We remain positive on risk assets. Economic growth indicators continue to be expansionary, consumer balance sheets are healthy supporting demand dynamics, and company earnings are strong, beating expectations. In addition, increasing vaccination rates and lower activity restrictions are supportive for the overall growth picture. We recognise, however, that the range of outcomes has broadened in recent months as we reach an inflection point in monetary and fiscal policy and face immediate headwinds of higher inflation and regulatory development within China.
Inflation continues to be our key discussion topic. The recent UK CPI print came in at 3.1% year-on-year annual growth, marginally behind the previous month’s figure of 3.2%. On a month-on-month basis consumer prices fell from 0.7% to 0.3% with a slowdown in the component of restaurant and hotel prices due to a base effect from last year’s “Eat Out to Help Out” scheme. We continue to believe many components contributing to higher inflation are transitory, however, input costs such as wage growth and energy costs are testing this. We expect inflation will remain at current elevated levels or even higher longer than initially thought, until mid-next year at which point we will see easing supply chain challenges. In an environment of rising input costs, companies with pricing power are attractive.
Though we will see a moderation in inflation from current elevated levels, we expect inflation to sit higher than we have experienced pre-pandemic, around or even above central banks’ targets. In line with the flexible/symmetric frameworks adopted by the US Federal Reserve and European Central Bank. Stagflation, where prices rise so much to choke off demand is unlikely with less union power, technology, and demographics – an ageing population, all pushing down on inflation.
In developed markets, we are at an inflection point where central bank policy is now becoming less accommodative. Asset purchases in the US are guided to reduce in November and rate hikes expected to come through in the UK in December. This is important, but has been anticipated by market participants, reflected by the move in sovereign yields. In a rising yield environment, our view is to remain underweight longer dated government bonds in general but see opportunity in shorter dated paper where rate hikes appear more fully priced, we are seeing examples of managers adding. Within credit, we continue to favour active implementation.
Economic growth forecasts have moderated with the International Monetary Fund (IMF) trimming its forecast for US economic growth to 6.0% from 7.0% in July due to a combination of supply chain disruption and the Delta variant. It is important to understand however that 6% is significantly above trend and ahead of pre-pandemic rates of economic growth. The Delta variant is less of a feature now in the US with average daily cases falling through September, down 11% in the last week from 108,000 to 95,500. We are still in a recovery phase with strong economic growth forecast not just for this year but also next year. Lockdowns are continuing to ease. We do expect economic data to moderate however, albeit slowly and from the exceptionally high levels. PMI data remains above 50 (in expansion) with some regions in Emerging economies showing improvements in PMI data for September. An example of this is the Caixin PMI for Services in China rising 6.7pts from the previous month’s reading.
Whilst the long-term view is real growth and inflation globally will sit above the trend demonstrated over the last decade, we may see these aspects move in higher frequency, accelerated cycles.
Earnings growth is expected to be robust for Q3 ’21 but moderating from the very high levels seen earlier in the year. Consumer balance sheets are strong leading to high levels of demand and over the short term an ability for consumers to pay higher prices.
Recent stock market performance in China has illustrated the idiosyncratic risks in investing in the region. China’s focus on reducing inequality and leverage within the economy, and intervening in the corporate sector to achieve this, has led to significant volatility. Even with valuations at current low levels, the True Potential manager cohort is not looking to invest further into this region. We continue with our preference for developed markets over emerging markets.
In conclusion: –
- In the main, equities remain our favoured risk assets as we move into next year.
- Duration exposure in fixed income is in focus in an environment we anticipate bond yields to grind higher.
- The rate of improvement in economic data is moderating but will remain expansive.
- Inflation to stay elevated longer than initially thought but to fall back mid next year.
- Higher levels of volatility create opportunity.