by Thomas Aubrey.
Credit cycle investors have performed on par with the S&P 500 since the beginning of March, with an allocation to US banks followed by US Industrials, generating returns of just over 16%. This performance beat Nasdaq, which increased by just under 12%, global equities at 9% (the UK market also rose by 9%), and US government bonds across all maturities which returned just 2%.
Despite this positive performance, many investors remain somewhat skeptical that the US can continue to outperform other international equity markets such as the UK due to the current level of valuations.
Exhibit 1: Asset class returns
While US equity valuations have dropped recently, US PE ratios still remain elevated compared to global markets, which in turn are higher than the UK. There is no guarantee, however, that cheap assets will increase faster than expensive ones, as there are often very good reasons why those assets are cheap.
Exhibit 2: PE ratio comparisons
For credit cycle investors, what matters most is future profit growth. The ex ante signals for the US equity market continue to be positive across all sectors in terms of trended near term profit expectations, with firms increasing their leverage related to investment which is a positive indicator of higher future demand.
The main concern for investors in the US market is therefore the future level of BBB bond yields, which are used as a proxy for corporate funding rates. BBB bond yields have remained stable since the start of the year, with only a small amount of credit deterioration observed in BB spreads and below from previous lows in the spring.
Exhibit 3: US bond spread indicators
The latest credit transition matrices for North American corporates from Credit Benchmark indicate continuing upgrades for both b and bb obligors with investment grade ratings experiencing similar low levels of negative credit transitions to the 2018-19 period. This data provides further evidence of a positive outlook in the extension of loans across North America, indicating relatively low levels of perceived credit risk by banks.
Exhibit 4: North American corporate credit transition matrices
Source: Credit Benchmark, Credit Capital Advisory
The bond market also reacted calmly to Chair Powell’s speech which stated that conditions have now been met to start reducing monthly asset purchases. Indeed, nominal yields declined marginally on the news, suggesting this is unlikely to derail investor optimism. The outlook for real long term bond yields is still towards zero as inflation falls and nominal yields tick up, returning real interest rates to their pre-pandemic trend.
The decline in real yields throughout the 20th century can be explained by a number of factors, including an increase in savings due to demographic shifts driving up demand for government paper, the falling cost of capital goods and a reduced risk of default. All of these factors continue to be pertinent in today’s market.
Exhibit 5: Downward trend in US long term bond yields
Source: Homer/Sylla, Federal Reserve, Refinitiv Datastream, Credit Capital Advisory
This leaves inflation as the major potential concern for investors in terms of its impact on bond yields. The main factors that continue to maintain higher inflation, besides food, are energy and new vehicles, which have been affected by the pandemic in terms of a fall in demand, followed by a jump in demand that has not been satisfied by new supply.
Key inflation indicators highlight falling commodity prices alongside the stabilization of shipping rates, while China’s PPI for manufacturing also flattened last month. While this provides evidence of capacity related issues being addressed by the market, the ongoing pandemic appears to have constrained the speed of this increase in supply, hence the delay to the downward transition phase.
In addition, the US labor market shows no sign of roaring out of control with private sector payrolls growing just under 4% per annum. The rate of growth in prices can therefore be expected to decelerate from next month and trend down below 4% by the end of the year.
Exhibit 6: Key inflation indicators
While the US market outlook remains positive, it is feasible that cheaper markets such as the UK could grow faster. However, a brief look at the UK suggests that the US could well continue to outperform.
The UK has been affected by a once-off protectionist shock due to its exit from the single market. Such an increase in costs will depress short term profits, hence the underperformance should not be a surprise.
In addition, the significant fall in trade openness of the UK economy of 11%, stemming from a lurch towards protectionism, is likely to lead to relatively higher inflation. This compares to Germany which has seen an expansion in trade openness by 5%, supported by an undervalued currency. France has seen a small negative shock and the US a 5% fall, although crucially it remains on an upward trend.
Exhibit 7: Trade openness comparisons
As argued here, the extent of trade openness has a significant impact on the slope of the Phillips Curve, which is one key reason why inflation has been so subdued during the era of hyper-globalization. The move towards greater globalization following the period of stagflation in the 1970s was conceived by capital as a solution to reign in what it saw as the excessive power of labor. Hence, any significant retrenchment from globalization is likely to affect inflation.
A recent update of this analysis based on a new long term unemployment series indicates that between 2002-2016, UK trade openness averaged 0.56, which corresponded to a slope of log changes of -0.8. This compares to the steeper curve of -1.1 for the period 1972-2001 with an average trade openness of 0.48. This suggests that the slope of the Phillips Curve is likely to steepen to around -0.95 unless the UK government decides to reverse its current protectionist stance.
Data from the UK labor market is beginning to show signs of tightening compared to the US with the UK PAYE labor force data likely to surpass its pre-pandemic level in the next few months, and record job vacancy rates indicate that the PAYE numbers can be expected to continue to climb. The high and much cited vacancy levels are likely to be somewhat inflated by timing factors given that it is hard to hire people quickly, which drives up cumulative vacancy rates.
This has resulted in private sector nominal wage demands jumping by more than 10%, although this has been inflated by lower base effects from last year as well as compositional effects given that it was largely lower paid jobs that were furloughed. However, if one assumes that outside the pandemic earnings would have continued to rise by 2%, then the recent jump is still over 5%; significantly higher than in the US. Furthermore, the increased demand for labor may well be exacerbated by the fact that many EU nationals left the UK during the pandemic, although it remains unclear just how many. This comes on top of continued undercounting of Europeans living and working in the UK with many more workers applying for settled status than expected.
The recent slowing of prices to 2.1% in July from 2.4% in June indicates that inflationary pressures due to rising labor costs have not yet begun to filter through to inflation. However, the steeper Phillips Curve indicates an increase in inflationary pressures for the UK with prices accelerating faster than the US by the end of the year. This will place downward pressure on profits, dampening any acceleration in profit growth.
There are often very good reasons why cheap stocks remain cheap, and for the UK this is likely to be due to relatively higher inflation.
Thomas Aubrey is the founder of Credit Capital Advisory.
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