Markets Weekly podcast - 21 June 2021

Henk Potts (HP): Hello.  It’s Monday, 21^st June and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist for Barclays Private Bank, and each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I will analyse the events that moved the markets and grabbed the headlines over the course of the past week.  We’ll then discuss the investment outlook as we go into the traditionally volatile summer months.  And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Investors as we know were forced to question the reflation trade last week as the Federal Reserve’s more hawkish tone and weaker Chinese economic data reverberated through financial markets.  Equity indexes fell back from record highs, yield curves flattened, the dollar strengthened and commodity prices tumbled.

There’s no doubt there’s a distinct change in mood music from the US central bank as policymakers appeared to deviate from the inflation is merely transitory message and officials indicated they would speed up the pace of policy tightening.

The central bank did reiterate the view that inflation is likely to subside as the supply of goods catches up with consumer demand but said officials would respond appropriately if price rises were more persistent suggesting inflationary pressures are indeed becoming more ingrained than previously projected.

The FOMC upgraded its estimates for inflation with the Fed’s preferred measure of headline and core PCE inflation markedly higher this year and modestly higher in 2022 and 2023.

Turning to the economic outlook. The statement said the indicators of economic activity and employment has strengthened. There was barely a mention it has to be said of the loss of momentum in labour markets. They did say risks emanating from the pandemic have reduced.

Projections point to a more robust growth profile as the Fed raised their forecast for real GDP growth to 7% this year and kept it unchanged at 3.3% for 2022.

In terms of the policy outlook Chair Jerome Powell said members would begin a discussion about scaling back purchases. The median member now forecasts two quarter point hikes in 2023.

We expect the FOMC to formally announce a taper at the September meeting and begin slowing purchases at the November meeting although Powell stated the tapering process would be orderly, methodical and transparent and they’ll give advance notice. Probably an acknowledgement that they don’t want a repeat of the 2013 taper tantrum to play out.

In terms of China, May’s data released provided further evidence of the slowing economy. Retail sales and investment growth fell short of expectations and factory output fell for a further straight month.

The data signalled that COVID disruptions at key port cities, rising input costs at factories and slowing credit growth are impacting activity, although we should recognise the numbers are of course distorted by base effects. The two year average figure still suggests solid if not spectacular growth.

Turning to the economic outlook. China’s looking to cement a remarkable recovery during the course of this year with growth around 9.4%. However, with the comparatives normalising, some clear headwinds developing it’s perhaps no surprise that year on year growth rates appear set to moderate over the course of the next 18 months.

We predict that growth in China will drift back towards a new trend rate to somewhere round about 5.5% in 2022. I think over the coming months we’ll closely monitor the data for signs of further deterioration given China’s influence on global growth but also its status as a leading indicator of the shape of the COVID recovery.

So thinking about market performance, equity markets are under pressure as I said.  STOXX 600 fell 1.6% on Friday. That’s the biggest drop since 11^th May with cyclicals, particularly the likes of the banking, energy, basic resources, leading the declines. The index finished the week 1.2% lower.

Over on Wall Street similar picture. The S&P 500 was down for a fourth straight session on Friday, fell 1.9% over the course of the week. That’s the worst weekly performance since February. And in bond markets the treasury yield curve flattened. The 10 to 30-year spread touched 111 basis points on Friday. That compared to 140 basis points before the Fed statement to the lowest since September last year. It was down nearly a quarter of a percentage point over the course of the week, that’s the most since 2011.

A number of strategists appeared to lose confidence in the much touted steepener trade which pays off when longer dated treasuries sell off at a faster pace than their short term counterparts. The move actually not a surprise for us. We’ve stressed many times that a repricing of the dot plot would indeed lead to flattening.

The dollar was in recovery mode last week as markets priced in the interest rate predictions and growth rate projections. The greenback was up for a sixth straight session on Friday, up around 1.9% over the week to close at a two-month high.

The stronger dollar, China slowing growth profile and tougher regulatory environment impacted the commodity complex. Bloomberg Commodity Index fell 4% last week generating its worst weekly return since the pandemic.

Copper for example was down around about 8%, lumber was down 15%.

Gold registered its biggest weekly fall in over a year. The precious metal was down 5.7% last week, falling to a six week low trading below the $1,800 an ounce level. Gold of course is negatively correlated with rising bond yields.

Oil prices remained resilient. Oil posted a fourth consecutive weekly gain as demand continues to recover and supply remains constrained.

So a dramatic week for markets no doubt about that although you could argue movements could have been more pronounced but for economic growth forecasts remaining robust although you can suggest that the peak of the recovery phase is now behind us.

The Fed is no longer seen as being behind the curve. The taper process we expect to be controlled and rate hikes are still some way off.

So that was the global economy and financial markets last week. 

I’ll now move on to consider how investors should be positioned over the next few months. To help discuss this I’m joined by Jai Lakhani, Investment Strategist for Barclays Private Bank.

Jai, good to have you with us today. Sell in May and go away is a much touted equity market strategy. What does history tell us about equity market performance over the course of the summer months? Should investors follow that maxim?

Jai Lakhani (JL): Well, good morning, Henk, and thank you for having me. To answer the first question history tells us that when you look at average performance summer months do indeed tend to be more volatile.

The MSCI AC World Index over the past 20 years shows July has been positive, 1.2% on average, but June and August have been more challenging with negative 0.5% on average.

However, it’s worth pointing out that the average is deceptive and skewed by a few outsized fallbacks when we think about June 2010, 2012 and 2019 and August 2002, 2011 and 2015. And while based on historical data you are most likely to lose money in June, 12 down months out of the last 20, you actually have more chances to experience a down month in January or February, 10 times out of 20, than in July or August, seven, eight times out of 20 respectively.

Also it’s worth pointing out that the fallbacks you do see in June appear pretty shallow.  They’re less than 1% in five out 12 down months. So as such there is no real reason to think that summers are a riskier period of the year for investors yet of course we do acknowledge the current environment isn’t completely free of risk.

HK: So when we look at equities we know they’ve notched up this incredible rally since the pandemic lows. That’s making some investors nervous. What are some of the key risk factors that you’re monitoring?

JL: Sure.  It is of course almost every week we hear equity markets touching record highs so it’s natural for investors to question are we due a correction?  Outside of black swan events that are always possible and not really something we can readily anticipate.

One of the risks I mention ties into this fact that we haven’t had a noted fallback in a while. Equity markets as we know don’t go up on a straight line. In any given year a 10% correction is considered normal yet we’ve only seen a brief 7% fallback in the September to October period and this proper correction hasn’t happened and globally equity markets are up 86% from the pandemic lows.

When we also think about no pullback a key risk consideration is valuations. Whilst relatively there isn’t per se signs of equity markets being expensive with the S&P 500 equity risk premium at 3% on an absolute basis multiples have compressed. The MSCI All Country World is trading at a 12 month forward earnings multiple of 18.6. When we think about historical averages that’s at 15.8.

It’s worth pointing out, therefore, that whilst we don’t see sharp deratings as likely it is conditional on monetary support and on earnings growth remaining strong and any disappointment on this front could be punished.

Thinking about this disappointment front you just spoke about the monetary side and we know the Fed talking about tapering and actually announcing it is coming at the Jackson Hole Symposium or the November meeting actually happening.

When we think about the unprecedent fiscal stimulus we’ve seen so far that does need to be paid back with higher taxes, particularly in the UK and US and G7 countries that this appears firmly on the agenda.  And so this can lead to investors reassessing growth forecasts.

And to bring us on to a final risk consideration it’s exactly this. We point out in the May’s Market Perspectives that we’re approaching several peaks. Think about the recent retail sales data in the US and the UK and PMIs peaking. As we know the markets are responding to the rate of growth, the second derivative, rather than to growth itself. And with growth slowing down from these very elevated levels there is a risk that the current enthusiasm may fade pushing investors to pare back their risk exposure.

HL: So taking into account those factors, what are the main reasons why people should stay invested over the course of the coming months?

JL: Well, I think many could look at what we just discussed and be wary.  However, it’s important to distinguish between short-term gyrations in markets from the longer term upward trend.

Shocks do appear to be in general transient in nature and that’s if the COVID-19 crisis taught us anything it’s that even the worst shocks are still transient in nature. Equity markets have been through Brexit, Donald Trump’s election success and now COVID-19 and these are all recent examples of worst case scenarios that haven’t had a lasting impact on equity markets.

And whilst we’ve said, they may not go up in a straight line they still go up over time as a reflection of wealth being created and companies’ earnings continue to grow.

Also, even if we think about these shorter term gyrations there is always a bull market somewhere and this is where your active managers have the opportunity to earn their stripes as it were.

When we think of August 2015 as China decided it was time to devalue their currency equity markets plunged, yet when you looked at oil it was up more than 3% that month. Gold jumped 3.5%. Chipmaker Nvidia and consumer electronics, such as retailers such as Best Buy, saw 13%.

When we think about fundamentals as well they remain strong. Whilst we mentioned that growth is peaking in regions such as the US and the UK others are just beginning when we take a look at Europe and Asia in particular.

Similarly when we think about the microlevel, the second-quarter earnings seen in July and August should offer the best quarterly year on year earnings growth that we’ve seen in decades, 63% is currently expected for the S&P 500. And, yes, this is courtesy of extremely favourable base effects and the reopening but this should provide some support to equity markets and help validate the current valuations.

And a lot of the time we view corrections against bubbles such as the asset bubble for the 2008 crisis or the dotcom bubble in 2000. Yet there is no real broad based exuberance in current markets. You do have the example of cryptocurrencies, the SPACs and “meme” stocks that have formed here and there. But a lot of air has been taken out of this and investors actually expecting a pullback has ironically meant that the consensus has built around this which could actually make the event happening unlikely.

HL: OK.  So what are some of the actions investors should think about before taking time off over the course of the summer?

JL: Putting it quite simply, stick to the basics. We all would have heard the adage of time in the market as opposed to timing the market and research shows that the strategic asset allocation accounts for 90% of the variability in returns. So sticking to a winning strategy in the long term will ensure stable returns over this time period.

What is the winning strategy? Effective diversification. We mentioned in recent Market Perspectives moving away from the 60/40 portfolio to include alternative investments such as private equity and hedge funds.

Prioritising active management in the selection process so there is that increased nimbleness during periods of volatility by repositioning portfolios to trim down cyclicality.

And finally, for investors willing to accept lower returns in exchange for reduced volatility hedging could accommodate a more tranquil summer holiday.

HL: Well, thank you, Jai, for your insights there. I think we’ve highlighted the importance of staying invested, focusing on active management and being diversified.

In terms of the focus this week the Bank of England’s interest rate decision will be on Thursday where they’re expected to keep rates on hold at that historically low level of 0.1%. That’s despite inflation rising above the target level in May for the first time in 22 months, evidence of an improving labour market and stellar growth forecasts for this year.

The MPC are expected to keep rates on hold into 2023 as they wait for the recovery to play out. Markets of course will be looking for any hints around the slowing down of asset purchases.

And with that I’d like to thank you once again for joining us. We will of course be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.