Alessio de Longis, a senior portfolio manager and head of global tactical asset allocation at Invesco Investment Solutions, recently published a blog post under the expressive title “Inflation Is Peaking, and Risk Appetite Is Improving.”
The analysis highlights comments Federal Reserve Chair Jerome Powell made at the end of August during a speech at the Jackson Hole Economic Symposium. During the important Fed meeting, Powell reiterated a lack of serious concern with the current inflation rate, and he confirmed a well-telegraphed Fed plan to begin tapering asset purchases in the fourth quarter.
“We believe inflation has peaked,” de Longis writes. “Our inflation momentum indicator, introduced last May, suggests U.S. inflation statistics over the past three months have stabilized and begun to roll over. These developments provide tentative support to our thesis that the spike in inflation would prove transitory, and that inflation should soon return to an average annual rate in line with recent history.”
The bottom line, de Longis says, is that while there are several economic and market developments that could shake markets in the near term—including still-surging COVID-19 infections, monetary policy communication, and upcoming U.S. debt ceiling and budget deadlines—the macro framework still points toward a positive backdrop for equities. The same can be said for cyclical assets, de Longis writes, and for emerging markets, leading many asset managers toward a tactical buy-the-dip strategy, rather than a risk-reduction strategy.
“Within equities, we favor emerging markets, driven by above-trend global growth, rising risk appetite and medium-term U.S. dollar depreciation, to support the asset class,” de Longis says. “We remain tilted in favor of (small) size and value across regions. In addition, we are tilted in favor of momentum, which currently captures value and smaller-capitalization equities, therefore concentrating risk in cyclical factors and reducing factor portfolio diversification relative to the past few years.”
In fixed income, de Longis notes, Invesco has closed its overweight exposure to inflation-linked bonds and has gone overweight relative to Treasury inflation-protected securities (TIPS).
“We are overweight credit risk and underweight duration versus the benchmark,” he writes. “We favor risky credit despite tight spreads, seeking income in a low-volatility environment. We are overweight high yield, bank loans and emerging market debt at the expense of investment-grade credit and government bonds. We favor U.S. Treasurys over other developed government bond markets given the yield advantage.”
Related commentary published this month by investment analysts at LPL notes the COVID-19 pandemic continues to present an unprecedented shock to a large majority of global economies. But, the LPL analysts suggest, the economic damage was met with an “extraordinary” global monetary response led by the U.S. Federal Reserve, the European Central Bank (ECB), the Bank of Japan (BOJ) and the Bank of England (BOE). According to LPL’s data, central bank balance sheets have grown by $10 trillion since the start of the pandemic and are currently at $25 trillion for the aforementioned banks combined.
“Monetary support has helped limit the economic damage from the pandemic, but now may be the time to start removing some of those emergency levels of support,” says Lawrence Gillum, LPL Financial fixed income strategist. “However, gently taking your foot off the accelerator is different from applying the brakes. We still expect monetary policy to be supportive for the foreseeable future.”
LPL’s analysts also find wage pressures are building. For the month of August, they write, average hourly earnings came in hotter than expected, an increasingly common occurrence, posting a 0.6% month-over-month gain versus expectations for 0.3%, and a 4.3% gain year over year versus expectations for 3.9%.
“Wages have important implications in the inflation debate, as they and rents are considered to be among the ‘stickier’ components of inflation,” the LPL analysts suggest. “[The most recent wage] report is likely to bolster those in the camp asserting inflation will be less transitory than the Federal Reserve thinks, though it should be noted that the lack of employment growth in lower wage in-person sectors likely contributed to the higher wage numbers.”
Looking ahead, the LPL analysts say there is ample reason to expect a strong job rebound in coming months.
“Schools closed for the summer, potential disincentives from enhanced unemployment benefits and the troublesome Delta variant have all acted as speed limits on the pace of employment growth recently,” the analysts suggest. “August’s jobs report, though, figures to be the last where all of these factors remain in full force. Enhanced unemployment benefits expired on Labor Day (ironically), meaning their effects will only be present for part of the September report’s observation window, and will be fully gone by the October report. Schools and day care facilities, meanwhile, are beginning to reopen, freeing up parents to rejoin the labor force. And, most importantly, we are seeing promising signs that the worst of the latest flare-up in COVID-19 cases may be behind us.”
In the view of Brad McMillan, chief investment officer (CIO) for Commonwealth Financial Network, if one momentarily looks beyond the pandemic, the markets look “pretty normal.”
“They look very much like what we would face in any growth environment,” McMillan says. “When an economy is growing, and doing well, more demand can generate inflation. At that point, the Fed will raise rates, and the government will likely respond as well. We are right in the middle of this scenario.”
This raises the question: Is there anything that would make this market cycle different? McMillan says the answer is “perhaps.”
“The biggest possible difference is that a case can be made that much of the current economic expansion is based on federal stimulus payments, rather than organic growth,” he explains. “The expansion will end when the stimulus payments do. In other words, with the economy and markets both rising, is this just a sugar high, rather than a sustainable expansion?”
McMillan’s personal view is that this is no temporary rush for the markets.
“First, while the stimulus payments did indeed stimulate the economy, we are now well past them, and growth has continued,” he proposes. “Second, with the growth in jobs and the rise in wage income and consumer confidence, consumer demand and purchasing power have continued to grow, supporting more spending growth. Third, we are seeing the same thing in business confidence and investment. Overall, earnings are strong enough to keep consumers and businesses spending and confident enough to keep doing so. If current conditions hold, this trend is sustainable. And this rise in demand, which now looks sustainable, is why markets have been moving higher.”
McMillan says the other big concern he hears about these days has to do with equity market valuations—namely that they are, by some measures, higher than ever before.
“Depending on the metrics used, valuations are, in some cases, at all-time highs, even exceeding those of the dot-com boom,” he observes. “But I don’t think high valuations are an immediate problem for two reasons. First, valuations have been high for the past five years and more, suggesting this trend is a systemic change rather than a spike. Second, low interest rates provide a credible basis for a systemic change, both mathematically and behaviorally. Third, within this change, stock prices have changed consistently with earnings expectations, suggesting that the market is behaving rationally—but within a higher value range.”
In other words, until interest rates increase materially, stock prices are likely to be supported in the current range, McMillan says.
“A related topic is whether fixed income faces similar valuation risks,” McMillan warns. “With rates low, bond prices, like stock prices, are high and potentially vulnerable. But the risks are larger for bonds. I’ve talked about focusing on credit for return, rather than bond duration. Duration is a risk that can and should be managed—but, again, it is nothing to panic about.”