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Five insights in five minutes

Five in Five: US inflation, HY, Europe equity, China internet, carbon
16 July 2021

    US inflation

    Our recent India Insights report explained that the pop in inflation there was due to short-term supply-side constraints feeding into food and beverage prices. Meanwhile, in China Insights, we showed that the correlation between mainland producer and consumer prices has actually been negative for the past five years. This week the debate over whether inflation is transitory or not moves to America, with June posting the highest annual rise in prices in three decades (if you exclude a blip in 2008 when oil spiked to $150 per barrel). We remain in the transitory camp, and calculate that two thirds of the month-on-month increase was due to energy and sectors that are re-opening post pandemic, such as used and rental cars, airlines, restaurants, hotels and so on. Inflation alarmists also point to more US small businesses raising prices than at any time in 40 years, and job vacancies at a record high. Whether there is slack in the labour market is hence a key question. One little-discussed observation suggests there is: Americans are re-joining the workforce at a much faster rate in states that ended pandemic benefits early. As more states follow, wage pressures should moderate.

    Investment relevance: all asset classes

    US inflation 

    High yield

    In their hunt for income, investors continue to embrace global high yield corporate bonds – and rightly so as economies rebound and cashflows surge (see note beneath). Although this has pushed yields to record lows, high yield credit spreads remain almost four times higher than their investment grade peers (350 versus 90 basis points) as of the end of June. Selectivity within the asset class remains key. Even if default rates are minimal for the remainder of the year (1.8 per cent according to Moody’s baseline scenario), spreads offered by the most fragile of high yield issuers (bonds rated CCC and below, representing around a tenth of the global market) barely overcompensate the risk. Hence our fixed income team sees far more value at the opposite side of the spectrum, within BB-rated issuers. So-called ‘fallen angels’ soon to be restored to investment grade status are particularly attractive. Finding yield these days is harder, but there are still pockets of opportunity for active asset managers to dip into.

    Investment relevance: global high yield, Asia high yield, emerging market high yield

    High yield 

    European equities

    Contrary to what our readers in Italy or England may think, not everyone on the planet was following the European Football Championship over the past month (especially in South America!). But there are a trillion reasons why global investors should be eyeing the region’s equity markets. Thanks to Europe’s economy kicking-off, companies in the Stoxx 600 index, excluding financials, will make almost €1 trillion of free cash flow over the next two years, according to Bloomberg consensus data – no doubt spurring a leap in shareholder payouts or mergers and acquisitions, or both. If firms did nothing, net debt-to-ebitda for the benchmark would fall from 1.7 to 1.2 times. That would be the lowest level for a decade, and hence it would be inconceivable that European corporates wouldn’t begin raising debt. Assuming an appropriate leverage ratio for each sector between one time for cyclicals and three times for defensives, another €900-odd billion of funding could be available – making dividends, buybacks or deals even more likely. Fortza Europa!

    Investment relevance: European equities, global equities, multi-asset, European credit

    European equities 

    Chinese internet stocks

    The CSI Overseas China Internet index and the Dow Jones Internet Composite index were marching arm in arm out of the March 2020 valley, until they didn’t. April this year marked the point of separation, since which the Chinese internet index has dropped 16 per cent whereas its US counterpart has gained 12 per cent. Clearly there is uncertainty arising from Beijing’s increased regulatory scrutiny over its own tech giants, as we wrote about last week. But President Biden also signed an executive order last week that addresses anti-competitive conduct in the internet sector, proving that stricter regulation is not exclusively a Beijing phenomenon. Not to mention the stronger fundamentals the main Chinese players have relative to their American peers – for example revenues have grown more quickly than they have for Fang stocks over the past five years, as seen in the chart below. And from a valuation perspective, the median 5.4 times enterprise value to sales ratio of the Chinese ‘big four’ is more attractive than the Fang’s 7.9 times.

    Investment relevance: China equities, Asia tech, emerging market equities

    Chinese internet stocks 

    Carbon costs

    The European Union this week proposed far-reaching plans to more aggressively reduce carbon emissions. This includes adding more industries under the Emissions Trading Scheme, through which companies must essentially pay to offset their emissions, and accelerating the reduction of carbon allowances. In our Mid-Year Outlook we highlighted the potential for carbon offsets to be portfolio diversifiers, given their independent set of price drivers. As regulations tighten, carbon prices are set to continue their steady ascent – up nearly 70 per cent this year alone in the EU. Adding to the good news for clean energy investors, US politicians joined Europe in proposing a carbon tax on imports. Should these plans become policy, it means carbon-intensive exporters such as China and India would be incentivised to speed up their energy transition plans, which, per the chart below, have lagged. Indian exports, for instance, are more than four times as carbon intensive as the US, and ten times more so than the EU.

    Investment relevance: emerging market equities, Asian equities, European equities

    Carbon costs 


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