2H Outlook: The Pause That Refreshes

As we approach midyear, Covid Speed’s breakneck pace seems to have slowed. Cross-asset markets have paused, with stable stocks, bonds, and FX over the past month. A sense of transition has emerged in the economic outlook: Chinese growth is rolling over, US growth is peaking, Europe is reopening, and emerging markets (EM) are trailing. And the state of Covid, while still bad in EM, is vastly better in developed markets (DM). JP Morgan notes investors need to prepare for a multi-speed world: from early-cycle timing to mid-cycle conditions to late-cycle valuations. I concur.

During this pause, let us pull back and consider the 2H outlook. As we do, we should remember the duelling dualities: physical price pressures versus the ‘digitalization of everything’; ESG financing caps versus energy/mining expansion; equity markets led by the twin engine of value and growth; surging money supply versus inexistent velocity. It is a growing list of intellectual and financial stimulation. How these resolve will help dictate market direction over coming months. When summer ends and we return to (in-person) school and (in-office) jobs, the markets will focus on the year ahead, and 2022 will loom large.

As we transition from liquidity- to earnings-driven markets (note China’s credit impulse turning slightly negative), I remain constructive on risk assets. I view equity and commodities as in early-cycle bull markets and sovereign debt as in an early-cycle bear market, and I remain cautious on the USD, which looks to be breaking down. My broad asset allocation parameters remain unchanged: overweight equity, non-US equity, value, cyclicals, SCs; overweight commodities, including both old and new energy, and metals, both precious and base; underweight fixed income, prefer credit versus sovereign.

I remain committed to the thematic space. And I believe an important near-term direction ‘tell’ occurred last week when ‘crypto carnage’ led to crypto’s second-worst week ever – down 40% – and yet ARKK, thematic’s poster child, closed up on the week. The public market’s reaction function is strong – nothing gets out of hand for long. Regulars know I like to let the market tell me; it told me last week that the selling pressure in the growth, high-beta names is exhausted. I think the public market’s ‘bubble talk’ is misplaced and better directed at the private market space.

For now, let us look ahead to the remainder of the year, where I see climate replacing Covid as a main driver of economies and markets.

The Climate

The climate space is bustling. China is cracking down on crypto mining and will soon launch its national Emissions Trading System. The G7 stated it will no longer finance new coal projects. And the IEA notes that lithium demand will rise 40x to meet the Paris Accord targets in coming years. Much is happening, and fast. Here are two takeaways.

First, expect this pace to continue given the near-global commitment to dramatically reduce the world’s carbon footprint by 2030. Not only do governments widely share this goal; corporations, their shareholders and customers do too. Some argue we are at an environmental, social, and corporate governance (ESG) inflection point driven by rising climate uncertainty, stakeholder capitalism and ESG disclosure. All this ensures the climate will be an important investment theme for the current decade and beyond. So understand it, and invest accordingly. Covid was a one-year event; the climate will be multi-decade.

Second, I expect corporate stakeholders to increasingly challenge companies to disclose their carbon footprint and how they plan to lower it. If you doubt that, check out Exxon’s AGM and its new board. Consequently, I expect the price of carbon to rise significantly in coming years together with the likely imposition of Carbon Border Adjustment Mechanisms (CBAM). I also expect a continued ESG push to reduce financing for various energy and base metal expansion/exploration efforts. The IEA’s recent report suggests as much: it advocates no new oil/gas exploration efforts, effective immediately. This will likely prompt a perverse price increase for many of these commodities – demand related to clean energy and ESG-impacted supply will create a supply-demand gap that only rising prices can close. Investing in both carbon and copper makes sense.

Economics

US inflation is the name of the economics game. How high will it go? Will it become embedded in the wage cycle? Will the Fed wait until it sees the whites of inflation’s eyes? And so on. I expect the Fed to stick to its average inflation targeting (AIT) program and wait until the data supports a decision to begin raising rates. I continue to see higher rates as good. Some inflation is far better than none, and the likelihood of embedded inflation is low given a large labour pool, rising productivity, easing bottlenecks and peak US growth already upon us. Taper talk is underway, while US money velocity remains close to 61-year lows. As noted, I expect the digitalization of everything to act as a serious brake on physical price pressures.

The first in, first out, staggered nature of the globe’s Covid reopening should help here as well. China led the reopening process last year, and its growth rates have likely already peaked. Q1 GDP growth was only 0.6% QoQ. Its government remains focused on ensuring financial stability and so the likelihood of prices getting out of hand seems very low (and most recent readings suggest little to worry about). The US is next in line; after a robust vaccination process, its reopening is well underway, with growth likely to peak this quarter. Housing is rolling over, retail sales have peaked, and the various ISM/PMI data suggest the same. Most bond market indicators do not support inflation fears.

Europe and EM will follow the US in coming months and quarters. Europe will reopen as vaccination finally accelerates, with EM struggling behind. More vaccinations should allow key EMs to follow the DM lead and gradually reopen their service sectors as the goods-producing space has already stabilized. This staggered reopening implies a robust global economy that continues to grow above trend through 2022 and most likely 2023, supported by solid consumer and corporate balance sheets, consumption and capex growth as bottlenecks ease and fiscal and monetary accommodation is gradually unwound.

Overall, I expect a sustained and increasingly synchronized global recovery cycle that starts to look more normal as we exit 2021 and enter 2022. Inflation fears may continue, but much should be in the price – who has not already positioned for the great inflation debate?

Politics

This autumn’s action will be in Europe and Asia, with Germany selecting a new leader and Japan deciding whether Yoshihide Suga deserves to remain prime minister. Do not forget the Chinese Communist Party’s July centennial celebrations – suggesting across-the-board stability into autumn.

Under President Joe Biden, the US political temperature has dropped (at least insofar as in-your-face impact). Much remains to be done regarding the administration’s American Jobs Plan and American Families Plan, which themselves will likely have a big impact on the 2022 midterm elections.

Europe is advancing its Joint Recovery Fund (JRF), and monies should begin to be disbursed in 2H. The periphery is the big winner here, and Italy and Spain particularly have an opportunity to recast their economies. Germany is most interesting – after 15 years of Angela Merkel as chancellor, Germany’s next leader may well be another woman, Annalena Baerbock, the leader of the Greens. Finance Minister Olaf Scholz of the SDP is also gaining traction, suggesting how far Germany’s pendulum has swung towards fiscal spending with a green focus.

Latin America’s politics remain depressing, but it is all in the price. The region has also suffered the biggest economic hit from Covid. Notwithstanding poor politics and economics, the region’s FX and equity markets have stabilized and turned up.

Policy

Despite all the spilt ink to date (with more to come), policy will likely take a back seat over the next few months. That is, at least until we reach what I call ‘the testing time’ of late summer/early autumn when clean inflation/economic data should provide more insight for policymakers and investors to judge exactly where the various economies are along their recovery paths.

Focus will be on the US because China never really pulled the policy levers to the same extent. Europe is further behind and consequently much less likely to have any significant policy changes on the monetary side. On the fiscal side, as noted, the JRF should begin disbursing funds and so act as a support. Europe may grow faster than the US in 2022.

While the focus may well be on the US, I expect little policy change. The Biden administration will likely get the bulk of its legislative program passed, and the Fed will be very slow to move off its wait-and-see stance – especially if the bond market is not pushing it to do so.

Climate policy will also take centre stage as we enter autumn given the upcoming UN Climate Change Conference (COP26) in November. One area to focus on is the potential for a multi-region Carbon Border Adjustment Mechanism (CBAM) to encourage China in particular to withdraw from coal burning. As most know, coal is the one energy form that China has a fair amount of at home, and so coal utilization is both an energy security and climate issue.

Note also the rapid expansion of China’s Covid vaccination process – now giving roughly 15 million shots a day as it races to enable large-scale celebrations for its centennial. This sharply contrasts Japan’s inexplicably slow vaccination process before the upcoming Olympics.

One longer-term policy consideration is the potential for a sharp policy swing, especially in the DM, from fiscal stimulus to what some are calling the mother of all fiscal contractions looming in 2023 and beyond.

Markets

Staying invested and riding through the occasional market ‘pothole’ has been the right approach. I expect this to remain so in coming months. I think the ‘pause that refreshes’ is setting us up for another leg higher in global equity prices as markets continue to pass the reins back and forth between the twin engines of growth and value. ACWX, for example, has been in a 10% range since January; I expect it to break higher in 2H. As momentum swings to the value segment, the large-cap growth names have rerated to become much more GARPY (growth at a reasonable price).

Selling is exhausted in the high-beta growth and thematic names. Inflation fears are overdone, as signalled by 10-year UST rates and breakevens. And there is softening in the commodity space and USD weakness. With all this, further equity appreciation could be the path of least resistance and maximum pain considering how many equity managers swear inflation is returning ‘big time’. Those managers throwing in the inflation towel could provide the fuel for the next up leg.

In this scenario, thematic names do well as the climate, cyber and fintech spaces among others continue to gain attention. Morgan Stanley notes, for example, that its unprofitable tech basket just had its worst relative performance versus SPY of any basket (out of 100+) at any period over the past decade. The thematic space has absorbed a punishing correction and has stabilized across the major segments of climate, cyber and fintech. The growing number of ransomware attacks and the realization of minimal standards in US (and, I imagine, other nations’) critical infrastructure reinforces the cybersecurity opportunity.

Some potholes may appear around the Jackson Hole meeting or more likely the September Fed meeting as potential taper talk and thin markets could spur some volatility. The equity market seems to be focusing on longer-term inflation risks.

I expect US growth to downshift to a more sustainable pace. Rising job gains, consumption and capex will aid this as Europe recovers, with its tourism and service sectors regaining ground while select EMs follow suit. Company earnings should remain robust – JPMorgan is calling for $225 in 2022 US EPS and $245 in 2023, with sustained operating margins as supply bottlenecks are worked out and pricing power provides support. The firm also noted that, notwithstanding very strong Q1 EPS beats, 2021’s remaining quarters only saw a modest 2% increase in expected EPS. This suggests plenty of room for continued positive surprises. Note those 2022 EPS estimates put the SPY at under 19x 2022 E – expensive, perhaps, but not bubbly.

Europe also is generating very strong company EPS, and Morgan Stanley for one expects that to continue. The old firm just came out with a seven-point bull case for Europe including said EPS growth, attractive valuations, under-ownership, cyclical bias and more. Dividends and buybacks in both the US and Europe are running at high levels and provide further support.

I still believe that there is no bubble in public equity or commodities (or crypto for that matter given its most recent selloff – down 40%, the second-worst weekly performance behind only last March’s Covid collapse). Such volatility reinforces the need for proper sizing and risk management in a multi-asset portfolio. But you cannot count Bitcoin (BTC) out given how many major selloffs it has both endured and recovered from. The volatility, however, will likely put off institutional enthusiasm somewhat while perhaps accelerating the adoption of the blockchain-related pick and shovel opportunity set.

Many equity segments remain well below the highs of recent years. Some of my favourites are EU banks, Latin American equity, US energy, airlines and batteries – all 20-50% off 2018 or later highs. Latin American equities represent true laggards, with the main regional ETF down over 30% from its 2018 high. The Latin American markets just came first, second and third in StoneX’s latest ETF country rankings, however, suggesting some things are stirring. The region could have its day in the sun as it reasserts its traditional relationship with the commodity space, reopens its economies and attracts new money.

Government bonds are early in a bear market. Expect the 10-year UST to work towards 2% as we exit the year and the German bund to reach the zero bound simultaneously (the Bloomberg consensus calls for bunds to reach zero only in Q3 2022 – talk about behind the curve). For those wondering why the 10-year UST bond just broke 1.6% on the downside, remember that, thanks to quantitative easing, supply to the private sector has never been lower while those same USTs represent a large majority of the globe’s positive-yielding safe assets. Taper talk has already started and should be mostly discounted, perhaps implying that even the late summer/early autumn testing time may not be all that testing.

The recent pause in the commodity space is healthy. It allows for inflation fears to dissipate somewhat while setting the stage for further gains in the years ahead. While commodities lead JP Morgan’s YTD cross-asset performance rankings, on a rolling one-year basis they have just poked their head into positive territory for the first time since 2014. As more economies join the reopening process, I expect continued broad commodity price gains and still believe in investing in both old and new energy. Gold should continue to benefit from continued negative real yields.

On the FX front, I expect further USD weakness as US exceptionalism gives way to the exceptional size of its twin deficits and shrinking yield gap versus European debt. China’s yuan continues to impress with its strength – now at a three-year high versus the USD and a five-year high versus its trading basket. That is one way to offset soaring commodity prices. It is hard to see a major selloff of the USD versus the majors, but room exists for significant pickup in some EM FX such as the Brazilian real.