Different directions
Central banks are diverging. Investors expect the Bank of England to increase rates before year-end for the first time since the Covid-19 crisis after policymakers warned about rising inflation. In the US, core inflation is tentatively stabilising. So although the Federal Reserve may begin tapering its asset purchases soon, a rate hike is probably at least a year away. Meanwhile, the ECB is likely to keep its policies unchanged for even longer.

Foreign exchange rates are likely to reflect these diverging monetary policies. The US dollar will probably strengthen against the euro in the near term, driven largely by the difference in government bond yields between the two regions. We believe that sterling will also appreciate against the euro as the UK recovers from supply shortages, some of which are related to the Brexit readjustment.

We continue to believe the economic outlook is positive and that there’s more value in US equities, emerging market (EM) sovereign debt and Asian high yield bonds than in low- or negative-yielding government bonds. However, we acknowledge that conditions have weakened slightly. Momentum in stock markets has decelerated meaningfully over the past few months. Economic and company earnings growth is still solid but probably past its peak. Meanwhile, the risk of prolonged supply shortages is affecting certain sectors and central banks are scaling back their monetary support. In our view, the cycle has not reached its end, but the risk–return outlook for cyclical asset classes has deteriorated slightly.

Asset allocation changes
We have reduced our equity overweight versus bonds by closing our overweight position in UK small cap equities. At the same time, we have reintroduced government bonds, while keeping a significant underweight in duration.

UK small caps are among the most cyclical equity markets, given their sector composition. With the pace of global growth decelerating from recent or even record highs, conditions could become more challenging for these companies. The UK economy faces severe headwinds from transportation shortages, rising gas prices and the increasing likelihood of higher interest rates.

We continue to overweight risky assets in portfolios. First, US stocks, which offer a balanced sector mix and strong earnings momentum. Second, EM sovereign bonds for their carry (relatively higher yields compared with developed government bonds). Third, Asian high yield bonds for their attractive and asymmetric return outlook over the next six to 12 months.

Higher energy prices are affecting the global economy in two main ways. First, the pace of growth is slowing, and yet a slowdown was inevitable at some point after the rapid expansion during the early phase of the recovery. Second, inflation is elevated and may remain so for a bit longer before settling back down. Despite some concerns of stagflation (where inflation is high and growth is low), we believe the situation is unlikely to deteriorate significantly.

The economic cycle may feel like it is beginning to enter a more mature period. However, it’s still young, having just restarted after the shock of the pandemic-induced lockdowns last year. The disruptions, shortages and bottlenecks that are occurring as the global economy readjusts are slowing the pace of economic growth. But there is already evidence that some of these issues are fading and we believe the outlook remains positive.

Central bankers keep a close eye on inflation expectations. If households expect prices to spiral higher, policymakers may need to increase interest rates. Yet short-term expectations (the next 12 months) tend to be heavily influenced by the current level of inflation. This makes them a poor indication of future monetary policy. With inflation likely to settle back down, we believe the Fed is likely to wait at least another year before it begins to hike rates.

Energy prices have been rising sharply following an increase in demand and bottlenecks in supply. The lack of wind is another reason – gas-fired power stations have had to make up for reduced output from wind turbines. These dynamics are particularly evident in the UK, with the economy impacted by the surge more than elsewhere and where interest rate hikes now appear likely sooner rather than later.

The energy shortage has rattled financial markets because investors are worried about the fallout. Government bond yields have risen and stock markets wobbled. However, we continue to believe this type of inflation spike, rather than becoming a self-fulfilling spiral, will eventually settle back down as the global economy readjusts from the disruption caused by the Covid-19 virus.

Although the pandemic continues to cast its shadow, many of us are eager to embrace life’s pleasures as cultural events open to visitors again. The latest feature in our For a richer life series covers the International Documentary Film Festival Amsterdam. Artistic Director Orwa Nyrabia explains the value of documentary filming and how the festival has evolved.

Higher energy prices are weighing down on the global economy at the moment, but the outlook remains positive

An energised market

COUNTERPOINT
SEPTEMBER 2021