01 October 2021
In the five charts below, our investment experts highlight five areas that may be key to the direction financial markets take in coming months. This month we look at surging power prices, accelerating retirements from the US workforce, how much inflation matters, how cheap emerging markets look and if US equity volatility is set to rise.
Power prices have surged across Europe in recent weeks. The reason isn’t down to bad weather, unlike the 2018 spike driven that was down to the cold snap nicknamed the “Beast from the East”. This time it’s a structural storm that is causing natural gas prices to skyrocket.
Low gas storage levels, lower supplies from Russia, higher Asian demand, low renewables output and nuclear maintenance outages have combined to create a significant imbalance between supply and demand.
We expect a gradual return to normal as the effects of the above problems recede. However, for investors this won’t help alleviate concerns over inflationary pressures in the short term and may pressure companies’ margins in the latter half of the year.
America may be facing a structural decline in the labour supply. The number of people in the US leaving the workforce to retire has surged since the start of 2020, during the pandemic.
More workers retiring has broad implications, especially given the US Federal Reserve’s goal to maintain its target range until labour market conditions “have reached levels consistent with the Committee's assessments of maximum employment”.
Indeed, a drop in labour participation suggests that “maximum employment” might be reached sooner than was implied by the pre-pandemic trends. In turn, this may open the door to a quicker pace of monetary policy tightening, something financial markets aren’t fully positioned for.
Increasing inflationary pressures haven’t translated into higher government bonds yields yet. Although the US core consumer price index was slightly below expectations in August, at 4%, it remains elevated by historical standards. At the same time, the yield on US 10-year Treasuries has been hovering around 1.5% this year.
By convincing investors that any inflationary pressures would be “transitory”, the US Federal Reserve (Fed) has been able to successfully decoupled inflation and yields. This suggests that in order to forecast the direction of yields in the short term, one needs to look at the Fed’s second mandate (employment) rather than prices.
However, as we move into next year it may be more difficult keep inflation and yields decoupled, as employment recovers and “transitory” loses its meaning.
Emerging market (EM) stocks’ valuation has fallen significantly compared to their US peers. China’s regulatory crackdown has put much downward pressure on EM indices this year, causing them to lag substantially other broad-based equity markets.
That said, the relative underperformance appears much larger than the expected weakness in earnings. This suggests that markets are already pricing substantial downwards revisions and that, if they don’t fully materialise, EM equity markets have become attractively valued.
We agree with this assessment, acknowledging that it may take a few quarters for this value to crystalise and see China’s monetary policy easing as a critical first step.
The information ratio for the MSCI USA index is at a 20-year peak, when comparing the index’s 10-year rolling returns to the 10-year rolling volatility. In others words, investors have rarely been better compensated to take additional risk than seen in the last 10 years, reflecting the extraordinary bull market seen in that time.
As such, we would expect the information ratio to rollover, as lower returns are met with higher volatility. It seems only a matter of time. Such an environment generally bodes well for truly active managers.
Our investment experts highlight our main investment themes, looking at how investors can play their part in tackling climate change, if proposed tax hikes might hit equity valuations, bonds fit for this stage in the credit cycle and whether surging energy prices threaten the economic recovery.
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