During our recent strategy week, when LGIM’s investment teams gathered to debate the market outlook, we concluded that we’re more comfortable regarding the next three months or so – but probably more worried looking into 2022.
Over the shorter term, we think the weaker US job numbers and the lingering virus uncertainty mean that the Federal Reserve (Fed) is unlikely to signal a tightening of policy prematurely. Policymakers might bring up the topic in their July meeting, but are more likely to wait until September, in our view.
Even then, we think quantitative-easing tapering will only start towards the end of the year. So markets, for now, should continue to be buoyed by bond purchases and extremely loose liquidity conditions.
We have recently seen two very strong inflation prints, and like all economists, the Fed will be busy increasing their inflation forecasts. The consensus is firmly of the opinion that this rise in prices is temporary, but there is an increasing risk that it proves stickier than hoped. However, the debate won’t be resolved until later in the year and we doubt the US monetary guardian will change its mind before then.
Commodities and peripheral spreads
Corporate fundamentals look rosy in the coming months. Strong earnings are helping price-to-earnings multiples to decline and companies to delever. Higher taxes via an international minimum rate or as part of President Biden’s infrastructure plan are a potential threat, but there is a lot of uncertainty around implementation. Moreover, the magnitude is small compared to the large positive earnings surprises we’ve witnessed this year.
Looking further ahead, we can see multiple threats as and when the Fed – and other central banks – tighten policy, as discussed during our recent CIO call. (You can listen to the podcast on Apple, Spotify, our website and Audioboom.)
Meanwhile, rising funding costs via higher short-dated yields or a rallying dollar could undermine popular carry trades and pose questions for over-levered entities. Indeed, we are seeing this take place to some degree in China which is already trying to tighten credit conditions.
Perhaps the current commodity rally could come under pressure. And it’s interesting to note that European peripheral credit spreads are near multi-year lows, even though debt is at the highs. It’s worth noting that we’re not as worried about emerging markets on aggregate as we have been in previous tightening cycles, thanks to generally better debt and current account profiles (although there will always be specific vulnerabilities).
Rise of the bulls
Back to the shorter term. Our biggest concern is probably that investor sentiment is becoming a little too positive and valuations are stretched, particularly across fixed income markets. Nonetheless, our majority view is that risk assets can continue to grind higher over the summer given the very supportive backdrop.