With Growth and Policy, Which Matters More: Level or Change? Market Update from Hartford Funds
Pandemic risks, persisting inflation pressures, and levels of growth and policy support are driving the economic outlook.
The pandemic’s path remains the key to the economic outlook, and what
we’ve learned about it since last quarter is concerning: Additional variants
are possible (and potentially more transmissible and virulent), vaccine
protection could wane over time, and a significant percentage of the
population may remain unvaccinated. This new reality is reflected in reduced
economic activity (FIGURE 1), the resurgence of growth stocks over value
(as measured by Russell 1000 Growth Index1 vs. Russell 1000 Value Index2),
and a return to record lows in long-maturity yields. On a more positive note,
growth is still strong, economies are unlikely to go back into lockdown, and
stimulus remains supportive. All of this leaves markets caught between two
narratives: The pace of growth seems poised to slow, but the level of growth
is likely to remain above par.
Against this backdrop, we continue to seek a pro-risk stance over the next
6−12 months, preferring equities to bonds. But relative to last quarter, our
optimism is tempered somewhat by a slight downgrade to our macro and
policy outlook—including the potential for modestly slower growth, a slight
reduction in policy support, and inflation that’s more persistent than the
market expects. Within equities, we prefer Europe, which we continue to
believe is on the cusp of economic outperformance, and we have reduced
our emerging market (EM) view to neutral given the high costs of COVID19, high inflation,
and political volatility. We remain moderately bearish on
government bonds in Europe in particular, as yields seem too low given our
macro forecast. Credit spreads3 are generally rich, but we find some value in
bank loans and EM debt.
We have been advocating value-oriented exposure from a sector, market-cap,
and regional perspective. However, given the slightly less favorable fundamental
and policy backdrop, we think asset allocators should be more balanced between
growth and value. We continue to think commodities are supported by our inflation
outlook, and we favor energy and industrial metals, which have historically been
more sensitive to rising inflation than equities and can potentially help hedge
against a rise in interest rates.
Equities: Optimistic on Europe
We are moderately bullish on European equities due to attractive valuations, the
sharp increase in vaccinations, and high savings levels, which should allow for
more robust spending if consumer confidence increases as we expect. We are also
optimistic that Germany’s elections this fall could lead to a more supportive fiscal
environment and one that may influence the broader European stance. While
Europe has evaded the Delta variant’s wrath better than the US thanks to higher
vaccination rates, we are wary of the variant’s unpredictability and the potential
for further spread on the continent.
We’ve downgraded our view on EM equities to neutral as many countries are
experiencing expanding fiscal deficits and high inflation, and central-bank rate
hikes could slow domestic economies. Pockets of value persist among commodity
exporters and countries less dependent on tourism, but differentiation is key. We
would be selective in China given potential weakness in the cycle and uncertainty
related to the government’s regulatory push and deleveraging in the property
industry (FIGURE 2). Within Asia, we are neutral on Japanese equities. We see
tailwinds from cheap valuations and Prime Minister Suga’s resignation, which should
bode well for the business-friendly Liberal Democratic Party. But we are concerned
about China’s slowdown, which may feed through to the broader region.
We maintain a neutral view on the US. We think the US economy will slow somewhat
but stay strong, and consumers are in great shape. While policy support is slowly
declining, it remains highly supportive. Indeed, the Federal Reserve (Fed) seems
convinced that inflation expectations will remain anchored at low levels even as it
keeps its foot on the stimulus pedal. Our view is that inflation could be more
persistent than expected, given challenging supply shortages, rising wages, and
a hot housing market, which tends to lead to sticky shelter inflation. Higher, more
persistent inflation could unsettle equity markets, and valuations are expensive.
Thus, we prefer a quality bias and a balance between growth and value.
Commodities: Strong Fundamentals and a Unique Portfolio Role
We are bullish on commodities given the inflation dynamics discussed, as well
as supply/demand imbalances across energy, metals, and agriculture. Capital
expenditures have been very weak for the past decade following a free-spending
period focused on growth rather than profitability. More structurally, environmental
concerns are feeding into higher costs and potentially lower supply. Our research
shows that commodities have historically been the only asset with a materially
positive beta4 to inflation, so from a portfolio-construction standpoint, we see a
case for at least some commodities exposure.
Low Rates, Tight Spreads: What to Do in Fixed Income?
We agree with market consensus that the Fed may likely begin tapering around
year end. We see the European Central Bank (ECB) as more hawkish relative to the
nominal growth picture in its economy, and we think sovereign rates in Europe are
likely to drift upward. In credit, valuations are rich, with most spreads well inside of
median levels. However, defaults are likely to stay very low, and demand technicals
are strong as demographics and pensions generate huge demand for yield.
Within credit, we prefer EM debt to US high yield as EM spreads are considerably
wider (FIGURE 3). Credit valuations have been a reliable indicator of forward excess
returns—a dynamic we continue to trust. We think Mexico, Russia, and EM countries
in Central and Eastern Europe are attractive. We also prefer bank loans, which offer
attractive valuations vs. US high yield and could benefit from the Fed beginning to
We find securitized credit attractive relative to investment-grade corporates from
a valuation and risk perspective, given the abundance of asset types. We continue
to favor US residential housing, where millennials should be a growing tailwind for
demand. Securitized credit also offers floating-rate structures, which are appealing
from a duration5 perspective. The updated risk factors adopted by the National
Association of Insurance Commissioners may increase demand for AAA- and
Our base case is that central banks have clearly communicated their intentions to
taper slowly, but a policy mistake remains a risk given the amount of liquidity in
the system and its importance to markets. Bumps could occur if the Fed or ECB are
perceived to be too hawkish, or if their plans don’t change quickly enough in the
face of a new variant or other COVID surprise.
COVID remains the boogeyman. Its impact on consumer preferences (more saving/
less spending) could last longer than expected. And with more than five billion
people unvaccinated worldwide, the potential for new, more dangerous variants
requires investors to stay nimble and monitor portfolio risks carefully.
In addition, China’s opaque system is difficult to analyze, and government priorities
aren’t easy to infer. Although not our base case, China’s renewed focus on
socializing wealth via regulations could continue or even increase. China’s housing
market and debt levels are also concerns, as highlighted by Evergrande’s recent
On the upside, two major market drivers, the Delta variant and China’s regulatory
approach, could both ease in the coming months. EMs could benefit if China’s
policymakers temper their tightening of the property market, boost infrastructure
spending, and loosen climate controls—moves that could be spurred by politics
ahead of the National Congress in November 2022.
Markets may also be positively surprised by the patience of central banks and find
themselves awash in liquidity for several more quarters to come. Interest rates may
stay low for an extended period, despite the economic recovery, and risk assets6
could appreciate further.
Finally, our inflation concerns may be ameliorated by a pickup in productivity,
something that many economic models predict and that could be boosted by
government spending on traditional and technological infrastructure after many
years of underinvestment.