We work with Wilshire, one of the nation’s largest investment research consultants, to bring you investment and market insights. Each quarter in The Macro View, we bring you Wilshire’s quarterly viewpoints on the big economic stories, with insights about the asset classes that may appear in your investment portfolio. Let’s dive in.
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Are we heading toward peak economic growth?
Global securities markets continued to trend higher during the first half of 2021, benefiting from the reopening of global economies and higher earnings growth, particularly in the US. Global economic data pointed to a continuation of the recovery in the first quarter, leading some economists to upgrade their forecasts of global growth. Please note that past performance does not guarantee future results.
At the same time, investor sentiment has been gradually shifting, as enthusiasm regarding the early cycle recovery has started to wane, and concerns about peaking economic growth in the US began to surface. The US economy grew at an annualized rate of 6.5% in the second quarter, falling short of expectations but returning to pre-pandemic levels, primarily due to a decline in inventories and less government spending.
On the other hand, personal consumption remains strong, with spending on services surging during the second quarter despite a material decline in the demand for goods. Despite the rise in cases of the COVID-19 delta variant, higher frequency indicators continue to show an increased degree of mobility (people out and about), indicating that the impact on the consumption of services is likely to be limited.
Furthermore, historically high job openings indicate that employment conditions should improve materially, which is also likely to be supportive of consumption. Nevertheless, the current labor shortage in the US has implications on wages, particularly in the services sector, where most of the hiring is taking place today. This, in addition to persistent supply chain issues, indicates that inflation risk is elevated in the near-to-intermediate term. As these pressures settle over time, we may begin to see some offsetting structural factors, such as technology driven secular shifts that may continue to place downward pressure on prices over the long-term.
It’s generally a good idea to remain diversified
In this quarter’s Investment Strategy Update, we take a deeper dive into the labor market, underlying indications of rising core inflation, interest rate expectations, equity valuations, and the recent change in sentiment in both equities and fixed income. We have become more concerned with interest rate risk and are directly reducing duration risk in portfolios and/or further reducing our allocation to core fixed income in favor of more flexible/alternative mandates that exhibit less duration exposure. We also continue to favor emerging markets and US value equities, which are more attractively valued (in relation to other investments) and are likely to benefit from a pro-cyclical/post-recessionary environment.
Investors have become fixated on monetary policy in recent months, as the prospect of a taper in the purchases of treasuries and mortgage-backed securities by the Fed becomes increasingly probable in late 2021 or early 2022. This may result in more volatility in the near-term as investors process this risk, however it’s important to recognize that equities can appreciate while interest rates rise, provided that the economy is growing at a healthy rate. Wilshire continues to promote diversification and remains judicious in the allocation of our active risk budget, particularly given expectations of heightened volatility. We provide a summary of our rationale and supporting exhibits in the following sections.
Asset class perspectives August 2021
Fixed income vs equities
Despite a positive economic outlook, which would normally be expected to benefit equities coming out of a recession, valuations are not materially more attractive in equities vs. fixed income, resulting in a neutral or balanced view.
Large cap vs small cap equities
Wilshire recognizes that small caps are likely to benefit from an economic recovery, however given the dramatic level of recent outperformance in small caps, Wilshire believes that the early cycle recovery is mostly behind us.
Growth vs. value equities
US value equities offer more attractive valuations and are expected to be the primary beneficiaries of a material recovery in earnings in 2021 and 2022. On the other hand, US growth equities valuations are rich, and are likely to face relative headwinds from higher yields in the future. Therefore, Wilshire maintains their overweight view in value equities as compared to growth focused equities.
Global ex-US vs. US equities
Despite somewhat attractive relative valuations in non-US. developed market equities, the US. continues to outperform its foreign counterparts in vaccinations, which has led to lower COVID cases and is supportive of a faster reopening and higher economic growth. Given the balance of the factors noted above, Wilshire maintains that a balanced approach makes sense.
Emerging markets vs. developed equities and US
Emerging economies are forecasted to deliver somewhat stronger economic growth in 2021 and 2022 and have historically outperformed coming out of recessions. Furthermore, relative valuations are attractive and emerging markets will be a primary beneficiary of increasing consumer demand and manufacturing capital expenditure cycles as the global economy continues to exhibit above trend growth. Therefore, Wilshire maintains their overweight view in emerging markets and the importance it has as part of a diversified allocation.
Macroeconomic outlook: Growth is peaking, but expect above trend growth
Second quarter global economic data indicates that global growth may be peaking, as the unprecedented economic recovery begins to level off. The IMF recently increased expectations for global growth to 4.90% in 2022 and continues to upgrade its forecast for US growth (Exhibit A). Despite recent concerns about the impact of the COVID-19 delta variant, it is increasingly unlikely that global governments will impose another lockdown, particularly in developed nations with relatively high vaccination rates.
Exhibit A: IMF Forecasts strong real GDP growth
Furthermore, measures of economic sentiment are continuing to indicate growth in both the services and manufacturing sectors, with nearly all of the developed world still signaling expansion (above 50), as shown in the PMIs in Exhibits B & C, respectively.
Exhibit B: Projected growth in the services sector
Exhibit C: Projected growth in the manufacturing sector
Wilshire has been forecasting a shift in consumer preferences from goods to services, which is now coming to fruition based on the personal consumption data in the second quarter (Exhibit D). The continued increase in various indicators of mobility such as traveler throughput is an early indication of the growing demand for transportation services.
Exhibit D: Consumption of services to fuel growth
Sentiment has been gradually shifting during the second quarter and into the third quarter, as enthusiasm regarding the early cycle recovery started to wane (is becoming less positive), and concerns about peaking economic growth in the US. began to surface. As one reliable metric of quality, Exhibit E shows the recent recovery of high profitability relative to low profitability companies.
Exhibit E: Recovery of profitability factor reflective of concerns regarding peaking growth and mid-cycle transition
In the last Macro View, Wilshire noted that “the early cycle recovery and rally may be behind us and there are likely better days ahead for high quality companies,” which has come to fruition.
While Wilshire has been expecting this change in market leadership, they can’t dismiss the impact of some of the recent tailwinds for the performance of high-quality equities, such as concerns regarding the COVID-19 delta variant and the prospect of less accommodative policy. Irrationally low nominal and real yields may imply that these concerns are overdone. It has become increasingly clear that the equity market is taking cues from the bond market, and as yields on US Treasury bonds began to decline, investors began to favor higher quality “defensive growth” equities and secular growers, the latter of which are very supported by unusually low real yields.
As investors move past these concerns, we may again begin to see a preference reemerge in favor of more cyclically sensitive, reopening related sectors of the market, which may not bode well for high quality companies in the short-term.
It is generally beneficial for investors to maintain a diversified approach and some degree of balance between quality and deeper value exposures, as well as asset classes (stocks vs bonds) and geographies (US vs Non US) which may facilitate meaningful diversification benefits in portfolio structure, particularly at this point of the cycle.
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