Curmi & Partners

From the reflationary trade to stagflation concerns

By Robert Ducker

The Delta variant spread was the primary market mover throughout July and August, with most of the major economies reporting a significant increase in cases. Consequentially, these economic growth concerns led to a flattening in the yield curve and to another month of underperformance for value stocks relative to growth stocks.

Global equities rallied +21.1% YTD (as at 20/08) as economic activity recovered from the impact of the lockdown and other curtailment measures imposed by governments over the past 14 months. Initially, inflation overshoots led to some market jitters as the economic recovery started to gain some traction. In the US, core PCE exceeded 3% (in April 2021) for the first time since 1992, leading to a spike in equity volatility pushing the VIX to its highest levels since February. Investors were concerned that the FED could be forced to act early, which would likely weigh on economic growth, should the inflation overshoot persist for longer. We argued at the time that the overshoot was transitory, mainly driven by the re-opening, as the economy recovered from one of the deepest recessions since the second world war. At first, the inflation overshoot favoured value stocks as investors initially looked for an inflation hedge (Global value outperformed growth in May,  but has lagged in June and July). Yet, the reflation trade came under pressure as economic growth in certain countries started to moderate.

The US economic growth has likely peaked as the tailwind from the re-opening is starting to fade. The services industry was heavily hit by the pandemic as restaurants, hotels and travel companies were forced to temporarily cease operations to help minimize the spread of the virus. The Services Purchasing Manager’s Index (“PMI”, a survey based economic indicator) data seems to have peak in May (70.4). Manufacturing was less effected, and the recovery was much faster, with a PMI peak in March. Meanwhile, it took just one year for real personal consumption to recover to pre-pandemic levels (March 2021), another possible indicator of peak growth. This economic growth moderation has weighed on investor sentiment during June and July.

The notion that we are past peak growth for the global economy has weighed on value stocks. The expectation at the start of the year was that value stocks would finally outperform their growth counterparts, supported by strong synchronized economic growth, loose fiscal and monetary policy, and a rally in the commodity market. This has been the case for most of the year so far, though the trend has shifted sharply since June with value underperforming growth in both months (by 6.0% in June and 2.3% in July). This underperformance of value is being primarily driven by concerns over the moderation in growth in the two largest economies, the US (discussed earlier) and China. In China, the swift unwinding of pandemic policy support as the economy recovered has weighed on activity, with all four PMI’s declining in June. This led to a surprise cut in the RRR rate by 50bp, which exacerbated investor fears around China growth. The release of the Caixin manufacturing PMI on 02/08 (50.3 in July, down from 51.3 in June and below consensus of 51.0) was also disappointing. Notwithstanding, fears of a sharp deceleration seem to be overblown according to Goldman Sachs, with solid credit growth, still-robust trade and sequential improvement in industrial activity and retail sales.

The delta variant spread has only added to the doubts on the global growth trajectory. Concerns over the delta variant spread have created a challenging backdrop for value stocks as it could have a negative impact on global economic growth. Cases rose sharply in the UK and in other countries around Europe. We note that there has been a clear disconnect between case growth, hospitalisations and deaths when comparing the current data with data reported earlier in the year before the vaccine deployment reached certain levels. We are seeing a significant differences in countries with a high vaccination rates (UK, US and Europe) and those with low levels (EM’s) or those countries that employ a zero case policy (Australia, NZ and China).

Conditions remain supportive for value stocks but we do not expect a broad based outperformance. Value stocks rallied strongly since the Pfizer vaccine announcement in November 2020, as investors started to price-in the impact of the recovery on economic growth. During this phase, the traditional cyclical sectors outperformed, with the rally broad-based. On a YTD basis, Banks and Energy, both traditional value sectors that have struggled since the global financial crisis, have been the clear outperformers. Despite this, as conditions start to normalise, stock selection (as opposed to sector exposure) will be the main driver of alpha in the latter months of 2021.

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.