08 Dec 2021
Is the global economy about to come to a shuddering halt? After repeatedly defying market forecasts, some commentators are now predicting the beginning of the end of the extraordinary rebound in economic output and corporate earnings that we’ve seen in recent months.
It’s not hard to understand concerns. Central banks are signalling interest rate rises and, in the case of the US Federal Reserve, preparing to rein back their massive monetary stimulus programmes.
Higher inflation, initially viewed as transitory, appears to have taken a firmer hold than initially assumed. Corporate profits, which trounced analyst estimates over several successive quarters, are looking more pedestrian and, to some, market valuations seem stretched.
Higher inflation…appears to have taken a firmer hold than initially assumed
I’m not so sure that recent growth disappointment will persist and I feel more confident that growth is going to remain robust. While I wouldn’t expect material upgrades in economic forecasts, I do think the current cycle of downgrades will end, and soon. In corporate terms, businesses have grown increasingly skilled at managing market expectations; and, indeed, in the US, firms are still beating consensus forecasts in the recent reporting season.
I do think the current cycle of downgrades will end, and soon
Inflation, it must be said, is more troubling, particularly with headline rates at multi-year highs and policymakers openly expressing their worries. Conditions can change rapidly, but we appear to be heading into a period of higher inflation that is more than simply the result of short-term supply disruptions and the impact of recent recovery in global growth.
Markets, as always, are driven by both current and forecast levels of inflation and growth. If I’m right, then the nominal yields on bonds should rise further from historically low levels. Real yields, adjusted to reflect inflation expectations, should also rise, although probably remain in negative territory.
This would, in turn, put equity valuations under some pressure; rising bond yields reduce the present value of future cash flows. Longer-duration growth stocks, while supported by secular trends, would be vulnerable, given elevated valuations and sensitivity to changes in interest rate expectations.
Despite rising inflation expectations and higher bond yields, US equities have stormed ahead, with growth shares delivering strong absolute returns and keeping pace with cheaper value stocks. Looking forward, negative but rising real yields, along with secular tailwinds, should support growth stocks although valuations in that area may well come under pressure. Value areas of the market may well benefit from rising inflation expectations and interest rates, and a recognition that economic growth will remain robust. A more balanced market, as seen so far this year, will likely persist in the coming months.
Emerging markets, on the other hand, have had a torrid time, driven in part by China’s increased interventionism in areas such as technology. For me, the jury is still out on whether Chinese shares look attractive over the longer term but policy action has increased the risk premium on the Chinese market, justifying a lower valuation.
Currency markets have also been tough. For sterling, higher interest rates should be supportive, but there are numerous challenges, not least the current account deficit, inflation and the ongoing fallout from Brexit.
A more balanced market…will likely persist in the coming months
Standing back, however, I remain confident and believe that stagflation – where growth is anaemic but inflation is rising – can be avoided. It’s a tough call, and the margin of safety is limited, but for me, there’s still a good amount of gas left in the juggernaut’s tank.
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Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.