This is an extract from our Asset allocation monthly – Long Covid
US macro – Headwinds
It has become clear that supply chain bottlenecks and inflation will last longer than thought. We expect core inflation (as measured by the Personal Consumption Expenditure index) to rise for another year, to around 4.4%, before falling back to 2% in 2023.
To deal with the higher prices, households will likely draw down some of the savings they accumulated during the pandemic.
The US Federal Reserve can be expected to increase its projections of future interest rates – in the ‘dot plot’ – in December and will be preparing the market so that this does not come as a surprise.
Europe macro – A positive outlook, but vulnerable
Europe is more vulnerable to the disruptions from the post-lockdown reopening than the US. The increase in natural gas prices is more damaging as it is a much more important energy source for the region, and manufacturing is a larger part of the economy, particularly in Germany.
However, the outlook is still positive. Consumer confidence has held up despite lingering worries about Covid and higher prices. So far, the surge in energy prices has not derailed spending. Supply and energy issues should abate, the EU support funds will be disbursed, labour market dynamics remain favourable, excess savings are high, and eased travel rules should boost tourism.
For the first time in a long time, core inflation is now around the ECB’s target. Our calculation of the seasonally adjusted monthly changes in core inflation components shows cooling pressures, however. We expect core inflation to fall to below the 2% target by the end of next year. Upside risks include minimum wage hikes, offset by easing supply chain stress.
China macro – Beijing to the rescue?
China has been facing numerous challenges recently: debt-laden property developers, Covid infection outbreaks, flooding, and now power shortages. However, government efforts to boost supply and damp demand have led coal prices to drop sharply. They could fall further in the coming weeks as increased imports add to coal and gas supplies.
As Chinese growth slows, many observers expect renewed measures from the government to spur a rebound by increasing credit. The credit impulse has often led economic growth in China by around six months.
Markets and central banks
Our medium-term outlook is upbeat: solid growth, modest inflation pressure and loose monetary policy. In the short term, we worry that confidence in the growth outlook will wane, particularly given the weakness in China. Stagflation is one of the key concerns for investors (see Exhibit 2).
Since markets have now assimilated the news on inflation, and concerns over property developers in China have waned, earnings are the key focus. Despite worries over margin pressures, reported results have been surprisingly strong. While supply and labour shortages have weighed on CEOs’ minds, the ability of many companies to pass along price increases has helped maintain margins.
Meanwhile, 10-year US Treasury yields have risen further, driven almost entirely by inflation expectations alongside higher US core inflation. The market increasingly sees inflation higher for longer as Covid disruptions linger, energy prices surge and rental inflation is teed up to accelerate in US.
Market expectations of what central banks will deliver have changed. The US Federal Reserve is now expected to raise interest rates more frequently – twice by the end of 2022. Expectations for ECB policy are also shifting in a market that is increasingly sceptical of its ‘temporary’ inflation narrative.
We expect the ECB to try to push back against this view by stressing that it expects rates to remain at present or lower levels until at least the end of 2022. It will be important that it emphasises that rate rises are unlikely in 2022 and 2023. If not, markets may assume that rates will still go higher later.
- We are long equities: We believe the medium-term outlook is good thanks to a solid economy and strong earnings growth. Equities still look attractive versus bonds despite rich multiples.
- • We are long US and Japanese equities. Within the eurozone, we are overweight EMU small caps, which should benefit from being high beta and more attractively valued relative to large caps. We reduced our overweight in European banks. Bank results should benefit from the expected rise in long-term yields. Earnings revisions and their relative valuations are also supportive.
- We rotated our overweight position in emerging market equities to US equities given the many challenges EM equities face, particularly in China.
- We are overweight US small caps vs. US equity. A pickup in economic momentum, the return of the reflation trade or a steeper yield curve could all be drivers of already attractively valued small caps.
- Being underweight duration is a strategic position given the favourable economic outlook, the current low level of yields and the prospects of a normalisation of monetary policies.
- We closed our short position in EMU sovereign debt as yields rose to near our target.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.