The rapid spread of the Delta variant is challenging the pandemic-response programs of governments throughout the world. Cases are rising even in countries that previously tamed the virus and/or have mostly vaccinated populations. The greater concern has to do with unvaccinated emerging-market countries that may not be properly equipped to deal with outbreaks and, in these regions, case counts may not start to fall until there is more progress on vaccinations or some level of immunity is achieved. The good news, however, is that vaccines are proving effective at preventing severe illness, meaning that hospitalizations and deaths are not rising commensurately with case counts. As a result, the U.K. is lifting all restrictions and COVID-19 measures are being relaxed elsewhere.

Another concern for investors is that economic growth may be peaking after a strong rebound from last year’s deep recession. The eventual scaling back of stimulus and calming of pent-up demand could further weigh on growth and inflation going forward. Purchasing managers’ indices (PMIs) are already moderating in most major regions and suggest momentum in economic growth is declining (Exhibit 1). But it is worth recognizing that these leading economic indicators remain strong in absolute terms and are consistent with a robust economic expansion. While economists look for growth to fall in 2022 from 2021, the consensus estimates for growth next year are still well above those that we have become used to in the post-financial-crisis era (Exhibit 2).

Exhibit 1: Global purchasing managers’ indices

Note: as of July 1, 2021. Source: Haver Analytics, RBC GAM

Exhibit 2: Weighted average consensus real GDP

Growth estimates for major developed nations

Note: as of July 19, 2021. Source: Consensus Economics

Inflation jumps, Fed exhibits patience

Inflation may be peaking after altered demand preferences, constrained supply chains and significant stimulus contributed to a spike in consumer prices earlier in the year. Certain goods and services, such as used cars, have experienced significant price increases while many baskets in the Consumer Price Index (CPI) were little changed. Moreover, measures that aim to remove the effect of extreme price movements don’t suggest that inflation is worryingly high (Exhibit 3). The “U.S. trimmed mean,” for example, is a measure of core inflation that ignores the largest and smallest price fluctuations in the consumer baskets, and this metric’s latest reading is 1.85%, below the Fed’s 2.0% target. We also note that prices of some commodities like copper and lumber have declined in recent weeks, and shipping costs are no longer rising as quickly as they were earlier in the year.  These moderating price trends could mean inflation readings will subside going forward. In fact, market-based measures of inflation expectations have already begun to moderate (Exhibit 4). U.S. Federal Reserve Chair Jerome Powell supports the view that recent price pressures are transitory and that inflation will fall back to more reasonable levels without the Fed having to intervene from a policy perspective.

Exhibit 3: U.S. inflation measures

Note: as of July 19, 2021. Source: Bloomberg, RBC GAM

Exhibit 4: Implied long-term inflation premium

Breakeven inflation rate: nominal vs 10-year real return bond

Note: as of July 19, 2021. Eurozone represents GDP-weighted breakeven inflation of Germany, France and Italy. Source: Bloomberg, RBC CM, RBC GAM

Bond yields drop, valuation risk swells

The notion of transitory inflation, decelerating growth and rising virus risk has pulled bond yields meaningfully lower in the past quarter. Since peaking at 1.75% at the end of March, the U.S. 10-year yield has fallen over 50 basis points to 1.20% – its lowest level since February of this year. The U.S. 10-year yield is now well below our modelled estimate of equilibrium and represents elevated valuation risk (Exhibit 5). The bond market may be reflecting concerns that initial optimism about the economic recovery was overdone. Other recent signs of moderating optimism are a flattening in the yield curve and a decline in real yields. These market movements suggest that the Fed’s ability to raise interest rates throughout this cycle may be limited.

Exhibit 5: U.S. 10-year T-bond yield

Equilibrium range

Note: as of July 19, 2021. Source: RBC GAM, RBC CM

Credit markets wobble

In credit markets, the gap between yields on government bonds and those on risker corporate bonds rose to their highest since May. While widening spreads can be an indication of problems, the current credit cycle appears to be in its early stages based on a spike in defaults that often takes at least five years to recur (Exhibit 6). Excesses generally build gradually, and time passes before another round of defaults is triggered. While we might not see spreads narrow much further from current levels, especially if sovereign-bond yields keep falling, it would be unusual to see a sustained widening in credit spreads at this early point in the cycle.

Exhibit 6: High yield bond spread

Note: as of July 16, 2021. Source: BofA, Credit Suisse, RBC GAM

Stocks hover around record levels

Many equity market indices are hovering near records amid low interest rates and surging corporate profits. The S&P 500 Index has extended its year-to-date gains to 17% as profits have reclaimed their pre-pandemic levels and investors remained optimistic through the first half of the year. Nearly a quarter of S&P 500 companies have announced second-quarter results, with 88% exceeding expectations. While profit growth has been strong, investors are paying a high price for those earnings. The S&P 500 is trading more than one standard deviation above our modelled level of fair value, suggesting the need to lower return expectations and recognize that the market would be vulnerable should the positive outlook deteriorate (Exhibit 7).

Exhibit 7: S&P 500 equilibrium

Normalized earnings & valuations

Note: fair value estimates are for illustrative purposes only. Corrections are always a possibility and valuations will not limit the risk of damage from systemic shocks. It is not possible to invest directly in an unmanaged index. Source: RBC GAM

A look into equity market trends reveals a risk-off tone

There are signs that investors are becoming more cautious. The constructive trends that occurred in late 2020 immediately following positive vaccine test data have been reversing since May. In recent months, growth stocks have outperformed value stocks, large-caps have dominated small caps, breadth has narrowed and international stocks have trailed U.S. equities (exhibits 8 to 10). All of these trends suggest investors are shifting away from economically sensitive segments of the equity market and are possible signs that the economy is about to enter a slowdown.

Exhibit 8: Relative style performance

Note: as of July 16, 2021. Source: Bloomberg, RBC GAM

Exhibit 9: S&P 500 Index

Equal-weighted index/cap-weighted index

Note: as of July 16, 2021. Source: Bloomberg, RBC GAM

Exhibit 10: MSCI World Index

Note: as of July 16, 2021. Source: RBC GAM

Asset mix – trimming fixed income allocation, moving proceeds to cash

The economy is growing at a rapid pace and the current expansion could still have several more years to run. We expect that, once the economy is strong enough to withstand rate hikes, bond yields may move higher as the Fed embarks on monetary tightening. Rising bond yields would weigh on total returns for fixed income, and we expect low to slightly negative returns in sovereign bonds over our one-year forecast horizon. As a result, we remain underweight bonds and took advantage of the recent decline in yields to trim our allocation to fixed income by one percentage point. Stocks continue to offer superior upside potential and we are therefore maintaining a modest overweight in equities. However, we recognize that valuations are demanding and that a variety of indicators are recently signaling the need for caution. For these reasons we opted to move the proceeds from the sale of bonds into cash instead of stocks. Our current recommended asset mix for a global balanced investor is 64.0% equities (strategic: “neutral”: 60%), 34.0% bonds (strategic “neutral”: 38%) and 2.0% in cash.