The emergence of the Delta variant of COVID-19 has once again cast a shadow over the economic recovery and left some investors questioning whether it is in fact broken.
It has been quite an about-turn. Only a month ago investors were fretting about significantly higher economic activity, inflationary pressures and the prospect of the Federal Reserve (the Fed) tapering too quickly to bring the economy under control, with some even questioning the Flexible Average Inflation Targeting Framework (FAIT) introduced by the Fed only a year earlier.
With US 10-year treasury yields falling close to 40 basis points in a few weeks and cyclical value stocks slumping at the same time, it appears some investors believe the entire economic recovery - rather than just inflationary pressures - could be transitory. Indeed, with US 10-year real yields at -1%, breakeven inflation (a market-based measure of inflation expectations) at over 2% and a curve that is pretty flat, levels would imply a rather abrupt end to the current post-corona economic recovery - making it one of the shortest economic upswings in documented history.
To be clear, valuations remain as unappealing as ever, geopolitical tensions continue to simmer and the recovery appears more uncertain than a few months ago. However, similar to early 2020 we encourage investors to look through the noise and focus on their long-term investment strategy.
Despite issues with the Delta strain, data prints are still okay and we remain confident that the economic recovery is intact. In the US, earnings have been upgraded for 14 consecutive months and while inflation continues to be a concern, wage growth remains tepid (for now) leaving us confident of earnings prospects. We believe that the S&P can sustain these high multiples as long as real yields remain negative.
Regarding the FAIT, it appears there is confusion in the market as to what the Fed actually wants to achieve. The flatter curve appears to point to a focus on a 2 to 3-year horizon for inflation, however, if the Fed does actually look at longer term inflation (as we suspect it does) then the Economic Symposium at Jackson Hole, appears a good place to provide clarification on the framework. With the possibility of some taper talk mixed in, real yields could become higher and steeper quickly, providing an environment for the value trade to reemerge.
To summarise, it is our belief that the recovery is still intact, which coupled with the expectation of strong earnings revisions and the potential for higher yields, frames our view that there is scope for equities to grind higher from here.