Economists and investors alike are busily revising up their already-high expectations for 2021. Fuelled by a massive fiscal expansion and rapid vaccine deployment, the US economy will set the pace this year, but the rest of the world will not be far behind. Economic data continues to consistently surpass expectations around the world, and in virtually every sector of the economy.
Forecasts for booming economic growth have been pulled forward into the first half of this year, and financial markets have rotated — at times violently — out of last year’s winners into more economically sensitive sectors, with energy the biggest winner so far.
The highest global GDP growth in decades should translate into high corporate earnings growth, which will either ease equity market valuations, push stock prices higher or some combination of both.
But we are also already seeing some of the downsides to the upside scenario. Starting this spring, y-o-y inflation will almost certainly increase, but only temporarily, we expect. Investors can safely ignore this data quirk, especially if monthly increases remain modest, as we expect they will.
Inflation may also rise this summer for more economically relevant reasons. As more consumers shift their spending from goods to services, we are likely to see a relative shift in price pressures that could cause overall inflation to rise. This is especially true if businesses encounter difficulty quickly expanding their operating capacity in the face of a sudden increase in demand.
Small business surveys already show this becoming an issue. Employers are having trouble finding new workers to fill open slots, and a large number expect to raise prices in the next few months. Job openings in the US are more numerous than they were at the end of 2019. Central banks are unlikely to view such a phenomenon as a reason to urgently tighten policy, however. The overall increase in inflation is likely to be modest, and it should pass as supply rises to meet demand.
A broad-based and durable rise in inflation is still a long way away for the world’s largest economies. In early 2020, as the US economy was creating close to 200,000 jobs per month and the unemployment rate was dropping to 3.5%, inflation remained quite tame.
Today, despite considerable progress since last April, the unemployment rate is 6% and over four million people have dropped out of the workforce altogether. This gives the Fed and other central banks facing similar conditions plenty of room to keep monetary policy easy for a good while longer. We do not expect the Fed or the European Central Bank to reduce their asset purchases until 1Q2022, at the earliest.
Where to focus if markets struggle to keep pace with the economy? This year has already brought welcome news regarding the pandemic and the subsequent economic recovery. The trouble for investors is that much of this good news has already been priced into markets.
Markets are anticipating a strong global economic recovery, as well as higher inflation. Investments tied to those trends can continue to perform well, assuming the news continues to come in better than expected as it has in recent months.
Better-than-expected economic data and faster-than-expected drops in new Covid-19 cases have boosted commodity prices, long-term interest rates and inflation expectations. They have also helped US small cap stocks handily outperform large cap stocks, with the technology sector taking a back seat to energy and financials.
Emerging markets assets have also received support, which is typical during periods of synchronous global economic growth, as long as sharply higher interest rates and a rising US dollar do not derail things.
The reflation trade still has legs, but we advise investors to be more discerning in how they invest for the global reopening and recovery, given the run many of these assets have already had.
Real assets like real estate, farmland and timberland are among our favoured asset classes in a reflationary environment, especially given their inflation-resistant yield. We are investing in renewable energy infrastructure and US housing in light of the sharp increase in demand for new construction and shifting demographics.
Within equities, we are emphasising near-term opportunities in the financials and consumer-related sectors, while also keeping an eye on industrials that could benefit from publicly funded infrastructure investments.
We remain bullish on US small caps, emerging markets and cyclicals for the longer term as the economy reopens but think those areas could be subject to volatility over the coming months. We see tactical opportunities in some growth stocks that have experienced recent underperformance.
In fixed income, while (Treasury Inflation-Protected Security) TIPS have outperformed nominal Treasuries as inflation expectations have increased, we prefer to take more risk in credit sensitive parts of the market, including emerging markets.
Improving fundamentals can help spreads compress even further, and higher-yielding parts of the market should prove less susceptible to a further increase in interest rates. Leveraged loans and other floating rate products are another preferred area for this reason.
One unmistakable feature of 1Q2021 was the increased interest in speculative investing among individual investors (as well as a handful of institutions). Intense interest in online trading communities — in assets ranging from Bitcoin to GameStop to silver — led to eye-popping rallies, some of which have proven to be more durable than others.
With liquidity plentiful and average net worth at its highest level ever, many investors are willing to pay high prices — at times clearly divorced from fundamentals — for assets with no intrinsic value that generate no income as long as they believe they can sell them to the next buyer at a higher price.
Investments primarily, if not entirely, driven by speculation can be extremely volatile with in- consistent correlations to other asset classes. As such, they are difficult to incorporate into a diversified asset allocation and can be subject to sudden, severe losses.
While we know it can be tempting to follow the latest trend or the hottest stock, we suggest remaining diversified and limiting exposure to any single asset or asset class.
Brian Nick is chief investment strategist of Nuveen’s Global Investment Committee (GIC).
Photo: Bloomberg
