2021 Enters the Home Stretch

Variants & Supply Shocks Curbing Recovery Expectations?

Introduction

2021 has passed at what has felt like a rapid pace, as we enter the final quarter of the year already. Inflationary pressures and major supply chain disruptions across various segments of the global economy, coupled with the Delta variant have become the dominant storylines and narrative within financial market coverage.

Amid this, we find it very interesting that the bond market remains relatively sanguine about the specter of inflation over the medium to long term, as evidenced by the muted reaction in yield curves.

Rise of Delta

The rise and spread of the Delta variant has been a major storyline over the summer months and likely will continue to be as we head into the final quarter of year, with children returning to school and warmer weather fading away. The variant has caused market participants to question the continued velocity of the global recovery. The anger of people on all sides of the debate around masking, vaccinations, and lockdowns is a flashpoint for the larger socio-economic issues that have been driving politics in Western economies, and increasingly in China, as evidenced by many of the reforms they are levying on technology businesses, under the auspices of curbing wealth accruing to those in those businesses. This is a trend that is expected to continue to persist.

Despite the uncertainties, equity markets continued to exhibit strength for the 2021 calendar year, albeit equity markets gave some gains back during a relatively weak end to September. In the fixed income markets, we saw marginal rises in yields in North America, with Canada yields rising to a larger degree then the US, and credit spreads remaining tight.

Within equity markets, we had been seeing leadership rotate back towards sectors that had done well during the pandemic and are viewed as more defensive then cyclical. This is in response to the aforementioned growth concerns as market participants begin to view Covid as potentially endemic and something that is likely to be with us in some form for quite some time. However, during the weakness in the back half of September, we saw all sectors selling off outside of energy. 2021 has seen sector leadership fluctuating as future global growth expectations and lingering pandemic scares have caused capital to tactically reposition a few times.

The shift to less cyclical sectors during the majority of the third quarter is somewhat in opposition to credit markets. The below chart from Bloomberg and Deutsche Bank shows the percentage of high yield bonds in the US that currently have yields below US CPI. This is to say, that on a real return basis, these bonds are negatively yielding. Therefore, credit markets are either not worried about inflation persisting, or are pricing in low growth expectations and a possible central bank policy mistake and as such are willing to lock in a negative real rate of return. Regardless, this area of the market bears watching, especially as the Fed looks to ease off their bond buying programs over the remainder of 2021 and into 2022.

Since this is the high yield segment of the credit market, it is easy to extrapolate that investment grade and government credit is also exhibiting this negative real yield dynamic. This highlights the fact for investors that expected returns from the fixed income segments of their portfolios should not be counted on to be a major contributor to overall portfolio returns. This has been something that we have been arguing for a few years now, and our investments into alternative asset classes and strategies are in large part to mitigate this very fact.

Inflation & Cost of Living

Realized inflation growth has materialized quickly as the global re-opening commenced. While there is considerable attribution in this data to low comparable readings during the initial lockdowns in response to the pandemic, how the economic data progresses from here will be very important for central banks, governments, investors, and society at large. It impacts the decision curve for central banks in Canada and the US, who have indicated a willingness to accept some inflation overshooting relative to their target, however, sustained continued growth in inflation could force them to act on interest rates, potentially sooner then they would want.

Moreover, as we can see with the election in Canada, cost of living and affordability is one of, if not the biggest issue voters want to see the candidates and policy addressing. Supply chain constraints continue to remain highly prevalent, as evidenced by many of our portfolio companies conference calls during this earnings season. Several businesses have indicated that as costs rise, they will look to pass on these costs to the consumer. A risk to global financial assets would be an environment where inflation is strong and economic growth is not, commonly referred to as stagflation.

Within our portfolios, we continue to favor a barbell approach that includes some cyclical sector exposure in energy, financials, global infrastructure, and materials that stand to benefit from a recovering global growth environment. The other side of the barbell continues to invest in many of our longer-term secular growth areas, such as cybersecurity, medical devices, and technology. This strategy remains prudent as different potential outcomes will affect these areas differently. Across the portfolio, we remain focused as always on investing in high quality businesses, with strong balance sheets and cash flow profiles. We continue to view businesses with strong moats and pricing power, and real assets such as infrastructure, as natural hedges to inflationary pressures.

For individual businesses, continued supply chain issues, along with tightening labour markets leading to wage growth pressures are front and center. As we enter earnings season again, how companies continue to guide investors in the face of these issues will be important to monitor, as some companies will undoubtedly continue to execute well in this environment while others will struggle. We would expect to see winners and losers continue to emerge and be rewarded or punished accordingly in the marketplace.

Within fixed income sleeves of the portfolio, we continue to remain on the low end of our allowable asset allocation ranges and favour a lower duration profile in our holdings. As we mentioned previously in this letter, we continue to allocate capital to alternative assets and strategies in large part to replace the income from bonds, as the lower yield environment quite simply means that bonds do not provide the same income stream they used to provide to investors.

Global investors will be paying close attention to Covid case rates, particularly as schools return to a more normal state, and winter months begin. Any major change in the global trajectory for re-opening, travel, and consumption patterns would threaten the global recovery.

Another major area of focus for investors will be on global inflationary data. It is fair to say that a large driver of the increases in price level data seen in 2021 can be put at the feet of supply side shocks, and not necessarily demand driven pressures from consumers. If that remains the case, then as the supply side of the equation normalizes, we could very well see inflation readings return closer to central bank target levels. However, the longer the inflation data remains elevated, increases the pressure on central banks to use policy to attempt to curb inflation.