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There is a growing sense that the world is getting back to normal—and what a relief it is! We see more people venturing out, getting haircuts, going to hotels and restaurants, and returning to the office. Unfortunately, many countries are still dealing with more contagious and virulent mutations of COVID-19 and low vaccination rates. But, in aggregate, the global economy is recovering with the aid of accommodative fiscal and monetary policy, supporting the strong performance of risk assets1 and the continued rotation from growth to value.

Inflation is the boogeyman now. US inflation leapt 5% in May from a year earlier, well above the Federal Reserve (Fed) forecast for 2021. The central debate at the June Federal Open Market Committee (FOMC) meeting was whether inflation is transitory or persistent, and the FOMC’s recognition of the upside risks to inflation accelerated their tightening path from zero rate hikes in 2023 to two hikes in 2023. Even though the market has priced in earlier hikes, the Fed’s base case is that temporary factors and base effects are still distorting inflation prints. We see an elevated risk that supply/demand imbalances in labor and commodity prices may become more persistent. In housing, for example, structural drivers are contributing to higher prices and could feed into rents 12–18 months from now (FIGURE 1).

FIGURE 1

Persistent Inflation Could Show Up in Rents

US CPI-Shelter Index and Composite Home Price Index

Past performance does not guarantee future results. US CPI-Shelter: US CPI Urban Consumers Shelter SA; Composite Home Price Index: S&P Corelogic Case-Shiller 10-City Composite Home Price NSA Index. The US CPI-Shelter Index is a measure of the costs associated with housing, not including investments and upgrades. The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measure the value of residential real estate in 20 major US metropolitan areas. Chart data: December 2001–April 2021.

Against this backdrop, we continue to seek a pro-risk stance, but it’s tempered by a worse growth/inflation trade-off. Within equities, we are bullish on Europe, which we believe is on the cusp of an economic acceleration, and moderately bullish on EM, given their leverage to an improving global cycle and strong commodity prices, as well as continued US-dollar weakness. We remain moderately bearish on government bonds, especially in Europe where negative rates are particularly vulnerable to an improving cycle. Credit spreads2 are generally rich, but we find some value in bank loans as well as EM sovereign and local debt.

Rising inflation supports our value-oriented tilt toward non-US equity markets, smaller caps, and cyclical sectors such as financials, consumer discretionary, materials, and industrials. Within commodities, we favor energy and industrial metals, which have historically been more sensitive to rising inflation than equities and can potentially help hedge against a rise in interest rates.

 

Equities: More Room to Run

Among equity regions, we favor Europe, where we expect the sharpest increase in vaccinations (after a sluggish start) and economic growth, and where we find valuations attractive. Leading economic indicators suggest the consumer sector may soon be booming, joining an already strong manufacturing sector.

While we are moderately bullish on EM equities broadly, we see pockets of value and, as always, believe differentiation is key. In Asia, we’re hopeful that the Chinese credit impulse will hold up and think net commodity exporters throughout the EM complex could benefit from higher commodity prices and better terms of trade.

We are neutral on US and Japanese equities. While we are quite optimistic about the US economy, equity indices tend to be dominated by growth-heavy, interest-rate sensitive, and expensive stocks. We are also mindful of a potential increase in corporate taxes, which could hamper earnings. We prefer value-oriented equities in the US, as well as smaller caps, which are typically more sensitive to changes in economic growth and less sensitive to rising rates. Similar to Europe and EM, Japan stands to benefit from a stronger global cycle. However, we’re less optimistic about any domestic catalyst pushing equities upward and prefer Europe and EM.

Across factors and styles, we generally prefer value-oriented companies that can do well in a higher growth and interest-rate environment. While value has outperformed growth since September 2020, it still has a wide gap to close after lagging dramatically over the past decade (FIGURE 2).

FIGURE 2

Value Has Ample Room to Outperform

Value/growth, Russell 1000 Indices

Past performance does not guarantee future results. Chart data: 1/2/10–5/28/21. Russell 1000 Value Index is an unmanaged index measuring the performance of those Russell 1000 Index companies with lower price-to-book ratios and lower forecasted growth values. Russell 1000 Growth Index measures the performance of the large-cap growth segment of the US equity universe. It includes those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth values. The price/book ratio is the ratio of a stock’s price to its book value per share. Source: Bloomberg.

Commodities: Cyclical and Structural Factors Underpinning Performance

We continue to see higher commodity prices as one source of inflation, given broad supply/demand imbalances across energy, metals, and agriculture. As discussed last quarter, there are also structural changes that appear to be making commodity prices more inelastic. First, capital expenditures have been on a downtrend for the past decade, after a period of overspending and under-delivering on long-term projects (FIGURE 3). Second, amid the transition to a lower-carbon world, areas such as metals and agriculture are facing higher costs and potentially lower supply due to climate-related goals.

FIGURE 3

Commodities: Lack of Capex May Inhibit Production

Capex by the large iron ore, copper, and gold producers (US$ billions)

Capex data is for the top five diversified miners by market cap, top six copper producers by market cap, and top six gold producers by market cap with history as of 2000. Actual results may differ, perhaps significantly, from estimates. Chart data: actual: 2000–2020; estimated: 2021–2024. Source: Bloomberg.

Our Multi-Asset Views

Views have a 6−12 month horizon and are those of the authors and Wellington Management’s Investment Strategy team. Views are as of June 2021, are based on available information, and are subject to change without notice. The authors’ process has been updated to incorporate a wider set of inputs from the Investment Strategy team; changes in views will be included again starting next quarter. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities.

Finding Value in Fixed Income

The Fed’s more hawkish stance is likely to keep US long-term interest rates range-bound over our 6- to 12-month time horizon. We expect the Fed and the European Central Bank (ECB) to remain accommodative and to very cautiously begin a tapering process sometime around year-end 2021 or early 2022. Still, we think inflation will increase more than central banks forecast. This could pressure global rates higher, and Europe’s negative rate structure seems particularly vulnerable in the face of accelerating nominal growth.

We think credit valuations are rich, with most spreads well inside of median levels since inception of the indices (FIGURE 4). That said, default rates continue to decline and demand technicals remain strong, driven by demand from Europe and Asia, as well as from US pension funds seeking long-duration3 assets to lock in their improved funded status.

Within credit, we prefer short-duration sectors, such as bank loans and certain areas of the securitized market. We continue to view securitized assets as a way to express a positive view on residential housing, but remain cautious on commercial property, such as malls and offices, where the outlook is more uncertain. Low mortgage rates, declining unemployment, and millennials’ growing demand for housing continue to be potential tailwinds for sectors such as workforce housing and credit-risk transfer. EM debt spreads have lagged the tightening in other sectors. We think the outlook for EM will begin to brighten as these countries receive vaccines and benefit from global growth and stimulus. While EM central banks are actually hiking rates to tamp down inflation, we expect currency gains to contribute to local debt performance.

FIGURE 4

Most Credit Spreads Are Rich

Option-adjusted spreads, 6/21/21 (bps)

  Current Percentile since
inception (%)
Median Low Inception Date
US corporates 82 19 112 51 6/30/89
US high yield 281 6 441 233 1/31/94
EM debt 351 39 386 149 12/31/94
US commercial mortgage-backed security 54 0 104 13 6/30/99

Past performance does not guarantee future results. An OAS (Option-Adjusted Spread) is a measurement tool for evaluating yield differences between similar-maturity fixed-income products with different embedded options. A basis point is a unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indices and the yield of a fixed-income security. US corporates is represented by the Bloomberg Barclays US Corporate Index ; US high yield is represented by the Bloomberg Barclays US High Yield Corporate Bond Index; EM debt is represented by the JPMorgan EMBI Global Diversified Index; US commercial mortgage backed securities is represented by the Bloomberg Barclays US CMBS Investment Grade Index. Please see index definitions below. Sources: Bloomberg, Wellington Management.

Risks

We think the inflation debate will be the market’s focus in the coming months. However, as noted, we expect the Fed and ECB to announce tapering plans in the fall. We think central banks will be extremely careful in how they communicate, but bumps could occur as markets may be sensitive to any perceived change in policy support. The tapering theme and the prospect of less fiscal support in the second half of this year may cap total returns in risk assets and are the main reason we are only moderately bullish on developed market equities.

Another risk is the potential for COVID variants to spread further and disrupt the recovery. We are also monitoring the global cycle impact of tightening financial conditions in China.

On the upside, global markets may be underestimating the Fed’s commitment to its new average inflation targeting policy. A scenario could unfold in which interest rates remain anchored at low levels for longer than anticipated and risk assets ramp considerably higher.

Finally, governments are spending on traditional and technological infrastructure after many years of underinvestment. Targeted investments could potentially boost productivity and cap inflation because higher revenues can absorb increased wages without the need for higher prices.

Investment Implications to Consider

Stick with value — We remain in the recovery phase of the cycle, and the risk of inflation and higher rates points to potential outperformance in value-oriented exposures. We prefer non-US equities and other value-oriented exposures, including smaller-cap equities and cyclical sectors such as financials, materials, and industrials. We think there could be attractive opportunities in select energy companies that have strong plans for navigating the transition to a lower-carbon economy.

Get more selective in credit — Most spreads are rich but we don’t see a catalyst for them widening much. We think the best risk/reward potential in sectors such as bank loans, collateralized loan obligations, and residential-housing-oriented structured credit. We think EM sovereign and local debt may also offer better upside potential from a spread and currency perspective.

Pursue potential inflation protection with commodities — Inflation may reach higher levels or be more persistent than many asset allocators expect. While value-oriented equities may provide some protection, commodities (excluding precious metals) have historically been the most inflation-sensitive asset class.

Maintain fixed income for diversification — While our views tilt toward an economic recovery, we think it’s still prudent to consider an allocation to high-quality bonds in case of a sharp equity sell-off. A global fixed-income universe gives investors more opportunity to add value. We think municipal bonds can play a strategic role for taxable investors, especially given the trend toward greater federal spending. Precious metals and option strategies may provide additional ways to supplement bond exposure.

The views expressed here are those of the authors and Wellington Management’s Investment Strategy team. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams, and different fund sub-advisers, may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds. 

Subscribe to Nanette’s commentary at hartfordfunds.com/nanette

1 Risk assets (such as equities, commodities, high-yield bonds, real estate, and currencies) have a significant degree of price volatility.

2 Spreads are the difference in yields between two fixed-income securities with the same maturity, but originating from different investment sectors.

3 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

Bloomberg Barclays US CMBS Investment Grade Index measures the market of conduit and fusion CMBS deals with a minimum current deal size of $300 million.

Bloomberg Barclays US Corporate Index is a market-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more.

Bloomberg Barclays US High Yield Corporate Bond Index is an unmanaged broad-based market-value weighted index that tracks the total return performance of non-investment grade, fixed-rate publicly placed, dollar-denominated and nonconvertible debt registered with the Securities and Exchange Commission.

JPMorgan EMBI Global Diversified Index is a comprehensive global, local emerging-markets index, and consists of liquid, fixed-rate, domestic-currency government bonds.

Important Risks: Investing involves risk, including the possible loss of principal. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political and economic developments. These risks may be greater for investments in emerging markets. • Small-cap securities can have greater risks and volatility than large-cap securities. • Loans can be difficult to value and less liquid than other types of debt instruments; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks. • Different investment styles may go in and out of favor, which may cause the Fund to underperform the broader stock market. • Fixed-income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • US Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest. • Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. and counterparty risk. • The risks associated with mortgage-related and asset-backed securities include credit, interest-rate, prepayment, liquidity, default and extension risk. Investments in commodities may be more volatile than investments in traditional securities. Diversification does not ensure a profit or protect against a loss in a declining market.

BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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About The Authors
Nanette Abuhoff Jacobson Headshot
Managing Director and Multi-Asset Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds

Nanette Abuhoff Jacobson consults with clients on strategic asset allocation issues and works with investment teams throughout Wellington to develop relevant investment solutions across asset classes.

Author Headshot
Investment Strategy Analyst

Daniel Cook analyzes and interprets markets and translates this work into investment insights. He researches investment ideas for portfolio managers and consults with clients on tactical and strategic asset allocation.

 

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