Sovereign Wealth Partners and InvestSense Pty Ltd
It was another good one for markets despite some inflation driven wobbles along the way. Tech staged a comeback in the last full trading week of May but remained down by 1.5% for May. The same was true of ‘growth’ stocks globally. The Dow Jones Industrial average meanwhile was up by 2% in May, with much less volatility. May was therefore a month where the value tortoise beat the tech hare. This is a decent narrative for the year to date and, dare we say, perhaps looking forward in a reflationary environment. The real surprise in this context was how stable bond markets were last week and also throughout May. Every economist and asset manager across the world has had to grapple with how persistent rises in inflation are likely to be during the last month and there has been some mixed signals.
US Jobs didn’t rebound as much as expected but producer and consumer price increases exceeded already high expectations. In fact, the Fed’s favoured measure of inflation, the PCE deflator, came in higher than expected along with a raft of manufacturing surveys suggesting the US economy is heading towards full capacity (which would imply sustained inflation). Then the Biden administration announced $6 trillion spending plan. And yet, bond yields fell. This boosted tech stocks, whose greater earnings forecast to occur far out into the future and so now trend to be more sensitive to changes to expectations of future interest rates (the rate at which those earnings are discounted to a present value). At a sector level, interest rate sensitive sectors like utilities sold-off lending credence to the idea that interest rates themselves are not fully representing changes in market inflation expectations and that technical factors (supply and demand for Treasuries – see below) are dampening rate volatility.
If we see bond rates rise in response to sustained inflation rate rises (tentatively our base case) then floating rate credit and value based equity portfolios are likely to do well. If inflation subsides quite suddenly (also very possible at this point but not quite the base case yet) then tech stocks and fixed income treasuries may once more be in the ascendant. If inflation continues to rise but treasures remain low then central banks will have started to forge new territory but we will probably see more of what we have seen in the past decade or so. There is also the chance that markets may, in the short-term get quite excited about this. However, we still worry that in the medium-term the current levels of debt might make it a shorter-lived boom than the one we saw in the 60’s or 20’s under somewhat similar circumstances.
There are a lot of if’s in the above paragraph but that is the nature of the very unusual recovery we find ourselves in and, for now at least we think discretion is the better part of valour when making heroic market assumptions. Nevertheless, we are watching markets, and especially the inflation environment very carefully.