Friday 16th July, 2021
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This week we discuss the need for portfolio diversification in an uncertain world, the narrowing of the US market, Fed Chair Powell’s testimony on Capitol Hill, and the inflation tail risk.
Global equities have seen mixed performance over the past two weeks; and where there have been gains at index level, these have largely been driven by just a handful of mega cap tech stocks rallying on lower treasury yields and amid the reversal of the growth-to-value sector rotation. Over the past 6-8 weeks, there have been huge flows into technology and defensive sectors, and this capital injection has narrowed – if not eliminated – the outperformance of cyclical stocks year-to-date. In fact, US growth stocks are now ahead of US value stocks for the year! This is quite a comeback for growth (particularly during a cyclical upswing), and it should serve as a reminder to investors that one should never bet the farm on any single market trend, macro forecast, or investment theme. Diversification is probably the most effective risk management tool available to investors; and, in such an uncertain environment as exists today, we suggest that you make full use of it.
Looking to the future now (and more structurally at markets), the narrowing of the US market (through the return of Big Tech outperformance) could yet become as unhealthy as it did in 2020, when cyclical sectors were cast into the abyss and investors ploughed into stay-at-home stocks en masse – only for this trade to reverse sharply following the Pfizer vaccine announcement. Every market consensus sows the seeds of its own destruction, and there is always a danger that when the mood turns the subsequent collapse of conviction leads to considerable collateral damage and a broad sell-off. On top of seasonally thin liquidity this summer, investor optimism already seems to be on the decline. And for good reason. There are rising cases of covid-19 around the world, driven by the highly infectious Delta variant, even in countries with very high rates of vaccination (e.g., the UK and Israel). This is a dynamic that many scientists find troubling – and we do not yet know if it will put the brakes on easing restrictions. At the same time, investors are starting to grapple with the notion that growth and stimulus may have peaked. As a consequence, we would not be surprised if volatility now picks back up and we witness a sizable correction before the summer is out.
For markets, undoubtedly the most important set-piece news event this week was Fed Chair Powell’s wide-ranging testimony to the US Senate Banking Committee on Capitol Hill. For two days, he opined on the state of the US economy and on the outlook for US monetary policy, while investors hung on his every word looking for a change in guidance (or tone). However, neither in his prepared remarks nor in any answers to the subsequent questions did he deviate notably from the comments he made in June. Most crucially, he reiterated his view (which is the consensus at the Fed) that inflationary pressures felt in the US today (and elsewhere) are transitory, and therefore that they do not materially alter the case for keeping policy ultra-easy. To be sure, the June print for headline US Consumer Price Inflation (CPI), released on Tuesday, showed that prices have surged +5.4% since June last year. This is the biggest increase in headline inflation since 2008. And the +4.5% year-on-year rise in core CPI in June is even more historic, being the largest such increase since 1991. But Powell pointed out there was nothing in the underlying data to indicate that inflation was here to stay on a more permanent basis. The spike in the CPI data seems mostly to be due to base effects from last year, the rapid re-opening of the economy (after limited activity during the era of stringent lockdowns), and coronavirus-related supply bottlenecks that should pass in due course. For example, a big chunk of June’s headline inflation can be attributed to a c.10% increase in the price of used cars (adding to the +7.3% rise in May and +10.0% in April). Travel is picking back up, pent-up demand is being unleashed, and the car market is feeling the effects after a disastrous 2020. However, such price inflation is clearly unsustainable going forward.
We tend to agree with the Fed in their prognosis that the current inflation pressures will pass. However, we are mindful that the pandemic is far from over and therefore that supply chain disruptions are not about to disappear. Moreover, the Biden White House is pledging large spending increases on human and physical infrastructure and this could have inflationary consequences if not targeted effectively (as many Republicans fear). There is also the risk of a permanent de-globalisation following the pandemic as supply chain resilience is prioritised over ‘just-in-time’ delivery, and US-China competition ramps up (seen most recently in the dispute over Didi listing in the US). This may cause further stresses in supply chains at a moment of maximum vulnerability. Such tail risks should be considered in any prudent asset allocation, and we believe that an exposure to commodities (and metals in particular) makes sense.
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