Economic recovery brings strong growth but keep an eye on the inflationary pressures
29 July 2021
In the coming year, The Findex Investment Committee expect strong global growth as economies continue to recover from the pandemic, however, we remain wary of inflationary pressures and the effects this could have on markets.
COVID-19 vaccine supply is increasing, which is slowly allowing economies to ease restrictions and reopen. Further, we have seen substantial policy stimulus across most of the globe (both fiscal and monetary) supporting the recovery.
We expect the recovery to remain uneven, with some economies contending with serious new virus outbreaks. For others, the outlook is shadowed by slow rollouts of vaccines and limited scope for Government’s to increase their spending programs.
In Australia, recent activity data has been significantly better than expected. NAB’s April Business survey saw a very strong result with many indicators reaching new highs, reflecting an improvement inBusiness Conditions and Business Confidence. Furthermore, the Reserve Bank of Australia (RBA) has forecast Gross Domestic Product (GDP) growth to be 4.75 percent over 2021 and 3.5 percent over 2022.
After falling to near-zero levels during the pandemic, inflation is now a significant concern factor for investors.
Winners and losers would likely change dramatically in an inflationary regime. This may include a shift from growth to value companies and a move from traditional to alternative assets. Even some of the big investment winners in recent years, such as quality-growth companies, could struggle unless they adapt and are able to pass on price increases.
While inflation is now topical, we still find ourselves in a deflationary world with significant deflationary pressures, including but not limited to:
Digitisation (especially within the G7 countries) where we substitute capital for labour by digitising previously human processes;
Demographics where we have a rising cohort of older people who tend to save more and consume less;
Offshoring of local supply chains to less expensive supply chains in emerging markets;
High levels of debt that discourage private sector consumption.
Many of the deflationary forces are not going away anytime soon, however we do see changes occurring in these processes. A lesson learnt from history is that active economic policy such as permanently high government budget deficits and central banks allowing an inflation overshoot, can dominate other economic forces such as demographics, if applied forcefully enough (e.g. Hoover’s Depression and Roosevelt’s New Deal – deflation to reflation).
Global vaccination progress
Global vaccination rates have increased over the quarter. We have seen a large dispersion in vaccination rates, with developed countries significantly ahead of Emerging Markets. Tail-risk in the form of COVID-19 variants have emerged. Early testing suggests vaccine efficacy against such variants may be lower, but information remains limited at this stage. Markets continue to price in an accelerating economic recovery, rewarding regions more advanced in the reopening cycle. We continue to monitor the situation in India and the impact of the recent outbreak in parts of Asia.
Monetary and fiscal policy response
Monetary policy remains accommodative globally and central banks have reaffirmed their commitment to low interest rates until at least 2022.
In terms of fiscal policy, the US government’s US$ 1.9 trillion fiscal package remains the highlight of the quarter. We believe the size and scope of the fiscal package is supportive of the recovery. Given the uncertain longer-term inflation outlook and recovering labour market, we expect central banks to continue their ‘wait-and-see’ approach despite record amounts of fiscal stimulus. We expect low policy rates to continue over the medium term.
Recovery reflected in valuations
Economic recovery has continued globally, with the largest improvements noted in the US. Regionally, Europe and Japan have trended positively but are lagging on a relative basis.
Positive momentum in the Purchasing Managers Index is consistent with the strong improvements in export orders from countries like Korea and Taiwan.
Labour markets have improved materially but remain below pre-crisis levels. At this stage, the recovery scenario has been broadly priced into financial market valuations. This view is consistent with the level of forward earnings revisions which have occurred, and given the current environment, we expect this momentum to continue.
Inflation expectations and interest rates
Over the short-term (remainder of 2021), we expect US and Australian inflation to be in the range of two to three percent p.a. Due to the large fall in nominal inflation in June 2020, we expect the economic recovery back to pre-COVID levels to be the primary driver of inflation over the short-term, alongside bottlenecks in global supply chains and rising commodity prices.
The outlook on sustainable levels of inflation over the longer term remains uncertain. We see competing inflationary and deflationary factors on the horizon but at this stage it’s too early to tell. Given the uncertainty in long-term inflation, we expect central banks to keep interest rates low. This scenario is expected to support equities over the near-term despite valuations.
Asset Class Valuations – Long Term
On a relative basis, our analysis remains supportive of Growth Assets.
Equity markets continued their positive momentum in the first quarter of 2021. At current levels, most indices are trading above their long-term Price-to-book (P/B) and Price-to-earnings (P/E) (meaning they look expensive by historical standards). Historical earning yields are lower, reflecting the impact of the pandemic on corporate earnings over the period. This compares with forward earning yields which are materially higher, and are supported by recent corporate earnings reports, which have beaten sell-side estimates. Relative valuations have been driven by falling dividend yields versus bond yields, the latter having risen over the last six months.
The outlook across the Australian Real Estate Investment Trusts (AREIT) sector is mixed, looking more positive for Office and Industrial and less so for Retail. Cash rates globally are close to zero percent and central bank commentary indicates this is unlikely to change in the short-term. There is now slightly more value in government bonds, given government bond yields have risen over the last two quarters. Equity market volatility has moderated over the recent period and is consistent with the market view of risk receding.
Fundamental indicators today support a Neutral allocation.
Valuations are high with the market pricing in a forward expectation of recovery which has started to show in the latest corporate earnings reports.
Monetary policy and yield curve control have had an impact on rates globally but more recently the yield curve in the US has steepened considerably.
Systemic risk indicators support a Neutral position. Relative to the prior 12-months, market fragility and turbulence has moderated.
Equity flows today point to a Neutral position. When dissecting the flow data, we note equities reflect a risk-on environment with the majority of investors holding a risk-on bias in this space.
Bond flows point to a divergence in allocation with institutions adding to duration (longer dated) positions while increasing their overall exposure to high yield.
Findex Portfolio Positioning
Findex Investment Committee’s decision for this quarterly update is to maintain the current overweight to Growth Assets relative to Defensive Assets while making minor changes to the underlying composition of Growth and Defensive assets.
Whilst we acknowledge the surge in short term inflation that has been fuelled by supply constraints and pent up demand, the question is whether it has made a dent in the cumulative shortfall. The excessive build up in demand and lack of supply will lead to short term inflation volatility and we continue to monitor the production data and sentiment indicators.