Hottinger Investment Management
[vii] https://www.cnbc.com/2021/07/28/investing-china-stocks-among-asias-worst-performing-amid-regulatory-scrutiny.html
[viii] Barclays – Buckle up, we’re in the fast lane now – July 20, 2021
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