Themes investors should keep a very close eye on
Equity markets appear to be taking a bit of a breather after rebounding back earlier this month to new highs, but conservative investors haven't fully participated due to the sell-off in bonds this year.
Take a look at the Vanguard Balanced ETF Portfolio, which is up 4.5 per cent this year.
We worry that fear-of-missingout (FOMO) could entice these investors to onboard more risk at the wrong time, chasing equities when we are long overdue for a bull market pullback.
Others have the same worry. According to a recent Bank of America survey, 47 per cent of professional investors expect a correction of five to 10 per cent and another 29 per cent believe the market could fall as much as 15 per cent.
However, this doesn't mean investors can't tweak their portfolio's asset weightings to take advantage of potential macroeconomic strategies that seem to be dominating the forward outlook. In this regard, we see three major themes worth keeping a very close eye on.
CENTRAL BANK TAPERING AND INTEREST RATES
Central banks will likely do everything in their power to keep interest rates lower for longer given the incredible amount of debt being taken onboard.
Essentially, governments, including Canada's, are using COVID-19 as a means to implement massive social, infrastructure and climate-change fiscal programs, forcing their bankers to adopt Modern Monetary Theory and print enough money to buy all the debt being issued.
The goal is to let inflation run higher — that is, more than three to 3.5 per cent — to create the ideal situation for growing their way out of debt while keeping debt-servicing costs down to a so-called manageable level, and then bragging about it by comparing it to GDP.
The bond market is doing a good job of factoring this in and so there may not be a lot of near-term juice left in those sectors playing the rising interest rate trade — at least for now, anyway.
For example, United States Treasury yields actually fell last week on signs that the U.S. lost some of its startup momentum economically, surprising many.
This could mean that while duration risk has been somewhat diminished, bonds, for the most part, could be a dead money trade over the remainder of the year.
TRANSITORY OR STRUCTURAL INFLATION
The big question everyone is asking is whether inflation will be transitory or structural in nature as we move further into the economic recovery and last year's low baseline comparisons rise.
Just as with the work-fromhome scenario, we believe the safer bet will be on a bit of both, meaning inflation in some sectors will be transitory and in others it will be structural and more permanent.
For example, service sectors such as consumer discretionary, airlines and hospitality should normalize in time, while other segments like real estate and banking should continue to benefit from sustained higher activity levels, especially as interest rates stay suppressed.
Energy is a tricky one, since demand should also normalize, albeit at a higher level in a POSTCOVID-19 semi-inflationary world, but the sector has been severely undercapitalized, which could mean even higher energy prices.
Natural gas is apparently so scarce in Europe at the moment that coal-fired generation is being ramped up in order to meet normalized power demand. Materials sectors such as gold, silver and the miners could also be facing a similar situation.
THE COST OF LABOUR AND CAPITAL
We are already seeing some signs of wage hikes in order to entice employees back to work and off government assistance. Supply shortages and higher transport costs are also playing an important role, since consumer-sector companies have no choice but to compress their margins because only so much of these costs can be passed along to consumers. This will, in turn, affect future earnings and profitability for those companies.
On the other hand, interest rates, as long as they stay low, will benefit the capital-heavy and less labour-intensive sectors such as large-cap growth stocks in the technology sector.
Highly speculative segments of the market, like Bitcoin, special purpose acquisition companies (SPACS) and even meme stocks, are a good indicator of the broader availability of capital.
Understanding the macro risks should be a key part of tactically managing your asset allocations between bonds, equities and segments within the market.
Even though balanced portfolios are offering more moderate returns, most conservative investors, at a minimum, should be more than happy with a six-month gain of 4.5 per cent, so they should not get caught chasing returns.