By Robert Ducker
Equity markets have rallied for much of 2021 on the back of improving economic data and encouraging vaccine rollout. Most indices we follow are up in double digits, with global equities (“MSCI World Index”) generating a total return of +14.3% in Euro terms (up to 11 June). There has also been a change in market leadership as expected, with global value stocks (total return of +18.8%) comfortably outperforming global growth stocks (+9.7%) so far during 2021. Talk of deflation, falling bond yields and lacklustre economic growth that has prevailed for more than a decade has now shifted to talk of inflation moving above central bank targets and how this could potentially impact monetary policy. As we have noted in the past, a backdrop of strong synchronized global economic growth, loose fiscal and monetary policy, rising commodity prices and higher inflation are generally supportive for the value segment of the equity market. We look at two themes that have dominated year-to-date: (1) COVID-19 and (2) Inflation.
Today investors seem to be less concerned about COVID-19, as case growth in developed economies has significantly declined. The vaccine deployment for important economies has been largely successful with circa 60.8% of the UK population receiving the first dose of the vaccine compared to 52.2% in the US, 47.7% in Germany, 47.2% in Italy, 44.8% in Spain and 44.6% in France. It seems that investors are attributing a very low probability of a negative surprise coming from COVID-19, with most sectors now pricing-in most of the good news. Travel, leisure, and hospitality stocks are still lagging, primarily as travel bans are still in place and visibility remains clouded in the near term.
The potential for inflation in the US to move above the FED target rate (2%) has been flagged on several occasions by various FED officials, primarily on the back of weak comps, re-opening effects and semiconductor shortages (impacting mainly autos). The 4.2% year-on-year increase in CPI recorded in April, the largest increase since September 2008, spooked investors leading to an increase in equity market volatility. The VIX (a measure of volatility) peaked at 27.59 during May following the release of the CPI number, the highest level observed since early-March. The May inflation print came in even higher (+5.0% YoY), however in both instances the volatility proved to be short lived.
The uncertainty around whether inflation is temporary has been heightened by the increase in hourly wages recorded in both April (+0.5%) and May (+0.5%). The wage inflation is possibly explained by the current shortage of workers in the US due to (1) the generous COVID-19 related unemployment benefits that are still in place (2) COVID-19 related constraints (like limit on the number of people that can be together, illness etc). We think that the labour shortage could persist for longer, at least until benefits are phased out.
Equities should, at least in theory, outperform other asset classes during periods of rising inflation and underperform when there are fears of deflation. Firstly, the economy is generally doing well during inflationary periods. Secondly, and more importantly, earnings and dividends should rise with inflation. Additionally, periods of rising inflation pressures generally lead to higher interest rates, which implies a higher discount rate. These points explain why investors generally prefer value stocks during periods of rising inflation.
The biggest risk for equities coming from inflation is the possibility that the policy support, high levels of household savings and easy financial conditions could lead to the economy persistently operating above its sustainable capacity. This would lead to a positive output gap, potentially forcing the central bank into taking rapid action due to overheating economic conditions. Although this is a possibility, we believe that the current inflation overshoot will be short lived. The easier comps will soon disappear, while temporary COVID-19 shortages will ease in the coming months.
Our preference for value stocks in Europe remains, at least in the short-term. Europe’s economic growth has not yet peaked, and we therefore see upside in the region for carefully selected stocks. However, we still believe that the value trade will not persist beyond the current year, as structural problems could re-emerge.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.