Please see below the latest article from the Legal & General Asset Allocation Team which was received on 06/09/2021 and details their thoughts on markets:
Dancing in the dark
Markets remain in a holiday mood. The narratives on which we are focusing are slow-moving – inflation, the Delta variant, and the usual politics and economic datapoints. Could it be that investors are dancing in the dark, totally oblivious to the risks out there?
As with all Key Beliefs emails, this email represents solely the investment views of LGIM’s Asset Allocation team.
The Jackson Hole symposium is supposed to be a largely academic affair, but it excites investors as we’ve had a few shock policy announcements in the past.
This year, though, Federal Reserve (Fed) chair Jay Powell choose to relax investors. He doubled down on the view that inflation is likely to prove transitory, and gave five reasons to believe recent elevated readings could be temporary:
1) The lack of breadth behind the inflation spike. We largely agree with this assessment. However, we will be watching carefully should we see signs of broadening, especially in traditionally more sticky services.
2) Moderating inflation in pandemic-sensitive components. No dispute from us here. Used-car prices appear to have flattened off and indeed we expect them to become a large drag on inflation in 2022 as prices fall back to more normal levels.
3) Wages that remain consistent with inflation goals. While true, it is surprising that wages have not been weaker given the rise in unemployment. With demand expected to continue growing well above trend, if participation fails to fully recover the danger is that wage pressures intensify next year.
4) Stable long-term inflation expectations. Again true, but our research finds that the formation of inflation expectations is largely adaptive, so the risk is that the longer actual inflation remains elevated the more it might begin to place upward pressure on inflation expectations.
5) Global disinflationary pressure. Powell believes there is little reason to think this has suddenly reversed or abated. We nevertheless find evidence that some of the factors could be moderating, as globalisation seems less intense with countries increasingly looking inward and becoming more protectionist. Fiscal policy, while not yet fully embracing modern monetary theory, appears far less disciplined. Finally, and perhaps most important, is the shifting behaviour of central banks, led by the Fed. Its new framework is a commitment to run the economy hot, partly because it believes continued global disinflationary pressure and well anchored inflation expectations will ensure any inflation increase is so gradual it will have time to adjust policy smoothly.
All in all, Powell could well be proved correct. We also expect inflation to fall back to target for a while next year, but risks to this sanguine inflation outlook appear to the upside.
The power of love
If you ever need a clear example of the power of Strategic Asset Allocation (SAA), compare the performance of UK mid-cap managers versus US large-cap managers over the five years ending June 2020. The best-performing UK managers achieved 36.7%, while the worst-performing US large-cap manager performed slightly better with a 36.8% return. SAA drives portfolio returns, plain and simple!
There are many different models for SAA, some developed by Nobel Prize-winning economists. One unique point about our SAA approach is that we don’t believe it makes sense to presume that one model is able to capture the ever-changing complexity of financial markets well enough. We try to learn and take something from many different models.
For instance, the Yale model gets lots of attention among investors. It is heavily invested in absolute-return strategies and illiquid assets, and has hardly anything in standard asset classes like government bonds and equities. It helps that the endowment does not run daily or weekly liquidity funds and can spend a lot on fees and governance. We see the value of alternatives as well. They form an important and differentiating part of our strategies, but we look for solutions that fit daily liquidity and a more limited fee budget.
Finally, when it comes to building an SAA portfolio, we believe it is all about seeking exposure to the rewarded risks in a (cost) efficient way, getting rid of unrewarded risks, and trying to prevent a dangerous concentration of risks.
As with most things in investment, SAA is more an art than a science and investors should be wary of putting all their money in one model.
Back to life, back to reality
Perhaps surprisingly given the rally we have seen in equities and the narrative moving at a snail’s pace over the summer, consensus positioning isn’t that extreme.
One of our favourite sentiment indicators, the ‘bull minus bear’ survey of the American Association of Individual Investors, is flagging quite neutral sentiment.
The reality is that many people remain cautious. In our view, the most prevalent worries are:
1) Valuations. People usually point to absolute equity valuations, which indeed are scary, but we think valuations relative to bonds matter most.
2) Potential for rising inflation and interest rates. Though inflation is one of our key worries, we are more relaxed about the downside risks to equity markets from rising inflation and interest rates.
3) Peak growth momentum. The Delta variant and its rolling impact on growth is front of mind for many investors. Although growth momentum is fading, that needn’t necessarily take equities lower. Earnings momentum remains favourable, allowing valuations to drift lower while markets grind higher.
We therefore believe the bullish market case remains in place: the economy seems mid cycle, with massive excess savings, quite neutral positioning, and committed support from central banks.
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