Monthly Investment Letter: The return from orbit

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Richard Branson and Jeff Bezos haven’t been the only ones rocketing into space in recent months. From recession and disinflation in 2020, massive stimulus and economic reopening have allowed US GDP growth in real terms to hit 12% year-over-year in the second quarter, with roughly 4.5% inflation—an “exospheric” 17% rate of growth in nominal terms. In the Eurozone, real year-over-year growth was 13.2%, with roughly 2% inflation in the last three months. Data suggests that growth rates will stay in orbit for a few months yet; we expect year-over-year nominal US GDP growth to remain in the double digits until the first quarter of next year, while the Federal Reserve and other central banks continue to indicate they are in no hurry to raise interest rates.

Tactically, we think investors should continue to take advantage of the “zero gravity” conditions afforded by such strong nominal growth and loose policy. We see further upside for corporate earnings and equities, particularly those markets and sectors most exposed to global growth, including Japanese equities as well as the financials and energy sectors within the US.

But as all astronauts know, after liftoff, the most uncertain part of a space mission is reentry into the atmosphere, and in the months ahead we can expect a heated debate about how to navigate growth and inflation’s return from orbit.

Every inflation report above 2%—and we expect them to continue for several months—will lead to a chorus of calls for the Fed and other central banks to rein in stimulus, so that inflation doesn’t spiral out of control. At the same time, the Fed knows that overzealous attempts to tame inflation risk putting the economy and markets on course for a “hard landing.” We still think we are on course for a smooth landing, as the Fed stays patient, inflation recedes through 2022, and growth remains robust. We stay risk-on, though we downgrade emerging market equities to neutral.

Forward-thinking astronauts might also consider how the landing site might have changed since liftoff. So should investors. Bond markets seem to suggest we’re going to land in an even lower-growth and lower-inflation world than we had pre-pandemic—an outcome that would be long-term supportive of yield and growth investments. But at the same time, the increased penetration of the digital economy, greater labor market flexibility, new central bank reaction functions, and new fiscal policy philosophies could mean we find ourselves back in a higher-growth, higher-inflation world than before—an outcome that would be more supportive of cyclical and value stocks. I discussed this topic in more detail in my April letter, “Changing the narrative.”

So how to invest today?

1. First, investors should take advantage of this period of double-digit nominal GDP growth to invest tactically in reopening and reflation, which should benefit in our base case and be resilient if inflation surprises to the upside. We like Japanese equities, financials and energy stocks within the US, as well as companies exposed to reopening in the US and Asia.
2. Second, prepare for volatility on reentry by diversifying across regions and asset classes, including hedge funds, which can allow investors to remain engaged in markets while reducing directional risk. Global healthcare is one of our preferred sectors and presents both defensive and growth characteristics. Bouts of elevated volatility may also present opportunities to gain market exposure with potentially attractive alternative payoff structures.
3. Finally, combine tactical investments in reopening and reflation with strategic investments across growth, yield, and sustainability, which will prove especially valuable in case the bond market is right that we are about to land in a world of sustained low growth and low inflation. We particularly like greentech, digital subscriptions, and smart mobility.

Learning backflips in zero gravity

We expect rates of growth and inflation to stay well above historical norms for the next six to 12 months, and this should continue to fuel robust corporate earnings growth. Coincident with the lofty US GDP growth and inflation in 2Q, S&P 500 earnings shot up nearly 90% year-over-year.

Our read is that growth will stay strong for at least the next four quarters:

• Consumers have been spending the excess savings that they accumulated during 2020, which pushed demand for consumer durable goods significantly above trend. The savings boost to consumption is now starting to fade, although it will not disappear entirely. At the same time, household income from employment is increasing, which will provide more enduring support for consumer spending. In addition, with interest payments as a percentage of disposable income at 40-year lows, consumers are better positioned to take on more debt if they so desire.
• While manufacturers’ inventory levels are comfortably above pre-pandemic averages, retailers’ inventories remain very low. Recent increases in retail inventory have been very small, and sales are still generally growing faster than inventory. This suggests that retailers’ need to restock will be a source of real economic growth in the coming quarters. The customer inventory component of the ISM Manufacturing index is currently at a record low of 25. Historically, when this measure has been below 39, the headline ISM index has remained above 54 for over a year, indicating strong business sentiment and real growth.
• Job growth momentum should continue. July’s nonfarm payrolls report beat expectations with 943,000 new jobs, while previous months’ figures were also revised up. Although the jobless rate has declined to 5.4% from 5.9%, suggesting diminishing slack, payrolls are still 5.7mn below pre-pandemic levels, and 8mn below potential, if we consider trend payroll growth of 125,000 per month.

The ongoing imbalance between the supply of and demand for goods is contributing to inflation. In addition to shortages of raw materials and unfilled job openings, logistical issues, including an insufficient number of truck drivers, are contributing to cost increases. The prices paid subindex of the ISM Services index hit 82.3 in July, the highest since 1995. We expect the situation to improve by the end of the year, but some bottlenecks are likely to persist into 2022. In particular, shortages of computer chips are causing challenges, and it will take time for production to meet the present level of demand.

Elevated inflation can be a concern for companies if it means variable input costs rise. But in fact corporate margins hit a record high in the second quarter, as strong nominal GDP growth meant companies were able to earn more revenues against fixed cost bases. In the US, 90% of companies beat earnings forecasts, by close to 20% in aggregate. We now expect 45% growth in S&P 500 earnings in 2021 and think consensus forecasts for 2022 are likely to be revised upward by nearly 10%. As this earnings trajectory is confirmed, we expect the S&P 500 can reach 5,000 by the end of 2022.

Charting a smooth landing

Growth and inflation look set to remain elevated for the coming quarters. Yet a key debate for market participants in the months ahead will be whether high inflation persists as growth normalizes.

In our base case, we think inflation will fall through 2022 because relatively few items, such as used cars and gasoline, have contributed disproportionately to the rise in inflation this year. We note that median inflation (the price increase of the median good) has only increased from 2.1% to 2.3% so far this year. By the middle of 2022, we expect the price growth of those few items that have cast inflation higher to stall or even reverse, and think these negative base effects will push core PCE inflation below the Fed’s 2% target.

Many commentators are raising “stagflation” fears by pointing to a range of potential drivers—from COVID-19 to the housing market and policy errors—as reasons why the economy faces a period of high inflation and low growth.

Although we acknowledge the risks to our view, we see them as unlikely to tip us onto a stagflationary path:

1. COVID-19 variants.

• The spread of the delta variant has led to concerns that it could hold back consumer spending, reduce growth, disrupt supply chains, and boost inflation. On the demand side, the recovery in the US services sector suggests that consumer fear of the virus is low, and similar patterns can be observed in Europe. Data continues to suggest vaccines are effective at reducing healthcare burdens, allowing governments there to increasingly disregard case numbers, making renewed lockdowns unlikely. Of course, the situation is different in other regions: China has introduced curbs on domestic travel and closed tourist sites, and global supply chains have been affected by the closure of a terminal at the world’s third-largest port, Zhoushan. If supply chain disruption through port closures persists, it could prolong near-term pandemic-related inflationary pressures and weigh on Chinese growth in the short term. But we do not think the impact would be large enough to meaningfully slow down growth and elevate inflation at a global level next year.

2. House prices

US house prices are rising at their fastest pace in 30 years, with the increasing cost of buying a home often cited by the media as a key component of rising living costs. Yet very low long-term interest rates are limiting monthly mortgage costs, so most homeowners are not facing significantly higher direct housing costs. Housing also only indirectly feeds into inflation indexes: It is calculated using rents, which remain a relatively subdued input.

3. Fiscal policy

• US fiscal packages, including sending stimulus checks directly to individuals, have meant many consumers accumulated excess savings during the pandemic. These have been released into an economy still subject to supply bottlenecks, and are therefore contributing to the current spike in inflation. But once that stock of savings has been spent, and as supply bottlenecks ease, there is little reason to expect fiscal policy to heavily influence inflation. The infrastructure bill currently going through Congress is relatively modest in scale (compared with total US GDP), and spending is spread out over eight years, so its impact in any given year is likely to be small. And the remainder of the Biden administration’s spending plans, if passed, are likely to be at least partially funded by tax increases on corporations and high-income individuals. Although these measures could nudge inflation higher, by increasing demand in excess of supply, they would also likely not mean stagflation because there should be some offset as the spending should also drive growth.

4. Fed policy

• The potential for preemptive tightening by the Fed, which curtails growth, is part of the stagflation narrative. But, in our view, it is unlikely. First, the Fed’s reaction function has changed since adopting the average inflation targeting (AIT) approach, and recent Fed commentary has reaffirmed this view, with Atlanta Fed President Raphael Bostic saying, “The committee will no longer preemptively raise interest rates in response to a ‘hot’ labor market because of fear that inflation will eventually be a result.” Second, applying the AIT approach to US inflation data suggests the Fed doesn’t need to act: On two-, three-, and five-year rolling averages, core PCE inflation remains well below 2%. Third, the Fed has learned the lessons from the 2013 “taper tantrum” and is providing ample, gradual guidance about the withdrawal of monetary accommodation, reducing the risks of a policy communication error that might send 10-year yields sharply higher (or lower).

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What to do with China equity exposure?

Last month, we moved our preference for China stocks from most preferred to neutral given the high weighting in the MSCI China index of new economy stocks, which are facing elevated regulatory uncertainty at present. Heightened scrutiny on the education, gig economy, social media, and gaming sectors has raised broader concerns about both Beijing’s domestic policy direction and its stance on foreign investment, adding to existing concerns about the effects of US-China tensions.

Our view is as follows:

We are not bearish on China equities. Our neutral view still implies upside ahead, but amid the elevated uncertainty we don’t have high conviction that China will outperform other markets in the region over our tactical investment horizon. Over the longer term, we still see China as playing a role in global portfolios, and note that the market dropped by 43% in 2015–16, and by 32% in 2018, but subsequently fully recovered in both cases. MSCI China has fallen by 31% since February’s record high.

We do not believe the move toward tighter regulation is complete. We think further restrictions are possible in parts of the new economy, along with socially sensitive sectors such as property. As a result, within Chinese equities, we are more cautious on these sectors, until there is a clear catalyst or a signal that the current regulatory cycle is easing. Instead, we prefer those sectors shielded from, or supportive of, policy ambitions, such as greentech, cybersecurity, consumer durables, and energy.

We do not think other major industries will be compelled to go nonprofit. Political debates about profitmaking in the education sector are not unique to China, and the Chinese government has stated that the aim of reining in the after-school tutoring (AST) sector is to lessen the financial burden of education on families. In other sectors, we think Beijing remains focused on its long-term goal of self-sufficiency and leadership on the global stage and understands the role of the profit incentive in achieving that.

Overseas listings remain viable. Most overseas investors who have exposure to Chinese companies will do so using VIEs (contracts entitling them to a share in the company’s profits, without legally owning the underlying assets) or ADRs (stocks that trade on US exchanges but represent shares in foreign companies). Increased regulatory scrutiny has prompted concern that China might explicitly outlaw VIEs, while US regulators have introduced tougher reporting requirements for foreign companies, which could lead to delistings from US exchanges.

Our view is that the Chinese government still endorses the pursuit of a diversified capital base, and it knows that banning VIEs could harm China’s innovation and technological development. Indeed, we think policymakers’ renewed focus on the structure is part of the gradual process of validating it. Mainland China’s and Hong Kong’s regulators have made proposals that would endorse the listings of VIE entities on their respective exchanges, subject to new compliance and disclosure requirements. Meanwhile, Chinese ADRs have three years to comply with US regulations, and in the meantime we expect more US-listed Chinese companies to seek secondary listings in Hong Kong, if they do not have them already. ADRs can be freely converted in the event of a delisting in one market.

How should I take these issues into account in my investments?

Idiosyncratic political and regulatory risks are a feature of any emerging, or indeed developed market. Diversification across and within markets is key. We recommend that investors maintain their strategic allocation to China, and within China allocations we recommend diversifying across listing types to strike a balance between accessing growth, limiting costs, and mitigating risks.

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Investment positioning

Position for reopening and recovery

We favor those sectors and regions that have the most to gain from strong economic growth. We expect energy stocks to benefit from a further rise in oil prices in the second half of the year. We think financials should be well supported by rising 10-year Treasury yields.

We maintain a preference for Japan. Extensions of emergency COVID-19 restrictions have weighed on Japan’s recent equity market performance. But we are confident of Japan’s potential to catch up in the months ahead.

1. First, Japanese equities are well positioned to benefit from global economic growth: Over 40% of MSCI Japan’s revenues come from abroad.
2. Second, Japan has the highest operating leverage among the major regions, meaning earnings are highly sensitive to rising revenues. We forecast 42% earnings growth for the fiscal year ending March 2022.
3. Finally, the country is on track to reach our forecast of fully vaccinating 50% of its population by the end of September, a trend that should facilitate stronger domestic growth and boost investor sentiment.

At the same time, we move emerging market (EM) equities from most preferred to neutral. These stocks remain well exposed to global growth and rising commodity prices, and their valuations are also attractive, with the MSCI EM index trading at a 30% forward price-to-earnings discount to the MSCI All Country World Index, versus a 15-year average of 18%. But we think they will struggle to outperform global markets. As the Fed moves toward tapering, we expect 10-year Treasury yields to rise and the US dollar to strengthen in 2022, moves that have traditionally presented headwinds for emerging market stocks. In addition, further regulatory tightening in China could weigh on sentiment and drag on returns, given China’s 35% weighting in the MSCI EM index.

We also downgrade industrials to neutral. Business trends remain very healthy and conditions should remain favorable for some time. But as growth rates naturally slow, it typically becomes more difficult for this sector to outperform. A large infrastructure bill would support certain companies in the sector, but they only make up a small segment.

Hunt for yield

Yield generation remains a key challenge for investors, as benchmark yields have fallen and credit spreads have tightened to near record lows.

To help generate yield in portfolios, we maintain a preference for US senior loans. Senior loan funds have experienced the largest net inflows among fixed income asset classes, totaling USD 262bn year-to-date, and we expect these inflows to continue as interest rates rise and the Fed begins to hike short-term interest rates. Senior loan fundamentals have strengthened since 2020. Growing demand for their floating-rate structure and the positive real yields they offer should support the asset class in the fourth quarter.

In our Asian portfolios we have held a preference for Chinese government bonds (CGBs), which we now move to neutral as the drivers for the position have changed. We initiated the preference for CGBs last October for their attractive carry versus US Treasuries (3.2% vs. 0.7% on the 10-year tenor at the time), their projected yield decline amid monetary normalization, and potential Chinese yuan appreciation against the US dollar. These drivers have played out, and since initiation the CGB index is up over 9% (in USD terms) and the 10-year US Treasury index is down 2%.

But we now think the CNY will depreciate against the USD in the months ahead—the US is set to taper soon, and China is turning less hawkish—with macro momentum in China starting to lag developed countries. So we move to neutral on CGBs despite the still-attractive carry.

That said, we continue to see opportunity in Asia high yield. Tighter policies in China’s property sector, ongoing negative headlines around a leveraged property developer, and uncertainty about China’s regulatory direction have weighed on Asian HY bonds in recent months. Near-term sentiment remains vulnerable, but we think the risk-reward outlook over the next six months is constructive, and current valuations should provide a buffer against further drawdowns. We prefer BB rated bonds, shorter-dated quality Chinese property issuers, and those in the commodity and industrial sectors.

Risk-tolerant investors can also consider alternative yield strategies such as private credit markets, prudent use of borrowing to improve yields, and volatility-selling strategies using structured investments. In FX markets, with the pace of normalization and reopening varying across countries, we believe some currencies, like the GBP, stand to benefit from their relatively more hawkish central banks.

Protect against downside risks

As the Fed steers the economy to a smooth landing and COVID-19 uncertainty persists, investors should also review opportunities to diversify exposure to public markets, including into alternatives, or seek opportunities to add exposure to select lower-beta sectors.

We upgrade the global healthcare sector to most preferred as it offers attractive long-term growth, appealing shareholder returns, and a defensive/quality profile. Based on a 12-month forward P/E, the MSCI AC Health Care index is trading at 19.5x earnings versus the MSCI AC World index at 18.3x, a 7% premium which is in line with the historical average, and a substantial discount to other defensive/quality sectors, such as consumer staples. Next year, healthcare’s estimated annual EPS growth is expected to be 7% versus 8% for the overall market, but net earnings revisions are improving compared with the benchmark, which historically has supported the sector’s relative performance. Among defensive sectors, many healthcare companies offer the characteristics of pricing power, i.e., high and stable gross margins over time. Flexibility on variable costs also allows the sector to protect margins if inflation remains high. The sector’s short-term risk is mainly linked to US healthcare reform and to a large government shift on drug pricing. However, we believe that large drug price cuts are unlikely. In our view, both Republicans and centrist Democrats are likely to limit the scope of drug price cuts to a level that is manageable and probably a bit better than market expectations.

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