The global economy is growing rapidly as consumers resume normal economic activity. The re-opening is by no means complete, with levels of international travel still well below the levels seen prior to the COVID-19. Nonetheless, the unleashing of consumers in many large economies has led to a sharp increase in overall economic activity. Naturally, economic re-openings and activity are proceeding at different paces due to differences in vaccination rates.
Inflation spiked during the second quarter. The headline CPI is up 5.3% over the 12 months, the fastest pace since 2008. The spike in inflation to this point appears to be driven by the base effect (comparisons to low post-COVID price levels) and shorter-term factors. The sharpest price increases have been in areas tied to the re-opening of the economy. Our base case is that inflation moderates near central bank targets. However, risks to the inflation outlook are tilted toward the upside.
Despite the spike in inflation during the quarter, the yield curve flattened and long-term interest rates declined. Most of the drop in yields occurred following the Fed’s June meeting, suggesting that market expects the Fed will be willing to act against inflation over the short-term, reducing the risk that it would need to significantly raise rates in the future.
We believe the macro environment remains favorable for equities. Economic growth should remain strong for at least a couple of years, which will help the rally in earnings to continue. The longer-term challenge for investors is that high equity valuations and low interest rates suggest low returns on diversified portfolios.
While the intermediate-term outlook for EM stocks is favorable, in the near-term the headwinds in China and other EM countries are a source of risk. From an implementation standpoint, we suggest investors consider dedicated China allocations and active managers to capture to growth and alpha opportunities.
While we remain constructive on high yield given the favorable economic environment, elevated valuations are somewhat concerning and we continue to prefer the risk to reward of local currency emerging market debt within growth fixed income portfolios.