“We will not raise interest rates pre-emptively because we fear the possible onset of inflation. We will wait for evidence of actual inflation or other imbalances.” Jerome Powell, 22nd June, 2021
An easing of concerns over the future timing of a shift in global monetary policy, prompted in part by dovish statements from the Federal Reserve, saw a partial unwinding of the reflation trade that had dominated financial markets during the prior quarters. Lower core sovereign bond yields (Eurozone excepted) were accompanied by flatter maturity curves and a rotation back into growth stocks, putting long duration assets to the fore. The benign market conditions, which saw volatility indicators decline steadily over much of the period, ran somewhat counter to inflation data that continued to surprise on the upside as strong commodity prices, rising shipping rates and supply chain bottlenecks pointed to possible upward pricing pressures.
Citigroup Global Inflation Surprise Index
In terms of broad market movements, the period under review was positive and largely uneventful. The MSCI (local currency) World Index recorded gains over each of its three months and in nine of thirteen weeks. Continued progress in the rollout of vaccine programmes across the western world (with the pace in Europe picking up significantly) contributed to the buoyant mood, even as the latest, more virulent and transmissible (delta) strain of the Covid-19 virus spread across the globe and prompted delays in the easing of lockdowns or, in some areas, new containment measures.
Equity Market Indices
|Index||Q2-2021||Year to date|
|MSCI World ($)||7.31%||12.16%|
|MSCI World (EUR)||6.41%||15.72%|
|MSCI World (£)||7.31%||10.95%|
|MSCI World (local ccy)||7.15%||13.29%|
|S&P 500 ($)||8.17%||14.41%|
|FTSE UK All Share (£)||4.79%||9.29%|
|MSCI Europe ex-UK (EUR)||5.78%||13.52%|
|Japan Topix (¥)||-0.53%||7.70%|
|MSCI Asia ex-Japan ($)||3.02%||5.54%|
|MSCI Emerging Markets ($)||4.42%||6.46%|
|MSCI Emerging Markets (EUR)||3.55%||9.83%|
|MSCI Emerging Markets (£)||4.42%||5.31%|
Equity markets took their cue from the steady flow of historic and forward-looking indicators which, despite falling short of expectations in some instances, confirmed that the global economic recovery remains very much intact. In the US, Q1 GDP growth of 6.4% compared with the previous period’s 4.3% increase, with strong consumer confidence and purchasing manager surveys (PMIs) suggesting that, absent a major shock, momentum remains positive. Whereas data confirmed that the Eurozone dipped into recession in the first quarter, the 0.3% decline in activity was a better outcome than predicted, leading to an upgrade to the consensus forecast of a return to healthy (4+%) growth over the calendar year. Record prints for Eurozone PMIs, along with rising business and consumer sentiment are similarly auspicious. In China, meanwhile, where the recovery is several months more advanced than in the west, activity is now well ahead of pre-pandemic levels and where conditions have become more “normalised”, the authorities have been taking steps to prevent overheating in parts of the domestic economy. This resulted in Q1 GDP growth at a very modest 0.6% rate (albeit 18.3% year-on-year) and the composite PMI easing to a still expansionary 52.9.
Corporate news flow was equally upbeat, with earnings announcements providing plenty of upside surprises and very little in the way of bad news (for example, 73% of S&P 500 companies met or beat market estimates). Reported earnings for constituents of the MSCI AC World index were up 3.15% versus those in the previous quarter and a whopping 256.58% ahead of the corresponding period in 2020, which coincided with the height of the pandemic shutdown. Based on reported numbers and consensus forecasts, that values the index on a multiple of 22.7 times historic earnings and 19.1x for the next twelve months, implying growth of 19.08% in earnings for the forthcoming year. Meanwhile, takeovers, mergers and IPOs continue at a healthy rate, with transactions totalling more than USD2 trillion announced during the three months to 30th June.
Judging by the relative movements at a style and sector level over the quarter, central bankers’ efforts to downplay concerns over recent inflationary data has met with considerable success. The rotation back into growth companies and out of value / cyclical names during the second half of the period unwound almost half of the latter categories’ outperformance since the onset of the “reflation trade” that coincided with the announcement of the first vaccine in November of last year. A similar effect, though beginning earlier and of a smaller quantum, was seen across the capitalisation scale, with smaller companies underperforming their larger counterparts.
With the increase in earnings estimates outpacing global benchmarks’ gains and bond yields having retreating from their March-end highs, broad market valuations, though far from cheap, certainly appear more reasonable than has been the case for some while. Indeed, it could be argued that a prospective PEG (price/earnings to growth) ratio of 1.0 puts the current rating fairly and squarely in “fair value” territory. While it would be fair to say that the discomfort over market pricing that we have referred to in recent commentaries has given way to a more constructive view of risk assets, we have not yet been persuaded to add to equity weightings. Like many market participants, we would rather wait for at least some clarity over the path of inflation and associated data and the resulting implications for interest rates before committing further risk capital to the markets. In the meantime, we remain happy with the blend of investment styles, strategies and areas of specialisation provided by the current mix of active managers within portfolios.
MSCI AC Growth & Value vs MSCI World Index
Source: FE Analytics
The period’s market movements saw a downward shift in the US yield curve that sent the ten-year Treasury yield from an opening level of 1.74% (a 14-month high) to 1.47% and the Bloomberg Barclays US Government Bond (>1 year) Index post a 1.75% gain. Though more modest, a reversal of 13 basis points (bps) in the equivalent benchmark Gilt issue, from 0.85% to 0.72%, contributed to an identical 1.75% increase in the UK (>1yr) Index. By contrast, German Bund yields rose, with the ten-year benchmark bond ending the quarter 8bps higher at -0.21% and the government index down 0.36%.
A narrowing in yield spreads across the credit spectrum reflected the benign market conditions. Continued strong demand for corporate debt pushed spreads further into record territory, with US BBBs yielding an average of just 104bps over Treasuries at the quarter-end and a corresponding figure of 228bps for high yield. It was a similar story for hard currency emerging market sovereign debt, albeit that the quarter-end yield spread on the JP Morgan EMBI Index of 313bps (-11bps for the period) remains some 35bps above pre-pandemic levels and more than 140bps from the 2007 all-time lows.
The quarter’s action took place against the backdrop of a narrative from the major central banks that persistently stressed the transitory (“base effect”) nature of strong data and downplayed the likelihood of the need for a change in current rate policies despite headline inflation numbers that had moved or were expected to rise above official policy rates. As evidenced by the movements in both nominal and inflation-linked issues’ break-even yields, these reassurances were largely successful, even though the publication of the Federal Open Market Committee’s “dot plot” forecast implied a shortening in the timetable for the next US rate rise. While policy rates seem set to stay put for the time being, the quantum and pace of central banks’ asset purchase programmes is an entirely different matter and the (tricky) process by which the authorities communicate and implement their wind-down and eventual withdrawal is a potential source of volatility that will be keenly watched by the market.
Rather than conclusively signalling the end of the reflation trade, the rebound in US and UK core government debt markets suggests to us that the first quarter’s sharp sell-off was overdone, premature, or a mixture of both. It is probably also the case that rapid shifts in market direction – spookily, inflection points in the Bloomberg Barclays Global Aggregate Index coincide exactly with the previous two calendar quarter-ends – triggered short covering by momentum traders and those positioned for a full-blown taper tantrum.
At the risk of sounding like a stuck record, though the asset class is by no means a no-go area, we continue to believe that the risk-reward pay-off for a traditional “buy and hold” approach to fixed income investing is skewed very much to the downside (more so, in fact, given the most recent market movements). Prevailing absolute and relative valuation levels do, however, offer considerable scope for alpha generation, hence our preference for a blend of managers with flexible mandates that include the ability to hedge and / or take short positions alongside those focused on niche areas that offer nuggets of value, such as short duration hard currency EM corporates and selected banks’ subordinated paper.
Bloomberg Barclays Global Aggregate Bond Index (USD)
A closing level that corresponded to a modest decline of 0.85% in the DXY US Dollar Spot Index for the period under review represented a robust recovery from intra-quarter weakness that saw the trade-weighted benchmark down 3.85% at one point during May. Of the 17 major currencies listed by Bloomberg, the Australian Dollar (-1.58%) and Norwegian Krone (-1.04%) were the noteworthy movers on the downside and even then, the scale of their losses was relatively small. By far the biggest winner among those 17 “majors” was the Brazilian Real, which rallied strongly from the bottom of its historic trading range on the back of higher interest rate expectations and demand for iron ore to post a gain of 13.36% in US Dollar terms. Support for commodity currencies also saw the South African Rand appreciate by 3.11%, with the Taiwanese Dollar (+2.42%) and the Mexican Peso (+2.38%) completing the list of those recording meaningful gains.
We have commented previously on the potential attraction of emerging market currencies, which have shown signs of waking up after more than seven years of famine for investors. While top-down analysis is always helpful in identifying structural trends, as is the case with other asset classes in emerging markets, the vast and varied opportunity set represented by the investible universe means that an active, “rifle-shot”, approach is the only sensible way to tackle investment in this area. Based on our extensive research to date, we have concluded that the optimum way to access EM FX is via a focused, macro-driven, local currency sovereign bond strategy. Our deliberations as to the potential timing of an investment in this area are ongoing.
JP Morgan Emerging Markets Currency Index (USD)
Commodity markets were the focus of much attention, as the bullish trend in the asset class continued unabated: the Refinitiv CRB Index ended the period 15.37% higher in USD terms, with gains recorded by all 19 of the benchmark’s underlying components. The Rogers Ex-Energy Index was up 9.91%.
As implied by the figures above, energy prices were one of the major drivers of the markets’ advance during the quarter, with (US) Natural Gas the biggest index gainer. Reflecting a common theme across many of the commodity complexes, the acceleration in demand towards pre-pandemic levels resulting from the opening of economies has not been matched on the supply side. Whereas in the particular case of the gas market, the mismatch has been mitigated by a drawdown in inventories, other markets – lumber for example – have been hit by severe shortages, resulting in massive price volatility.
Crude Oil prices continued their upward trajectory, with the price of front month futures contract for West Texas Intermediate hitting a six-year high on its way to a $14.31 / 24.19% increase and a closing level of $73.47 per barrel (+$13.13 / 21.35% / $74.62 for Brent). While an agreement was struck between the major petro nations over the overall quantum and direction of production levels, the allocation of individual countries’ quotas was the source of rising tension, leading to speculation over future cohesion within “OPEC plus” and adherence to supply limits. With the prospect of the one last major component of demand – air travel – coming back on stream, however, a breakdown in current supply constraints may turn out to be a welcome relief for consumers (and inflation numbers) in order to prevent further tightening in a market within which talk of $100 oil has been gathering momentum.
Brent Crude (USD per barrel)
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