A Recession Like No Other
Following a global recession like no other, households in developed markets are flush with cash. Since COVID-19 broke out last March, real disposable income has grown at its fastest 14-month rate ever, the S&P 500 is 24% above its pre-pandemic peak and home prices are up 14%. With social distancing measures hindering consumption as incomes rose, household savings have exploded.
If the cash is spent in line with economists’ expectations, corporate profits should remain very well supported in the coming quarters. At the same time, the bottom-up consensus forecast for earnings growth is muted.
Since April 2020 the equity market has recovered in line with the recovery in earnings, meaning that equity market valuations have not gone up. As we expect to see solid earnings in the quarters ahead, this should continue to support equity markets.
Global economic growth is probably peaking as several COVID-19 emergency support packages are running out, but growth will remain solid. Uncertainty about the strength of economic growth going forward can create volatility in the equity markets but the underlying trend remains positive.
Given the solid performance of global equity markets in the first half of the year, the risk-reward profile for stocks has deteriorated somewhat. Nevertheless, with few signs that the global economy is heading towards another major downturn, the macro backdrop remains positive for risk assets.
The Golden Rule is “remain bullish on stocks as long as growth is likely to remain strong for the foreseeable future.” Historically, bear markets rarely occur outside of recessions. With both fiscal and monetary policy still supportive, and households in many countries sitting on plenty of dry powder, the odds that the global economy will experience a major downturn in the next 12 months are low.
That said, we do acknowledge that the risk-reward profile for equities has deteriorated since the start of the year. Global stocks have risen 12% year-to-date, implying that investors have priced in an increasingly optimistic economic outlook.
The economic expansion would imply rising real bond yields over the next 6-12 months. Therefore, we continue to favor equities over bonds, but expect more subdued stock gains going forward. We remain underweight on government bonds and generally expect low total returns over the next year from bonds.
The Global Recovery’s Path Forward
We think Europe and certain emerging markets, like China, are appealing given relative valuations and earnings upside.
Chinese stocks have underperformed due to the heightened regulatory scrutiny on domestic tech giants since late last year, the latest evidence of which being the authorities’ investigation of Didi, China’s largest ride-hailing app. Full details of the investigation have not been disclosed, so it is premature to make conclusions on this specific case.
The regulatory uncertainty adds to the risk premium on Chinese equities, but we doubt the impact will be long-lasting. We expect Chinese regulators will try to find a balance between catching up with regulations and avoiding overly tight restrictions that could suffocate the country’s tech sector.
The U.S. dollar gained over 2% in June after a change in tone at the Fed’s Federal Open Market Committee (FOMC) meeting but we think the U.S. dollar will resume its weakening trend as growth momentum rotates from the U.S. to the rest of the world.
While the stronger dollar and the slowdown in Chinese growth earlier this year could weigh on commodity prices during the summer months, the long-term outlook for metals is positive.
Inflation and the Fed
The U.S. Consumer Price Index (CPI) headline inflation came in at 5.0% year-over-year. We expected this number to be high due to several temporary factors, like rising used car prices because of a chip shortage, which limits the supply of new vehicles. However, this is not a structural phenomenon, and these price pressures will subside soon.
We always expected to see a spike in inflation in May, June, and July because of these temporary factors. And we expect inflation to soften after the summer.
What we found surprising is that the Fed issued a more hawkish statement in its June FOMC meeting. Effectively raising their inflation forecast while at the same time raising the ‘dot-plot’, which is a vote count on when Fed board members think they will vote to raise rates.
In our opinion that does not make much sense. Why would the Fed governors spend the last few months reassuring us that the inflation spike will be transitory, and then right when Consumer Price Index (CPI) headline inflation spikes, as was expected, raise their forecast for inflation?
It could be that the Fed was surprised by the extent of the commodity price surge, which has been the key reason behind elevated inflation. This may prove to be backward-looking. The surge in commodity prices reflects supply-side disruptions during the pandemic crisis, but prices will likely moderate as the underlying economy normalizes, with the goods sector weakening and services strengthening. This is already happening in the U.S., which is why we are seeing a correction in commodity prices.
The fact that the Fed decided to use their June meeting to raise their forecasts could either mean that the Fed has data we do not have, or it also got spooked by short-term data, or it fell victim to old-fashioned political posturing. The Fed is not as politically independent as we like to believe.
The U.S. President is the one who nominates the Chairman of the Fed and in four months, Biden can decide to re-nominate Powell or pick someone else.
The last Fed statement might not have helped Jay Powell to retain his job for another term. Even though Powell did his best to downplay the content in his press statement afterward. Timing is important, and it might not be on Powell’s side. If Biden’s infrastructure package gets approved in Congress, while at the same time monetary policy becomes less accommodative, this could offset the economic benefits of the additional fiscal spending.
For now, we stick with our view that the inflation spike is transitory and that the Fed is likely more focused on employment data than inflation.
Don’t Underestimate Biden
The Biden administration so far seems to be well organized and very focused on what Biden wants to achieve: more economic power for the middle class.
We think many economists don’t fully understand the impact of his policies. He is not a socialist but intends to bring back economic buying power to the middle class. Which is not necessarily the wish or to the benefit of Wall Street. While bringing back buying power to the middle class could have short-term negative implications for capital markets (for example through higher corporate and capital gains taxes) it will likely have a long-term positive impact on the economy and the stock market.
We think Biden is more resolved than people think. This means that despite so-called independence he would not want the Fed to stand in the way of his plans. We reckon Biden would want to see a supportive policy for his fiscal plans and for his desire for higher wages.
The moment of reappointment is the only moment that a U.S. President has a direct impact on Fed policy. This could lead to more dovish surprises in the coming months or alternatively Biden could pick a more dovish Fed governor like Lael Brainard.
The Future of Commodities
Structurally, oil faces a bleak future. Transport accounts for about 60% of global oil consumption. The shift to electric vehicles will undermine this key source of oil demand. Cyclically, however, crude prices could still rise as the global economic recovery unfolds. Supply remains quite tight, reflecting both OPEC vigilance and the steep drop in oil and gas capex of recent years.
In contrast to oil, the long-term outlook for base metals is favorable. A typical electric vehicle (EV) requires four times as much copper as a typical gasoline-propelled vehicle. By 2030, the demand from EVs alone should amount to close to 4 million tons of copper per year, representing about 15% of current annual copper production.
Strong demand from China should also support metal prices long-term. While Gross Domestic Product (GDP) growth in China has slowed, the economy is much bigger in absolute terms than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then. In the near term, however, base metal prices could stay weak because of slowing Chinese economic growth following last year’s recovery.
We are generally positive on gold. Since peaking last August, the price of gold has fallen more than one might have expected based on movements in real bond yields. Gold will also benefit from a weaker dollar later this year. Lastly, and importantly, gold should retain its standing as a good inflation hedge.
Investing in a Sustainable Future?
The world of tomorrow is not going to look like the world of today. The US, Europe and China have all committed to carbon neutrality by 2050 and 2060. Quality food will give way to responsible food, cheap goods to sustainable goods. Everything is going to be digital and software/semiconductors will be everywhere. These trends will be the dominant themes during the 2020s and beyond.
Investing in these trends requires a dedicated approach – adding one stock to a core portfolio won’t have a big enough impact and buying the sector outright ignores the often very high valuations of companies in these categories
Our portfolio team has constructed a Sustainable Future portfolio that seeks to strike a balance between large companies and small, famous brand names and reasonably valued ones, promising ideas and sustainable businesses. We score stocks to ensure valuation, quality, distress, momentum and sentiment, as well as Environmental, Social and Governance (ESG) traits are considered. We diversify by region and sector with the goal of building a portfolio that takes advantage of these themes.
The portfolio is focused on four key areas of potential future growth: Sustainable Food, Green Energy, Health Innovation and Digital Infrastructure.
If you are interested in exploring these themes, please discuss with us if this strategy could have a place in your portfolio and how it might fit with your personal investment objectives.
PLEASE READ THIS WARNING: This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
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