The last week was notable for the escalation in the Chinese authorities’ efforts to clamp down on the growing influence of large domestic companies (primarily tech related). The chart below shows the divergence in performance between Chinese Tech and US based technology companies, following a period of high price correlation. It does appear that investors judge the Chinese efforts to be contained to specific domestic concerns and do not expect it to spill over into the wider technology space.

Source: Strategas Research Partners

Also notable, is that despite the weakness in Chinese Tech and the economic impact of the increased government restrictions, cyclical companies in the Asia Pacific market have made new relative highs after three months of consolidations (first graph below). European cyclicals have done the same with firmer price action in the Industrials, Materials and Energy sectors (second graph below).

Source: Strategas Research Partners

Source: Strategas Research Partners

INCREASING DEMAND OF INDUSTRIAL METALS

The single most important piece of the cyclical recovery puzzle not in place is the failure of global bond yields to respond by moving higher. We highlighted the chart below just last week but thought useful to reproduce given the sharp rise in industrial metals during the week. The price of industrial metals (increasing demand due to rising economic activity) relative to precious metals (commonly used to hedge against economic uncertainty) is often a reliable indicator of expected economic growth and therefore interest rates. The gap between the relative performance of industrials metals and interest rates has widened further during the week. To repeat, one of these lines must give shortly – either rates are to rise, or industrial metals must experience a sharp price reversal.

Source: Strategas Research Partners

THE ‘TRANSITORY’ INFLATION

It seems that investors have given up on the prospect for higher rates, buying into the Fed rhetoric of transitory inflation which the Fed Chair, Powell, reiterated again last week. The same week that US Q2 core inflation printed at +6.1% – the highest rate since 1983 (first chart below). What is clear is that while transitory was initially used at the beginning of the year to mean a few months, Powell is now using the same word in the context of a period stretching much longer into 2022.

Source: Strategas Research Partners

This debate will take some time to be settled. Our concern is simply that the current low level of interest rates provides no valuation buffer should inflation rates prove more stubborn even at much lower levels. We do not need 1970s levels of inflation to cause a bond market sell-off. It just requires longer-term inflation expectations to get embedded at +3%. There are early indications that inflation is starting to seep into rents and wages (previously not impacted by rising commodities and supply bottlenecks). The chart below shows that a recent survey among US small businesses now places inflation at the top of their concern list.

Source: Strategas Research Partners

The future path of inflation is obviously important due to its impact on interest rates and financial asset valuation. It also can have a significant impact on corporate profitability if companies are unable to successfully mitigate rising input costs. So far companies have managed the early price rises through raising selling prices or improving productivity. That said, certain sectors are already starting to reveal the pain as evidenced by reduced profit outlooks by several Global Consumer Staple companies during the past few weeks. Corporate profitability currently rests at historic highs (chart below) and earnings expectations are elevated. Turns in profit margins have historically coincided with sizeable market declines.

Source: Strategas Research Partners

While we will continue to closely monitor for any signs of persistent inflation, we are enthused by the recent uptick in cyclical performance confirmed by the strong corporate results so far for the vast majority of our holdings. Despite some concerns as outlined above, global equity markets (ex-China) remain in healthy uptrends (table below) supported by accommodative policy.

Source: Strategas Research Partners