Five insights in five minutes
Equities and inflation I
We’re back from our Easter break and what a few weeks it’s been for investors. To summarise, inflation has ticked higher, bond owners are non-pleased (ten-year treasury yields added another 50 points since we last published) while equities rose and fell again. The fixed income moves make sense, but why are stocks seemingly so confused about inflation? To paraphrase Winston Churchill, equities are the worst assets to own during periods of rising prices, except for most of the others. Companies are relatively safe because cashflows adjust – unlike nominal bond coupons – as do balance sheets. Indeed, most inflation data are positively correlated to operating margins, as can be seen in the chart below for American firms. What about those red bars on the left, though? Indeed, the two measures that are negatively correlated, producer and import prices, no-doubt explain some of the nervousness in equity markets of late. But if they are close to peaking, with the former at four standard deviations above its 30-year average and the latter running at double digits for the past 12 months, then the outlook for profits will brighten.
Conversation starter for… global equities, US equities, Asia equities, emerging market equities
Equities and inflation II
Higher input costs, as described above, haven’t been the only inflation-related issue worrying equity investors since Five in Five has been away. Earlier this month, the market yield on ten-year US government bonds briefly traded below its two-year equivalent. That hasn’t happened since 2019. Historically, a so-called inverted yield curve has pointed to a recession on the horizon, albeit with a delay of typically 18-24 months in America. The spread to watch out for, however, is between ten-year and three-month yields, which tends to suggest that Federal Reserve policy is beginning to restrict economic activity. This curve remains a long way from inversion, at a healthy 190 basis point spread. Sure it will likely flatten in the coming months. But based on data back to the 1960s, an environment of positive spreads and curve flattening has been good for equity market performance. As illustrated below, the median S&P 500 return in the nine months following the inversion oscillates between five and ten per cent. So ignore the panic; yield curve inversions are typically a lousy predictor of equity underperformance.
Conversation starter for… multi-asset, equity portfolios
While you should never pay a valuation premium for a diversified company (equity investors can achieve the same result more efficiently themselves), portfolio diversification is a must. And the case for adding some emerging market exposure is as compelling as ever. For one, higher commodity prices benefit exporting countries in Africa, Latin America, and the Middle East. Accordingly, Latam stocks have been leading the way, seen in the chart below. As we highlighted earlier in the year, the region has been poised for a breakout due to a combination of attractive relative valuations and heavy weightings to sectors that perform well in the current environment – particularly financials and natural resources. Emerging market assets remain on sale, with earnings yields well above their ten-year average for some countries, while real bond yield differentials versus America are at the top of their historical range. Also worth noting that the difference between the spread on dollar-denominated bonds issued by emerging sovereigns and US high-yield corporate bonds is currently at its highest level since the mid-2000s.
Conversation starter for… Emerging market assets
The Reserve Bank of India kept its policy rate unchanged at four per cent earlier this month, despite mounting inflationary pressure. In fact, consumer price growth has breached the upper limit (six per cent) of the RBI’s tolerance band for three months in a row. Why the hesitation to raise rates then? Well, although the RBI has adopted an inflation-targeting framework, it could not act with a complete disregard of economic growth, especially during a post-pandemic recovery. Granted, the RBI did allow inflation to stay above six per cent throughout most of 2020 (see chart). But the central bank doesn’t have the extreme circumstances of a national lockdown to point to this time as an excuse for more leeway. Indeed, in its most recent statement, the RBI clearly prioritises inflation ahead of growth. So if prices continue to rise, investors would be well-served to observe the consequences of higher interest rates – bonds might become more attractive relative to equities.
Conversation starter for… India equities, India bonds
ETFs and Russia
For ESG investors in exchange traded funds, what has been the effect of the removal of Russia-based stocks from the MSCI and other indices? Unlike its landmass, Russian assets are surprisingly small in the scheme of things. Before the conflict, Russian companies accounted for barely a tenth of one percent of global ESG ETFs, according to Bloomberg data. Weightings were higher in large-cap emerging market ESG ETFs, but not worryingly so, at just above two per cent. Of course now that equity prices have tanked, positions are being measured in single basis points, meaning that impacts on portfolios are minimal, even if it were possible to sell. Based on publically available data, the biggest holdings globally in EM ESG funds are VTB Bank, Sberbank, Gasprom and Novolipetsk Steel – although many fund providers have written down the value of Russian holdings to zero. With index weightings now so low, tracking errors will not suffer. Newly launched funds in ESG ETF-land are devoid of Russian holdings altogether.
Conversation starter for… emerging market ETFs, global ETFs, ESG ETFs, emerging market equities
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