May 2021 Market Commentary — Hoxton Capital Management
During the past few weeks there has been a market sell off which has been relatively unimpactful for well diversified model portfolios. There are signs that inflation may be picking up faster than expected which have heightened investor tension. The primary concern about inflation and that it may impact profit margins and force central banks to start unwinding easy monetary policies sooner than expected.
Inflation, and more specifically, the lack of it, has not been as economists would have expected in the last decade. The expected impact based on the monetary policy stimulus and ever-expanding central bank balance sheets should have led to higher inflation rates than actual data shows. The chart below shows how closely linked inflation is usually to GDP. Recently we can see that there is a disconnect which is the reason we would have expected inflation to increase more over the last few years.
GDP to M1 Money Supply — US and UK
Some of the main reasons that inflation should have increased are:
- Increasing production costs and deglobalisation
- Changing central bank policy frameworks (running inflation above targets)
Increasing Production Costs and deglobalisation
To understand the impact on production costs, it is important to know what a supply chain is. A supply chain is a network between a company and its suppliers to produce and distribute a specific product to the final buyer. This network includes people, companies, information, and resources. The supply chain also represents the steps it takes to get the product or service from its original state to the customer. The main reason companies aim to manage their supply chain is to reduce production cost and remain competitive.
Deglobalisation is currently occurring due to global supply chains no longer being suitable or accessible due to trade restrictions or increased cross border tariffs. This means that companies are having to source materials from local producers, and as such, they have more bargaining power to demand higher prices which are typically passed on to the end consumer (resulting in inflationary increases). This is especially true for companies looking to maintain and increase profit margins. However, prices have seemed to stay fairly stable due to the monetary stimulus which has perhaps delayed the inflationary impact that should have occurred.
Changing central bank policy frameworks (running inflation above targets)
Central Banks such as the Bank of England (BoE) are amending their policy frameworks intending to push inflation targets above their usual levels. In the US, the Federal Reserve has adopted a new policy framework and it will deliberately push inflation above its 2% target to make up for the past shortfall. There are also expectations for rapid economic expansion due to a positive outlook when economies open up to a post Covid world. This should again result in repatching supply chains, reducing product cost, creating jobs and increasing GDP.
There does not seem to be a well-defined ‘exit strategy’ from recent and expected financial stimulus. It is thought that it may take over 30 years to unwind the last decade of stimulus packages in the developed world. The inflation dynamics at play, combined with perceived constraints on central banks to raise interest rates in an environment of rising and elevated debt, could call in question the credibility of inflation targets and confidence in central banks.
Market Valuations and Inflation
Markets may have already moved to price in higher inflation expectations. At the end of March, the S&P 500 index was valued at 34 times its earnings over the past 12 months meaning markets are seemingly well overvalued. The second quarter of 2021 is already well underway and risky assets continue to outperform bonds and cash by a wide margin. We have seen historically that even when markets seem very expensive the markets keeps rising.
The Cyclical Adjusted Price Earnings (CAPE) ratio aims to smooth out company profit fluctuations to further justify if a market is overvalued. As you can see from the below chart, the pink coloured areas show that even when the CAPE ratio is extremely high, the market can keep going upwards in trajectory. In 10 of 14 cases, the US market delivered a positive return over the period when it was more than 50% expensive than it should have been. This essentially means that using historical data suggests that remaining invested is the correct course of action to take.
CAPE and the S&P500 Total Return Index (Nov 1980 to Nov 2020)
Even if valuation levels in most equity markets seem generous, the cycle remains favourable for riskier assets. Global demand, earnings growth and inflation are just around the corner based on predictions of the short term and progression made to subside the pandemic (although covid variants are still a major concern). Considering the general positive outlook, nothing seems to justify a rebalancing of portfolios in favour of defensive assets such as bonds or gilts even if we are entering a more mature stage of the market, and timing the top of the market is extremely difficult and usually ends in catastrophe. Research shows that shifting fully out of stocks on the basis of intimidating valuations has been a losing strategy time and time again. One of the best things to do for peace of mind is to look at a zoomed out picture of the market (like the above chart), take out the timeline from the bottom, and look for the corrections. They are really difficult to find unless you know your market history really well.
Originally published at https://hoxtoncapital.com on June 2, 2021.