The pandemic continues to be the dominating force in global financial markets. Even as the 4th Covid-19 wave subsides, persistent supply shocks, their effects on prices, growth and inflation expectations, and central bank policy have all pushed volatility higher and confidence lower.
The decline of the Delta variant finally ushered in the strong cyclical bounce back we have been expecting, and our active returns have benefitted accordingly. We expect this positive theme of economic reopening to continue; however, we think it is prudent to add ballast to our broader reflation positioning, lock in some gains, and position the portfolios for continued choppiness.
Our Q4 trades seek out attractive opportunities in both equity and fixed income markets, while continuing to watch out for risks and factor in near-term uncertainties. We see a potential upside for improvements in the U.S. labor market, anticipate the Fed staying the course with interest rates, remain bullish on energy stocks in particular, foresee potential returns with Covid-era “Fallen Angel” bonds, and continue to increase exposure to U.S. treasury inflation-protected securities (TIPS). At the same time, we are reducing exposure to Emerging Markets (EM) and modestly recalibrating to gently pull back on risk. We outline our key takeaways and trade details below in more detail.
Key Takeaways
Accelerating Vaccinations Bolster the Economic Restart
With 56.4% of all eligible American adults being fully vaccinated for Covid-19 (as of mid-October) and death rates on the downward trend, we believe the macroeconomic backdrop remains positive and supportive of risk-taking, particularly in equities. Even with the emergence of the Delta variant and other strains, significant progress continues to be made in the fight against Covid-19. Combined with strong U.S. fundamentals and improving economic data, this is a very positive development for markets.
Potential Upside for Improvements in U.S. Labor Market
The number of U.S. job openings are at a record high and those employed continue to quit their jobs at record rates. In fact, the U.S. Bureau of Labor Statistics reported 10.4MM job openings and 7.7M people unemployed in September, an excess of 2.7MM available jobs.
At the same time, the federal pandemic emergency programs are expiring. Since the late summer, the U.S. labor market has seen a massive drop in total continuing jobless claims (about 7MM claims, or 90%).
The combination of the timing of these two factors could potentially help ameliorate the worker shortage. We are waiting to see if expiring federal programs result in bringing people back to take available jobs in the labor force, significantly lifting employment readings, boosting payrolls, and taking some pressure off wage increases.
Current Inflation is Powerful, But Likely Not Here to Stay
We see a number of short-term and medium-term elements contributing to inflation, such as supply-chain constraints, record consumer savings, rising wages, housing and rent costs, and energy prices. While inflation is certainly heating up, longer-term deflationary factors are also at play, like an aging U.S. demographic and increasing use of technology in production.
We’re positioning our portfolios for the medium-term: build a defense against inflation risks, but also treat it as an opportunity - especially in equities, energy, and commodities. We anticipate headline inflation to come in above the Fed target levels due to global supply shocks, and the Fed will follow their August 2020 “average inflation targeting” strategy - letting both inflation and the economy run hot.
Our positioning also reflects the potential risk that both investors and policymakers will incorrectly perceive the current supply shocks as being more consequential than they actually are, resulting in a sharp rise in inflation expectations.
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Energy Stocks an Attractively Value Investment and Inflation Hedging Asset
In our March trade earlier this year, we introduced an exposure to U.S. energy stocks, anticipating the economic recovery would result in increased demand. Since then, we’ve seen both Oil (WTI Crude) and U.S. Energy stocks soaring, with oil up over 70% YTD (Year to Date) and U.S. Energy Stocks up over 50% YTD.
Despite the performance gap between oil and energy stocks, we are still bullish on energy stocks in particular. We see an acceleration in pent-up travel demand with increasing bookings for the holidays. We also see demand picking up as temperatures start to fall in the Northern Hemisphere, particularly in China, triggering fears of whether they will be able to meet domestic heating needs.
As far as oil is concerned, despite pressure to increase production, OPEC+ has confirmed that the supply will stay the same - spiking oil prices sharply higher. It is forecasted that crude oil demand will only catch up with supply by Q4 of 2022. For these reasons, we believe energy stocks are an attractively valued investment and inflation hedging asset on the equity side of the portfolio.
Across Bond Markets, "Fallen Angel" Debt has Potential to Deliver Attractive Returns
Fallen Angel debt refers to former investment grade bonds recently downgraded to speculative grade. Essentially, the condition of the original bond issuer has been weakened to the point that the bond is now “junk.”
Despite their status as “junk bonds” or “fallen angels,” we have historically seen that an average of 15% of these bonds actually become “rising stars” and are upgraded within 12-36 months after their downgrade.
Covid-era fallen angels are following a similar trajectory to past cycles with about 4% being upgraded so far. We see an attractive case for potential future upside performance here, especially considering the magnitude of bonds that were downgraded or fell to “fallen angel” status last year.
Growing Near-Term Worries Call for Prudence and Allocating Risk Budget
We have sought out attractive opportunities in both equity and fixed income markets; however, we continue to watch out for risks in our clients’ portfolios.
Near-term uncertainties include the current showdown unfolding on Capitol Hill as Democrats attempt to pass a massive infrastructure spending bill and offset the cost with a new tax policy. Second, global growth has slowed since midyear with much of the concern stemming from disruptions in global supply chains and overall supply shortages in labor, transportation, finished goods, delivery times, and retailing. Third, as discussed above, some investors are questioning the Fed’s resolve to stick to its new policy stance and keep short-term interest rates pinned near zero as inflation runs hot.
These near term risks have resulted in choppy markets, and investors expect the volatility index to increase from its current level. While we advocate for patience for all, we believe it is prudent to gently pull back on risk.
Developed Market (DM) Equities Still Preferred Over Emerging Markets
In contrast to continued progress coming out of the pandemic for the U.S. and EU, sluggish earning expectations for Emerging Market (EM) equities keep us cautious on the region.
Our current exposure to EM is highly concentrated on China (from a country perspective) and in technology (from a sector perspective). With respect to China, growth has slowed sharply this year as fiscal and credit supports have been removed and restrictions have been imposed on housing and coal production. With this growth slowdown and our research showing improving trends in Developed Markets (DM), we will lean more into Developed Markets heading into year end.
Trade Details
- Our portfolios remain positioned for reflation and overweight equities, but have been modestly recalibrated with less active risk and reduced sensitivity to sector bets
- Moving further underweight Emerging Market equities, due to deteriorating regional forward-looking earnings data, as well as regulatory and debt crisis headwinds out of China
- Adding to Fallen Angel debt to position for growth, expecting this slower than usual upgrade cycle to begin to pick up as business conditions continue to improve
- Increasing exposure to U.S. treasury inflation-protected securities (TIPS), seeking to mitigate equity risks with the relative quality and resilience of government bonds, but with a hedge to rising inflation expectations
