Bumps in the road

Bumpy

Things might get a bit bumpy for markets as the summer draws to an end and “offices” become fully employed again. The easy part of the recovery from the Covid-19 shutdown in 2020 is behind us. In developed economies, most of the working age population has been vaccinated, most social restrictions have been lifted and we are closer to normality in terms of working practices than we were in September of last year. However, the Delta – and possibly other – variant(s) remain a cause for concern as the disease is spreading rapidly through unvaccinated communities and the efficacy of the 2021 vintage of vaccines is being questioned. This is contributing to ongoing disruption in global supply chains and labour markets. I don’t think the recovery and growth outlook is negated by this but there could be some “air-pockets” in the data and in investor sentiment as a result. And for many, inflation and the prospect of tapering will need to be taken into account in managing portfolios.

Shortages

The latest ISM report on manufacturing in the US highlighted the supply disruptions. The various components of the report showed customer inventories still close to record low levels and the backlog of orders at record highs. I caught up with our equity team this week and the anecdotal evidence was all about shortages, prices increase, longer delivery times and distribution difficulties. There was even a suggestion that the “just-in-time” inventory management system that evolved over the last twenty years might morph into something where big manufacturers prefer to hold higher levels of inventories. That has implications for logistics companies, warehouse availability and cost-accounting.

Growth extended

The supply issue has some macro-economic implications. Production can be affected if there are shortages. That can mean shutdowns and layoffs. At the aggregate level there could be some impact on industrial production and employment data. At the micro level, there might be implications for companies in terms of the narrative around earnings reports. However, from a cyclical point of view it means that the expansion is stretched out. Inventory levels will be rebuilt. Employment is still growing. Inflation may last longer but it doesn’t necessarily mean that we are in a new inflation regime.

Recovery to continue

Disruptions and delays to production are important but at this stage not enough to derail the recovery entirely. Consumers might not be able to buy what they want when they want but that is a time delay or substitution issue. Savings may remain higher than desired for longer, until goods become available again. At low income levels, if basic goods supply is disrupted there will be a utility impact that could create political headlines, but it should not be that significant in terms of the overall macro view.

Bumper earnings

Companies are enjoying a bumper earnings year so far. In the Q2 S&P500 earnings reports it was clear that margins expanded again. Whatever costs are being incurred are being passed on. The corporate sector can cope with these supply disruptions. The ISM report’s anecdotal information was that demand remained very strong. Production schedules are being re-shaped to reflect better supply-chain risk management, which is a response to various factors impacting global supply (Covid, Brexit, general shift towards more protectionism). The best companies will deal with this, use it as an opportunity to accelerate “sustainable transitions” – car companies could use production shutdowns to refit for electronic vehicle production, for example.

UK

We are into the bumpy part of the recovery. In some places the bumps are large. The UK is suffering from shortages that are both related to Covid and Brexit. Yet we shouldn’t get too exercised about this. Jobs and incomes are growing, and demand is holding up well. There are marginal shortages of goods, marginal shortages of labour, but the bellwether of the UK economy is the housing market and that is booming.

No tightening still

For monetary policy, now is not the time to tighten. Inflation has jumped higher, but the ex-post look at price indices is likely to show a one-step jump in the level of prices during the Covid-era rather than a steepening of the price curve (inflation). The Jackson Hole speech from Jay Powell suggested that there are two decisions to make about tapering and rate increases. The tapering decision is based on progress towards the Fed’s economic targets – which there is. This allows some flexibility in terms of the timing and scale of running down asset purchases. For rate hikes, we need to see full employment and clear evidence that inflation is running at the Fed’s target. Those conditions are some way off. I still can’t be that bearish on rates when the path of GDP expansion has become a little bit more volatile.

Stay with equities?

Given equity markets are record highs it might be tempting to reduce exposure at current levels, given the potential for some of these supply concerns to impact on the macro data in the months ahead. However, timing a market correction in the hope of selling now to buy back cheaper is not a strategy that I have a lot of confidence in. I remain of the view that, for now, equities are the only asset class that offer any risk premium. There is scant room for capital appreciation in most fixed income asset classes and clearly scope for underlying yields to rise back to the top of this year’s range. As always, the bar-bell of equity and long duration risk in a balanced portfolio remains a strategy that should serve well.

Welcome home CR7

One thing that is not in short-supply is the excitement surrounding a certain Cristiano Ronaldo and his return to Manchester United. He is one of the very few in the global game that has true star quality and I am sure he will bring goals with him to Old Trafford. Yes, he is 36-years old but, as his exploits for the Portugal national team show, he is still a game changer and a winner. I can’t wait for him to stride out next Saturday in a red shirt. Viva Ronaldo!