All board the Orient Express

One theme which continues to exercise financial markets is whether inflation is primed to make a comeback and – if so – what this could mean for asset allocation and portfolio strategies.

Inflation expectations are still ticking higher

Source: FRED – St. Louis Federal Reserve database

The five-year, five-year forward inflation expectation in the US now stands at 2.11%, its highest level since December 2018, and financial markets are beginning to react: bond yields are ticking higher, Bitcoin is going bananas while gold holds relatively firm and, within equity markets, cyclical growth (or ‘value,’ for want of a better word) is again trying to cast off a decade of underperformance relative to perceived secular growth sectors such as technology.

As this column has suggested before (30 October 2020), the battle for portfolio style (and performance) supremacy within equities can be seen by comparing the returns provided by two exchange-traded funds (ETFs) in the US: the QQQ Invesco Trust, which follows the price of the biggest non-financial stocks on the NASDAQ, and the Russell 2000 Value ETF.

If the line on this chart goes up, ‘growth’ is outperforming. If it goes down, ‘value’ is outperforming. As can be seen, cyclical growth can point to a streak of outperformance that stretches back to summer 2020.

Cyclical growth (or ‘value’) continues to stealthily outperform secular growth

Source: Refinitiv data

But this trend can be seen in another way too, this time on a geographic basis. Over the past decade, advisers and clients have adapted to the low-growth, low-inflation, low-interest-rate environment by buying long-dated assets such as bonds and equity growth (such as technology stocks), and forgetting about commodities, cyclical equities (‘value)’ and emerging markets. Yet as inflation threatens to creep back onto the radar, perhaps for the first time in 40 years since then Fed chairman Paul Volcker set about wiping it out, emerging markets are coming back into fashion too.

“As inflation threatens to creep back onto the radar, perhaps for the first time in 40 years since then Fed chairman Paul Volcker set about wiping it out, emerging markets are coming back into fashion too.”

This can be seen using the same technique as before, this time by dividing the performance of America’s S&P 500 index by the MSCI Emerging Markets (EM) benchmark. American outperformance peaked in September, since when emerging arenas have done better.

Are equities on the verge of favouring emerging over developed markets once more?

Source: Refinitiv data

Clear pattern

“If commodity price strength, dollar weakness and rising inflation expectations continue to coincide, then we could see a third major period of emerging market outperformance relative to the US (and by implication developed markets), to match those of 1988–1994 and then 2000–2010, at least if history is any guide.”

This return to form for emerging markets coincides with a period of strength for commodity prices (27 November 2020) and dollar weakness (4 December 2020). Whether it lasts may hinge to a great degree on those two trends, which also tie into the inflation narrative. If those three continue to coincide, then we could see a third major period of emerging market outperformance relative to the US (and by implication developed markets), to match those of 1988–1994 and then 2000–2010, so this EM resurgence must be monitored closely. If it proves to be no mere flash in the pan, then it could have profound portfolio implications.

The resurgence of EMs can be seen by digging deeper into geographic performance trends, too.

Japan may be the best performer, in total-return, sterling-denominated terms over the past 12 months, but Asia is a close second. The data from just the past six months – when cyclical growth, or value, began to try and forge its latest comeback – show outperformance from not just Asia, but the Middle East and Africa, Latin America, and Eastern Europe, too.

Emerging markets are forging a comeback

Source: Refinitiv data

East of Eden

“The shift to cyclical from secular growth can also be seen by looking at individual Asian countries. Global export plays like Korea and Taiwan have done well of late, but tourism and travel destinations like Thailand and Hong Kong are clear laggards.”

The shift to cyclical from secular growth can also be seen by looking at individual Asian countries. Global export plays like Korea and Taiwan have done well of late, but tourism and travel destinations like Thailand and Hong Kong are clear laggards. Perhaps South East Asia becomes the next leg of the post-vaccine, global upturn story.

Country performance trends within Asia also hint at markets’ desire to price in an economic upturn

Source: Refinitiv data

There may be other reasons for the return to form of EM, beyond commodity strength, dollar weakness and markets’ preoccupation with inflation and a near-term economic recovery, as this column hinted just under a year ago (SHARES, 16 April 2020).

Perhaps Asia’s outperformance reflects the view that region was first in and first out when it comes to the global pandemic (even allowing for recent local flareups). Given the experience of SARS in 2002–3, Asia may have been better prepared and equipped to deal with such a situation. In addition, Asian nations learned harsh lessons about debt during their currency crisis of 1997–8 and as a result aggregate government borrowing levels are generally much lower as a percentage of GDP than they are in the West.

Such facets could help to shape long-term outperformance too, especially as soundness of finances usually wins out in the end.