April 20, 2021
Over the past decade, the global economy has plugged along in a slow growth, deflationary environment. Catch phrases such as “lower for longer” and “new normal” not only stuck in investors’ collective consciousness, but were reinforced time and again. Bond yields descended into uncharted territory and growth stocks soared.
Enter COVID-19. The distortions caused by lockdown measures and the subsequent policy responses from governments and central banks have changed the dynamic. The big question is: have we entered a new secular phase, or are the changes brought about by the pandemic likely to be transitory in nature?
First let’s focus on the present. Inflationary signals are popping up everywhere we look. With elevated savings from fiscal transfers, cancelled vacations and diminished services spending, pent-up household demand has spilled into the real estate market. This has led to a supply shortage, soaring home prices and depleted inventories of building materials. A wave of commercial inventory re-stocking has caused delays at major shipping ports (the Suez Canal blockage saga certainly didn’t help matters either) and an emerging container shortage has spiked shipping costs. Industrial commodity prices are soaring as demand projections adjust to infrastructure spending plans and a global semiconductor shortage has impaired automotive production. This list is far from exhaustive.
Financial markets have quickly adjusted to these realities and extrapolated them out into the future. Per the chart below, the US 5 year break-even inflation rate (a market-derived proxy for inflation expectations) has gone from an all-out collapse last March to breaking out of its historical range and hitting the highest level in nearly 13 years. However, while a “base effect” from 2020 will all but guarantee an inflation overshoot this year, many of the pressures noted above will be heavily “front-loaded” in nature. Additionally, a number of the deflationary headwinds experienced since the global financial crisis remain. Notably, aging demographics and high levels of indebtedness present critical disinflationary offsets, despite the latter being alleviated somewhat by a successful household deleveraging in the US.
In our recent Five Minute Macro video and Ask Forstrong publication, we discussed the resurgence of “high pressure economics”, where pursuing above-potential GDP growth and pushing unemployment below the natural rate become primary policy focal points. This would require accommodative monetary and fiscal policy conditions to remain in place longer than commonly expected. We expect that the pursuit of such policies will be the defining factor which tips the scales in favour of higher inflation. However, we would caution against getting whipsawed by shorter-term figures which will likely be artificially strong and unsustainable. Over the next few years, our base case expectation is for inflation to settle in a range modestly higher than historical averages. Given this reflationary outlook, we continue to view our short duration fixed income positioning and overweight exposure to speculative grade issuers to be the most prudent approach in client portfolios.
GLOBAL STRATEGY OVERVIEW
The threat of rising inflation makes holding cash unattractive, as an acceleration of purchasing power erosion could play out over the next couple of years. However, with equities vulnerable to a “cooling off” period and longer-term bond yields rising in response to higher growth and inflation expectations, cash has become a critical diversifier and risk offset in the current macro environment. Cash and equivalents have been raised above benchmark this quarter in balanced and growth-oriented mandates, with a view to deploying excess cash into market weakness.
Bond investors appear to have come to terms with our hypothesis of a multi-year economic expansion, as yields at the longer end of the curve rose sharply last quarter. While momentum could potentially continue to fuel the sell-off in the near term, our view on bonds has improved, given higher yields and less vulnerability to positive economic surprises. Fixed income exposure has been increased in client portfolios this quarter, but remains modestly underweight.
In addition to broad equity market vulnerabilities, rising bond yields throw a stick in the spokes of growth stocks, which thrive when their future earnings streams are discounted at ever lower interest rates. We have added defensive and high yielding exposures this quarter to lower portfolio beta, boost income and pivot away from the most vulnerable segments of the equity market. Positions in US utilities sector and EM high dividend yield equities have been initiated in client portfolios.
As the world’s top copper producer and second largest lithium producer, Chilean equities offer a cost-effective exposure to industrial commodities. Both copper and lithium are critical components in electric vehicles, which aligns Chilean earnings with a long-term growth driver. Despite strong recent performance, Chilean equities are still reasonably valued and do not fully reflect the terms of trade boost exporters have received from rising commodity prices. We have increased exposure in balanced and growth-oriented strategies this quarter.
Gross-of-fees performance ($CAD) as of March 31, 2021. Returns for periods greater than 1 year are annualized.