Still up, but bumpier

We have a lot to thank the scientists for. Covid-19 vaccines were developed in super quick time, and over the last few months, mass vaccination programmes have allowed governments to ease restrictions. While I—like most of us—can’t wait to start getting back to some kind of normality, investors have also been encouraged by the surge in consumer activity we’ve seen as economies open up. In equity markets, for example, there has been a strong recovery in many of the sectors and regions that were most beaten up last year, such as value stocks and European stocks.

However, as investors look further into the future, their initial optimism is starting to wane. They have several questions: Will demand stay strong beyond the initial surge? Will inflation prove troublesome? And will central banks be forced to take their foot off the accelerator?

Like most market commentators, I’ve been giving these questions a lot of thought in recent weeks. At the moment, I still believe growth will remain robust in the next three months, but I’m becoming more convinced that inflation will linger—and that the result will likely be market jitters. While monetary policy remains highly supportive, with a first US rate hike not expected until 2023, talk of tapering by the Federal Reserve will no doubt become louder over the summer. Ultimately, I think central banks will, at the very least, ease off the accelerator pedal, and this will encourage bond yields to nudge higher.

How the stock market might react to higher bond yields is the subject of my favourite chart in the new Guide to the Markets. This chart shows how, historically at least, different sectors, styles and regions have responded to higher US Treasury rates.

J.P. Morgan Asset Management Guide to the Markets Q3 2021 - Page 65

A strong growth, modest inflation backdrop is expected to support corporate earnings. Despite the strong outperformance in the first half of the year, I still think the most attractive opportunities lie in the value segments of the market, such as financials. If US rates do move modestly higher over the coming year, it would certainly help the rotation to value. As a result, more value-orientated markets, such as Europe and the UK, could outperform.?

Coming up this November, we of course have the COP26 Conference, where leaders of over 190 nations are hoping to gather in Scotland to develop a plan to reach net zero emissions in the coming decades. Reaching net zero will require dramatic changes to the global economy, which of course is likely to have serious portfolio implications.?

While I’m optimistic that growth will be strong for the quarter ahead, and beyond, we do need to assess the risks. While the virus may continue to mutate, the news so far on the effectiveness of vaccines against new mutations is encouraging. The bigger risk, therefore, is that inflation is persistently troublesome.

For investors, persistently higher inflation would mean that bonds - which are supposed to be the key source of portfolio ballast - are actually the key source of risk, since persistent inflation would require a more rapid withdrawal of monetary stimulus. Investors should consider global fixed income strategies that can be flexible in the event of changing economic winds. Outside of fixed income, macro funds and real assets – particularly real estate and core infrastructure – could also serve as a good inflation hedge.

The macro backdrop for the second half of the year remains strong, but investors should buckle up for some bumps in the road.

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