Blog: You, us, everyone

July 2021: Top-Down View

Inflation: These days, all the attention is on inflation. That there would be a catch-up effect was clear; however, the extent of it might surprise more than just advised investors and economists. While supply-side effects are a big part of the current inflationary pressures, the demand side is also strongly driven by fiscal stimulus. Given that the economy was driven by credit growth before the pandemic, it cannot be a meaningful amplifier of inflation. Therefore, it must be direct stimulus from the fiscal side. But how big is the current stimulus?

The broadest measure of the US economy is the Chicago Fed National Activity Index; it measures 85 indicators on the US economy with positive values, meaning the US economy is growing above trend growth. The three-month average is currently 0.81 which is the highest since 1984, so the US economy is currently expanding at a rapid pace. This aligns well with estimates that the US economy by Q4 will operate well above its GDP potential, which at that point it is expected to further add to inflationary pressures. The current macro indicators on the US economy also suggest that we will get a very strong Q2 earnings season, which starts three weeks from now.

No disconnect between markets and the economy:

• The stock market does not look expensive relative to the average fixed income,
• Market gains are in-line with the recovery of the ISM Manufacturing index,
• Market gains are within the range of prior market recoveries,
• However, above average trailing P/E ratios point to lower long-term return.

The bull market remains on solid footing, driven by huge pent-up demand, surging earnings, and an accommodating monetary policy. Equity valuations are high, but reasonable relative to lower interest rates. Despite the past one month’s strong performance, the risk-reward ratio for small- and mid-caps, especially tech firms, continues to be favorable. While mega-tech companies offer steady returns over the long term, given their low-mid teen earnings growth prospects and solid balance sheets, they tend to lack reactivity in strong up-side market trends. Near-terms and small- and mid-cap companies are expected to continue to outperform the average market. 

Recent operating reporting continues to highlight solid end demand trends for small- and mid-sized companies. In particular, this applies to key segments like 5G, fintech, healthtech, and greentech as well as digital subscriptions. In these segments, average valuations are still about 10-15% away from their February top. Therefore, with positive market conditions, the recuperation trend for small and mid-caps is expected to continue.

Energy prices: Brent Crude gave up some gains after hitting two-year highs last week, falling around 2% as markets interpreted the Fed’s communication as more hawkish. However, we remain bullish on oil as inventories are likely to fall further into the summer when demand rises amid global reopening.

More broadly, we think investors should consider incorporating commodities into portfolios as they prepare for higher inflation. We expect broadly diversified commodity indexes to deliver total returns of about 10% over the next six months. We also favor energy stocks and commodity-linked currencies.

Preferred investment orientation

• Consumer discretionary: The sector should benefit from economic recovery, lower mortgage rates, and secular trends in e-commerce.
• Energy: Relative to oil prices, the sector looks cheap. Free cash flow yields are very attractive, capital discipline has improved, and the sector should benefit as demand recovers.
• Financials: Earnings should recover as economic growth rebounds and interest rates move gradually higher.
• Industrials: The sector is highly leveraged to an improvement in manufacturing sentiment, which should continue to improve as the economy rebounds.