Investors who decided to “sell in May and go away” were left disappointed as May 2021 saw global equities rally 1.4% and Australian equities rally almost 2% over the month in local currency terms. Over the past 70 years the May to October period has usually been the worst 6-month period for returns but more recently May has provided positive returns for US equities 7 of the last 10 years. This year was no different as the equity market ‘climbed the wall of worry’, and despite a few wobbles, managed to look through the biggest inflation jump since 2008 to post a positive return.
As mentioned the big news in May was the huge spike in inflation. While this was mostly anticipated due to base effects (dropping out last year’s very weak readings due mostly to oil), consumer prices in the US rose 4.2% year over year to April, significantly beating expectations of an already high 3.6%. Core personal consumption expenditure, the US Federal Reserve’s (FED) preferred inflation indicator, rose 3.1%, beating expectations of 2.9% and well above their 2% target. US 10-year government bond yields spiked up to 1.7% on the news and US equity markets fell almost 5% peak to trough over the month, but both finished off the month in a better place than when they started, suggesting the market was well positioned for this outcome.
The market and the FED are not worried. While the equity market in the US wobbled for a few days, this was mainly due to the resumption of the value vs growth trade (US value stocks are up almost 3% and US growth stocks are down 1.4% over the month), which in turn fuelled the continued rotation out of US equities (MSCI ACWI ex US was up almost 3% vs US equities up 0.7% in May). Despite the high inflation data, and despite it exceeding forecasts which already included base effects, the market and the FED continue to view the inflation increase as transitory.
Yes, inflation is running hot, right now. Pent up demand is being unleashed and supply chains are struggling to keep up. Commodity prices are up almost 50% over the year to April in USD terms causing input prices to rise. Workers are not returning to work because they either are receiving higher payments from government support or because they don’t believe their workplace is safe and/or they can’t go back to the office until schools are reopened. Whatever the reason, the root cause remains the extraordinary disruption caused by COVID-19, which hopefully will soon be in our rear-view mirror. If we believe workers will get back to work, supply chains will reopen and demand will level out in the future, then a few months of hot inflation are no cause for concern. The FED has already stated they will look through this spike and aim to target average inflation over time, so naturally the bond market regained its cool and yields remained essentially where they were before the inflation print.
For inflation to become a problem we need to see sustained inflation, not just a few months. The long-term outlook is a lot less clear. Those that view the inflation increase is transitory will argue that the world will return to normal – supply will increase to meet demand and demand will cool off once everyone has eaten out and gone on vacation a few times. The output gap remains unfilled, demographics continue to age, and technology continues to improve productivity. None of these point to more permanent increase in inflation but a return to the disinflationary era of the past 40 years.
The other side of the argument is that transitory inflation can become unhinged and turn into secular inflation very quickly. Commodity prices can continue to rise as very low investment in the sector over the past few years, when prices were depressed, means supply struggles to meet demand even if demand returns to normal. Monetary policy failed to get bank reserves into the real economy post 2008, but combined with the significant fiscal stimulus post COVID, the government can inject cash directly into the economy, which can be inflationary either directly through increased consumption or through monetary debasement. Globalisation is reversing, increasing supply chain disruptions and raising manufacturing costs, plus economies in North Asia are no longer incentivised to provide the world with cheap manufacturing labour as they pivot to internal consumption as their populations age. All of this points to longer term inflation, in a world where the Fed cannot increase interest rates significantly without bankrupting the US government. US debt to GDP is well over 120% and rising, unlike the low 30% in the ‘70s and ‘80s, meaning there will be no Paul Volcker this time around if needed.
While the truth is likely to be somewhere in the middle, we’re entering a period of uncertainty where we won’t know for a few months whether inflation normalises. This has very important repercussions for investors. If this rise is indeed transitory, then the value versus growth and rest of the world vs US equity trade has a few months left to run, at which point investors should return to portfolios biased to long duration assets with US growth stocks. If central banks manage to boost inflation long term to 2%, then the value versus growth rotation should continue as expensive multiples in technology stocks revert back to more palatable valuations. However, if inflation gets out of control, all stocks will sell off and perhaps more importantly, equity bond correlation will become strongly positively correlated. While this is not our base case, the risk of this occurring is the highest it has been in a long time.
We believe the easy gains are now behind us and we are at an important inflection point. The good news has been priced into markets and the way forward is less clear. Negative surprises could be growth disappointment, a geopolitical black swan or untethered inflation. While it is more satisfying to make a bold prediction, we are instead balancing these risks and diversifying the portfolio accordingly. We have maintained a low duration position and have built a small position in commodities in case inflation pushes rates higher, but remain relatively constructive on equities, particularly cyclical markets that show better value, such as Australia and the UK. However, as valuations have compressed expected returns on risk assets, we are not compensated for a significant allocation to equities. We therefore continue to diversify our risk across higher risk credit, such as global high yield corporates and emerging market debt, which we believe will deliver a carry return over the coming months while equity markets digest the reality of reopening. We remain tactically higher in cash to help dampen the potential equity volatility but look to take advantage of weakness in equity markets over this period of uncertainty.
Equity markets rallied across the globe with the US lagging. This was predominantly due to the inflation print spurring the resumption of the value versus growth trade. US equities rose 0.7% over the month but at one point were down 5% peak to trough. The growth trade unwind came quickly, as extreme option positioning caused dealers to exacerbate moves by selling into market falls to hedge their positions. Momentum trading CTA funds added fuel to the fire, flipping from 100% long to -10% short over three days. The NASDAQ fell over 6% and high growth funds like the Ark Innovation ETF fell almost 18% peak to trough. This caused the volatility index (VIX) to spike from 17% to 27% over three days.
During this period we were unsure how the equity market would digest the inflation print so we did not buy the dip. However, we believed the spike in volatility was an opportunity and perhaps due to market technical than a broad based positioning unwind. We therefore captured the volatility increase by selling out of the money July S&P 500 put options to earn premium. Volatility eventually fell back below 17% by the end of the month. We also used this as an opportunity to roll our put protection strategies closer to current market levels at zero premium. These continue to protect the portfolio from shallow drops from around 3% to 13% from current levels for zero premium.
Treasury yields spiked momentarily after the inflation print but settled down as the market digested the news. The FED was clear to articulate they do not plan on hiking rates any time soon and will continue to look through the next few months of high inflation prints. While some FED members are suggesting they will discuss potential tapering of asset purchases, this still feels like a low probability risk until later in the year. Credit spreads wobbled as well but remained well behaved throughout.
We maintained a low duration exposure in the fund at 0.75yrs at the portfolio level. Our base case is inflation may stick around for a while but not become unruly. Currently yields on longer dated bonds have repriced the most with the shorter dated bonds looking more vulnerable to an eventual hike. Therefore, while we have low duration within the fund, we would find more value in the longer end of the yield curve at this point in time. While credit spreads are extremely tight, the credit quality of both investment grade and high yield indices has improved due to company rating downgrades below investment grade which removes them from the index. On a quality adjusted basis, credit spreads are still tight but only back to 2018 levels. As earnings improve net leverage is improving and default rates continue to fall. We are therefore positioned to take the carry and prefer holding higher yielding credit for now.
The US dollar continued to sell off in May with the DXY index falling by 1.6%. The selloff was broad based, with British pound (GBP) rallying 2.8%, emerging markets FX 1.9% and Euro 1.7%. The AUD was mostly flat against USD. This broad weakness helped push commodities up 2.7% against the USD. We reduced our GBP position last month but remain long USD and JPY as a hedge against equity market weakness.
Published by Sebastian Mullins, Portfolio Manager, Multi-Asset, Schroders