In the June issue, we discuss: if equities are absorbing an inflationary side effect.
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The old financial adage of “sell in May and go away” bore fruit last month, as the MSCI All Country World equity index sold-off by 1% in sterling total return terms1. Arguably, markets were spooked by concerns of a stagflation environment of high inflation and low growth. This followed higher-than-expected US inflation, where April headline CPI rose 4.2% from a year ago — the highest rate for 13 years — and a disappointing US non-farm payroll number for the same month to raise investor concerns about a sustained recovery2.
However, given that US and global 2021 real GDP growth is expected to grow at its fastest rate for decades, the risk of stagflation seems low (see our May Investment Outlook).
Nevertheless, the side effect from unprecedented fiscal and monetary stimulus, as well as a pandemic-led supply-squeeze, is driving-up US inflation expectations and long-term Treasury yields. In turn, this has exerted a drag on frothy areas of the market like growth-style stocks (where historically demanding valuations are adjusting to rising discount rates driven by higher Treasury yields) and cryptocurrencies. Having previously promised not to tighten monetary policy, the market is concerned that the Fed may spoil the party by taking away the liquidity punchbowl abruptly. Policymakers could discuss tapering Fed asset purchases at the next FOMC meeting on the 15-16 June.
Despite concerns about changes to Fed monetary policy and the impact to the broader market, the fundamental equity backdrop is improving in line with an opening up of economies after the vaccine rollout. Consensus expectations for 2021 global annual Earnings Per Share (EPS) have risen to a rapid 37% from 28% at the end of last year, albeit from a low base last year from the pandemic3. There is also capacity for capital to rotate from the bond market into equities, as investors adjust to rising inflation expectations. This backdrop adds support for equities until the Fed decides on what level of monetary policy is appropriate for the US economy in a post-covid world.
Finding value in equities
The macro environment since 2010 of low growth and lower inflation is transitioning to one of high growth and higher inflation for the next year. This could potentially change the decade long market leadership from growth (i.e. tech) to value-style (i.e. energy and industrial) stocks, which generally outperform when US inflation expectations are rising. This is not to say that the tech business outlook looks poor, but in valuation terms there are probably more attractive opportunities, such as in the unloved “value” areas of the market.
There have been false dawns in the past, where value briefly outperformed growth during the 2010s, but then struggled as the disinflationary trend and lower long- term interest rates gave a boost to growth stocks. It is still early to tell, but with global inflation expectations accelerating, reflationary value-style stocks could well benefit beyond the short term (see our March Investment Outlook).
Moreover, faster EPS growth should support a rotation to value equities. From data going back to the 1950s, Absolute Strategy Research, an investment research house, show that value generally outperform growth in periods of high EPS growth. That’s because in transitioning to an ‘earnings rich’ environment from an ‘earnings scarce’ environment there is less advantage to owning growth/tech companies with stable earnings over recovering EPS in the value space.
The market is slowly adjusting to this changing macro setting. Global value equities have outperformed their growth counterparts by around 15% since a trough in early November yet remain 50% below its peak in 20064. This creates an opportunity to include value as a style in portfolios. On that front, the UK stands to benefit from its relatively high exposure to value. Out of the major developed markets, UK value accounts for a 50% share, versus Europe ex UK (41%), Japan (37%) and the US (25%)5.
Near-term UK economic and political risks have eased recently too. On the economy, UK March real GDP beat market expectations to leave the economy 6% below its pre-pandemic level, a vast improvement from being 25% underwater after the lockdown last year6. Importantly, the March GDP was 1.6% above the first quarter average, which implies there is momentum behind the economy over the coming quarters as lockdowns are fully lifted7.
On political issues, the near-term risk of Scottish independence has lessened somewhat following local and regional UK elections in May. Although the pro- independence SNP dominated the vote in Scotland it fell short of a majority in Scottish parliament and there has been a de-escalatory tone from Westminster. First Minister Nicola Sturgeon did re-affirm her commitment to a second independence vote but recognised that a legislative push for this would only begin in 2022 after covid-related issues have abated. Along with strengthening global growth, a favourable UK economic background and diminished near-term Scottish independence risk has helped UK stocks to outperform their global peers and for sterling to appreciate 3% against the US dollar year-to-date, a trend that could well extend into the second half of the year8.
1-4, 6, 8 Refinitiv Datastream, data as at 1 June 2021
5 Refinitiv Datastream, calculations by Smith & Williamson Investment Management, data as at 1 June 2021. ‘Value’ defined as energy, materials, industrials and financials sector
7 UK: Another upside surprise from March GDP, JPMorgan, Allan Monks, 12 May 2021
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.