The waters look to have remained calm in financial markets, despite the hot numbers coming from the real economy. Although we view the outlook as generally positive, the larger economies are at different stages in their journeys towards peak acceleration. Europe and some EM still have some room to go in this respect. But what all regions have in common is rising pressures on input and producer prices amid supply-chain disruptions, and inflation figures trending firmly higher. Strong undercurrents could make the environment far less safe than it seems.
We are approaching a pivot point for the US job market, as emergency benefits will stop in many states by the end of June. We know that the Fed will look at official data, not forecasts, and the changes in job data will not be seen before the August release, when some of the base effects in inflation should also start to fade. This will represent the pivot point. The Fed’s communication has already changed in this June meeting, acknowledging a strengthening economy and upgrading its 2021 inflation forecasts. However, it maintained the narrative that inflation has risen “largely reflecting transitory factors” with some risks on the upside. Uncertainty remains elevated: while markets buy into the transitory inflation path, we probably have some tougher months ahead. Inflation expectations have already risen, with 5Y-5Y inflation forward breakeven inflation reaching a seven-year high of 2.55%. This level already supports average inflation of 2%, the Fed target. Any further upside may risk de-anchoring long-term inflation expectations, thus forcing the Fed to act more aggressively than what markets expect.
On the investment front, this outlook confirms the need to move cautiously. While recognizing that the economic rebound still supports risk assets, investors may find themselves in rough waters if the narrative on inflation changes. With this background, we outline our convictions below:
- The cyclical reflation trade is not over but is getting less straight-forward – With economic surprises in the US fading, we appear to be moving towards a more balanced situation between expectations and reality. The reopening narrative that lifted all boats is losing steam, and this means that from here opportunities in the US equity market look more idiosyncratic and less dependent purely on market direction. An exceptional 70% of active managers beating the Russel 1000 in May (best data since 1992) is a signal of this change in the market. In Europe, the reopening narrative is just starting, and this is even more the case in EM, where there is still room for a more convincing directional trade.
- Rotations to continue amid high absolute valuations – Equity valuations are tight in absolute but not relative terms vs bonds, meaning that, over the medium term, there is no alternative to investing in equities. At this stage, however, we prefer to keep a more neutral stance approaching the summer test regarding the Fed’s policy direction. Furthermore, we believe the value rotation will continue, as the valuation gap is still very wide. However, we would not expect to see the same intensity that has been apparent since November. The trend will be less linear, but value looks set to dominate growth for many reasons (commodity cycle, cyclical recovery, rising interest rate path). In addition to value, we see the theme of dividend stocks coming to the fore that should outperform given the search for income.
- On bonds, we keep a short duration stance, while on credit we are constructive, especially in Europe, given the economic acceleration of the region.
- In EM, we also stick to a cautious duration approach. Inflation is not just a US matter – it is also an EM story, with EM central banks in a tightening mode, and a stronger dollar due to recent Fed signals could be a headwind for EM. So, we keep a neutral stance on EM bonds while we look for opportunities in currencies and equities.
Moving forward, we expect markets to remain in a holding pattern, with some movements resulting from the closing of positions by investors that are moving to neutral stances in this wait-and-see phase and from Fed’s communication (UST yields rose after Fed’s recent comments and the USD strengthened). Markets will need to see a big surprise to halt this calm trend. For the time being, we expect waters to continue to look calm. But, this does not mean they are actually safe, as strong currents may arrive soon. This is not a time to be complacent, or to take strong directional calls, and we suggest investors increase scrutiny to continue to benefit from the reflation trend.