Only the first statement is certain. The first half of 2021 has gone by so quickly that we haven’t had a chance to pay proper attention to all the exciting economic and financial developments. Economic indicators have shown unprecedented recovery in both the U.S. and Europe in the first six months of 2021, resulting in exponential growth expectations for corporate earnings on both sides of the Atlantic. The European industrial outlook, in particular, is taking off.
Chart 1: Changes in industrial business indicators in the US, the Eurozone and China.
However, the Chinese economic situation has looked remarkably weak for several months, with a decline in both industrial and service-related activities. The latest figures indicate that China’s annual GDP growth is expected to reach 6%. A very modest figure by Chinese standards, especially considering the significant measures taken since the start of the pandemic. Perhaps this is an undesirable consequence of the high exchange rate of the yuan against both the US dollar and the euro? Or is the demographic decline already starting to take effect? Either way, this (unexpected) scenario has triggered a significant drop in Chinese stock prices in 2021.
Whatever the reasons for the economic slowdown, the Chinese government is not sitting idly by and, after a pause of more than a year, is forced to reduce bank reserve requirements again. This will allow Chinese financial institutions to extend (much) more credit. Combined with lower financing costs, this should make it easier to extend credit to businesses and consumers in a renewed attempt to revitalize China’s industrial and service sectors.
Chart 2: China’s declining bank reserve ratios
On the other hand, the latest observations also show that the US ISM indicators have weakened somewhat, both for industry and services. However, it is precisely for this reason that they now offer a more realistic forecast and reflect credible and robust growth to be achieved in the industry and services sectors over the coming months.
It also indicates a diminished risk of the economy overheating. After all, the downside of an overly abrupt economic recovery is the risk of a significant rise in inflation, which in turn carries the risk of a loss of economic momentum under the weight of rising financing costs for investment and consumption.
Several U.S. inflation indicators now point to a substantial increase in the price level in 2021. The PPI, CPI and PCE indices have all registered a remarkable jump since the beginning of the year. This was reinforced by the latest release of CPI inflation, which (far) exceeded all expectations and showed a 5.33% (!) year-on-year increase in the general price level. If we take into account the volatility of food and energy prices, this indicates an increase of 4.45% compared to the same period last year.
At first glance, this is downright frightening, but it’s worth qualifying this terrible jump somewhat. Thankfully. Much of it can be attributed to specific developments in certain commodities that have recently experienced sharp price increases due to temporary supply shortages after the abrupt recovery in economic activity.
Probably the most notorious example is the increase in the price of used cars and trucks. The critical shortage of microchips means that new cars are coming off the assembly line with long delays, temporarily increasing the demand for immediately available four-wheelers. But this gigantic jump will also naturally diminish as supply bottlenecks gradually disappear.
Chart 3: Used Car and Truck Price Trends in the United States
Another segment that stands out for substantial price increases: operations that suddenly have to operate at a high rate after a near-complete economic shutdown. Typical examples are the striking price increases in restaurants and the aviation and hotel sectors. The latter is even now charging significantly higher prices than in the pre-pandemic period and may therefore return to its usual trend when the economy returns to normal.
The U.S. central bank, on the other hand, maintains that the current price increases are only temporary, partly because of a temporary imbalance in supply chains that will be resolved when economic activity returns to normal. On the other hand, the sharp rise in price levels is only a natural reaction to the price pressure in 2020, like a ball held under water and then suddenly released.
Given the muscular recovery in economic activity, an increase in inflation is inevitable, not only because it is a natural counter-reaction to the negative movement in price levels during the darkest days of the 2020 crisis, but also because of the emergence of bottlenecks in supply chains that are reflected in the most diverse parts of the industry. The disruption of component supply results in shortages ranging from bicycle saddles to microchips and leads to inevitable increases in wholesale prices (measured by the PPI index), which slowly but surely spill over to retail (reflected by the CPI and PCE indicators).
By the way, adding up the monthly deviations of the inflation numbers from its long-term target (2%) since the start of the pandemic, we come to the startling conclusion that we have just reached zero since the January 2020 outbreak. In other words, last year’s lagging inflation increase was offset by the 2021 increase. So the price level antics may be about to end.
Chart 4: Sum of price level deviations from the long-term inflation target (2%)
However, this conclusion is only valid if the CPI figure is used as a measure of overall price developments. The US central bank focuses its policy more on the PCE figure, which on the one hand uses a different calculation method, but on the other hand uses (mainly) a different composition of representative goods and services. Coincidentally or not, price changes for used cars or hotel stays have a much lower weight in this index than in the PCI. The PCE indicator pays more attention to long-term trends in the economy, which means, among other things, that rental prices gain in importance. And it is precisely they that are behaving more moderately.
Do you find all this confusing? You are not alone. The complexity of the methodology, the use of different types of indices (CPI, PPI, PCE…), the differences in the composition and method of calculation and the inaccessible technical jargon make it difficult for the uninitiated to get a clear idea of the real inflationary trends.
In addition, the expected inflation in bond prices differs considerably from the indices cited. The expected inflation is at a significantly lower level, which is interpreted as an expression of the financial markets’ confidence in the Fed’s attitude. This shows that a higher level of inflation is indeed expected in the future, but without threatening to turn into a spiral of rising prices, which in turn should be countered by substantial increases in key interest rates. Doubts are nevertheless mounting, especially after the staggering inflation rate published on Monday…
Chart 5: Changes in core PPI, CPI and PCE inflation in the U.S. compared to expected inflation.
However, this by no means means means that policy interest rates will not rise in the US in the near future. On the contrary. If economic growth were to normalize in the coming years, it would be natural for short-term interest rates to rise and move away from the current zero rate. Currently, a 25 basis point interest rate increase is expected in 2022 and two more increases in 2023.
Of course, this is not a catastrophe; more to the point, if policy rates were to remain frozen around the current 0% rate for much longer, it would signal a continuation of the (unexpected) economic malaise and additional stifling measures to contain the pandemic. For financial markets, the most important factors are the reaction of corporate earnings, the extent to which monetary policy is affected, and the extent to which rising inflation translates into higher long-term interest rates.
A 0.75% increase in policy rates would not be a problem at all for the equity markets: the increase in economic activity and the resulting increase in corporate profits gradually absorb these upward movements in short-term interest rates.
Immediately following the disconcerting news of the apparent pickup in U.S. inflation, long-term interest rates rose only slightly. The most recent observations even point to a sharp decline in U.S. 10-year yields (and in the wake of that, in Eurozone bond yields).
Chart 6: 10-year interest rate developments in the US and the eurozone
The reason for this decline is twofold: on the one hand, fears of additional measures to slow the surge in the delta variant of the virus, further delaying the economic recovery, have reappeared. On the other hand, the most recent employment figures not only showed a strong increase in the number of available jobs and new vacancies, but the attention of the financial markets was mainly focused on wage developments.
In contrast to the strong upward trend of the previous months, wages are now growing at only a moderate pace. This is important because accelerating wage growth is a stubborn and hard-to-control component of any inflationary trend.
However, with moderate monthly growth of 0.33 percent, average wage growth is currently within an acceptable range. As a result, the strong upward trend of recent months is being broken sooner than expected and fears of escalating labor costs are (temporarily) fading.
The latest indications are therefore that there is no risk of overheating for the time being, which means that long-term interest rates are under much less upward pressure and that stock markets do not have to worry about sharp increases in financing costs.
The optimism in European and U.S. economic indicators is of course largely due to the expected efforts of governments. Governments around the world continue to show great determination to take the necessary fiscal and monetary measures. Coupled with expectations of moderate interest rates and soaring corporate earnings, this prospect of an impending economic boom has translated into remarkable stock market gains since the beginning of the year. Even the Nasdaq, NYSE Fang and the S&P Composite Index have seen gains of 15% (and more). But similar gains have also been recorded on the European stock exchanges.
Graph 7: Evolution of different stock market indices (net return in euros)
However, Europe has lagged far behind its American rivals over the past decade. We assume that in the coming months, European stock markets will catch up with at least part of the US lead. After all, the expected boom is already more entrenched in U.S. stock prices than on the Old Continent, where the main recovery in European corporate earnings will not occur until the second half of 2021.
However, despite our increased weighting in European equity markets, the US position remains overweight due to the fundamental performance of US technology companies. Expectations in this sector remain high. The average growth forecast for the current quarter is estimated to be 10% higher than the record earnings recorded so far. Europe, meanwhile, is poised to surprise the investment community with a dramatic jump in growth beginning in the third quarter.
Much of this expectation is, of course, already reflected in stock prices, hence the ongoing race to the top on Wall Street and the European stock markets. To better illustrate the strength of the current stock market rally on both sides of the Atlantic, we have calculated the following statistic for you: in the current (half) year, the S&P Composite Index and the EuroStoxx have set no less than 36 (!) new daily records. Compared to other excellent (full) stock market years like 2013, 2017 and 2019, that’s more than double! If that doesn’t tell you anything, you should know that this means that in 2021, a new high was reached on average every four trading sessions. Impressive!
Of course, after such an upward movement, there are occasional heavy downpours. In the current environment, however, we opportunistically interpret such an event as an opportunity to rebuild our equity positions at lower prices.
Our equity position remains firmly overweight with a focus on targeted tactical picks in growth sectors such as technology, cybersecurity, robotics, fintech and the logistics sector. Geographic clusters are in the U.S., Switzerland, Scandinavia and Germany.
We are also clearly resisting the fads of the day: despite their recent surge, we remain conspicuously absent from the large mainstream European banks and the traditional travel and hospitality sectors. These segments are notoriously inefficient and would unnecessarily weigh on our future profitability. As previously mentioned, we prefer stocks from the fintech and cybersecurity sectors, specialized investment banks or companies that are riding the wave of new trends in tourism and leisure.
We prefer to leave the beaten path to others, such as low-value stocks or precious metals. In line with our economic outlook, we favor quality industrial companies, selected on the basis of our Quality-minus-Junk selection model.
In addition, we deliberately stay away from dead ends such as emerging markets, with one notable exception, which we (definitely) make for India. China remains in the portfolio, but without any emphasis.
The bond component of our portfolio consists of a balanced selection based on yield and safety: a mix of U.S. and European corporate bonds, Italian, Polish, and (to a lesser extent) Czech and New Zealand government bonds, as well as a notable and substantial focus on Scandinavian corporate bonds and Chinese government paper.
Our asset allocation model, which has proven so useful as a compass during the financial storms of recent years, balances expected returns and necessary risks with a quiet firmness, explicitly taking into account the investor’s profile.