The Next Phase in the Pandemic Era

21-09-31_ Market-Commentary

The rise of the Delta variant may well mark a new phase for financial markets in the pandemic era.

Deflation and recession were the risks during the initial phases. Now, inflation is an overarching threat as countries seek to continue economic recovery amidst a new surge of COVID.

In the coming 12 months, we believe the financial playbook will no longer be about increasing stimulus but taking it away. This process means the investment risks and opportunities continue to evolve, and we are making adjustments as necessary along the way.

Here is our review of where things stand.

The Delta Strain: Highlighting Diverging Fortunes

As the Delta variant progresses, we do not expect a replay of economic shut-downs for economically advanced markets. Vaccination rates and proven policies on social distancing, masking, and testing should support significant economic activity. The path through the variant won’t likely be smooth, but we don’t expect it to ultimately derail recovery.

In contrast, we see more persistent challenges for less developed countries as well as across social and income levels of developed ones. Lower vaccination rates, less diversified economies, and weaker health systems may well create structural challenges for years to come.

We therefore continue to see diverging fortunes (both economic and financial) between developed and developing markets over the coming year. We have an above-average weighting to US markets, as we discuss later in the report.

Unwinding Stimulus: The Wildcard

How the Fed decides to unwind its support—the timing, pace, and scope—will help shape financial markets over the next six to 12 months.

Unwinding involves first reducing the monthly stimulus in financial markets and then second having the flexibility to raise rates as the economy fully recovers. The order is important (reduction, then raising) as is the pace and timing. The process and scope will be determined by inflation targets and employment levels, and the Federal Reserve is being very careful in how it signals its intentions.

How this unfolds for investors is difficult to predict: if the Fed moves too quickly, it could choke the recovery; too slowly, it could stoke inflation.

Of some help, financial markets offer directional clues about the possible path.

Inflation: A Longer-Term Risk

We believe inflation presents a longer-term risk but will be contained for the coming 12 months. We take much of our queue from the bond markets, which we believe take a longer view than do equity markets.

In contrast to headline inflation of 5.4% in July, bond investors have a more tempered view. As of September 3, they expect inflation to be 2.6% in two years and even less in five years at 2.5%. To us, that means bond markets view current inflation to be temporary, driven by supply bottlenecks, pent-up demand, and artificially low prices a year ago. We should note, however, that inflation expectations are up slightly since mid-August.

Aren’t bond market messages being warped by the historic bond buying by the Fed? Certainly, but even so we have been seeing clear active signals over the past year as financial events occur. Bond markets began anticipating inflation in the spring, moving quickly to five-year highs before leveling off once the Fed began speaking about temporary influences.

In fairness, supplier markets and consumer prices have a different take, showing growing concern about inflation. Prices for rental cars and hotel rooms may recede, for example, but elevated wages and rent can become sticky and embedded in the system.

By year-end, we expect reported inflation to drop from summer peaks by simple math—prices a year ago had begun to improve already, making the annual jump less dramatic. Prices also aren’t out of line with those of 2019, pre-pandemic. Bottom line to us is that inflation will be ticking up but will remain tempered most likely well into 2022.

Economic Recovery: On Track?

Importantly, while it may not be a smooth path, we believe that US consumers have the means to spend once we navigate through the Delta variant. Their savings rate remains high, household income growth is favorable, and employment levels have improved.

After growing optimism last fall and into the spring, bond markets began showing some concern about the economic outlook earlier this summer, when the yield curve—an indicator of expectations about economic growth—began to flatten.

Recall that the yield curve is measured by the different bond yields over various maturities. When it is steep, it tends to mean long-term bond investors have less demand for safety, while a flatter curve means that they are more concerned about the future and demand greater safety.

Since mid-August, it has begun to steepen again, even as the Delta variant spreads, which we shows improving sentiment toward continued recovery.

Where Things Might Go Wrong

The risk to this “cautious optimism” is that inflation in fact becomes embedded in expectations and the Delta variant hits developed economies harder than expected. Inflation plus weak economic growth hints at stagflation. It last occurred in the 1970s.

August brought data that provided some ammunition to this concern: a weak jobs report in the US, wholesale producer price increases of 8% over last year, slowing services activity in China, and persistent supply chain problems.

We expect investors to be exploring the tension between rate of growth and level of inflation throughout the fall.

Investment Implications

Broadly, we believe the only way to navigate unpredictable situations is through diversification.

We also want to recognize market extremes, which alter the risk-reward balance, and incorporate those insights into investment strategy.

Here’s a summary of our outlook and positioning:

  • We believe fixed income carries above average risk on historically low yields. Investors gain little by holding bonds to maturity except preservation of capital, and that preservation of value becomes unattractive under inflation.
    • For that reason, for appropriate accounts, we have begun adding specialty investments that historically diversify away from stocks but add more attractive total returns.
  • Many investments that benefit from inflation are over-priced today, so we don’t recommend chasing them.
    • For that reason, for appropriate accounts, we incorporate a mix of public and private real estate investments across the capital spectrum. The strategy is to benefit from inflation while providing more attractive yields than bonds.
  • Equity markets are trading overwhelmingly on the outlook for interest rates. At the same time, the “recovery” trade that benefited cyclicals over big tech and fast growers has improved the relative attractiveness of the Value and Growth styles.
    • For these reasons, for appropriate accounts, we have begun adding an initial allocation to Large Growth stocks, to bring strategic style diversification at a time when economic outcomes remain uncertain.
    • We believe small cap stocks remain very attractive, particularly leveraged to economic recovery, and we maintain an above-average allocation to that group.
  • We continue to give greater weighting to US markets and below average weighting to international markets, particularly emerging ones. Emerging markets are relatively cheap, though.
    • We increased allocations to emerging markets moderately during the initial phase of the pandemic and would look to add to positions if weakness persists.

If you have any questions or want to chat about this report, please reach out to one of us on the CornerCap team.

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