What Does The Summer Have In Store For Markets?

Markets in May

U.S. equities ended May on a modest note as inflation concerns dominated the headlines. The S&P 500 secured its fourth consecutive month of positive returns with a gain of 0.6%. Value-oriented strategies led the way with both Growth and Momentum, last year's big winners, declining. Most factors posted positive gains, with Financial and industrial leading the way as expected. Surprising to many, the Tech sector has now underperformed the S&P 500 Index for the past year.

Confidence continued to grow as economies re-opened. Jobless claims in the U.S have fallen to a new pandemic low. Travel continues to rebound, with 1.9 million U.S travellers taking to the skies on Saturday 29th May, marking the busiest weekend of air travel since the pandemic began. Most importantly, successful vaccine rollouts continued in May, with the U.K recording its first day of zero daily Covid deaths since the pandemic began.

What lies ahead

Despite multiple reasons for economic optimism, the expected inflation that comes with a global re-opening is likely to result in some short-term market fragility over the coming months.

The most recent inflation figures saw YOY consumer prices increase 4.2% in April, the biggest 12-month increase since September 2008, the height of the financial crisis. Core PCE climbed to an annual figure of 3.1% in April, far exceeding the Fed's nominal target of 2%.

Inflation is likely to continue this run higher over the coming months. Rising commodity prices, a falling dollar, and wage growth resulting from severe labour shortages are likely to result in inflation figures of between 3% to 4% over the summer.

While short-term inflation moves suggest a continuation of the rotation into value stocks, it's important to note that the current inflationary environment is unlikely to persist over the longer term. The combination of transient inflation drivers and long-term deflationary factors should see inflation fall back to around 2.5% later this year.

So what does this mean for your portfolio?

Now is an opportune time to recalibrate your portfolios to avoid obvious interest rate risks. In my view, it is a time to be underweight long-duration assets, whether they be 20 Year Treasuries or disruptive tech stocks with no free-cash-flow. High volatility and small-caps and lower quality names should be avoided. Companies with superior cash-flow generation will continue to anchor portfolios as the current gusts of inflation takes hold.

I remain positive towards equities, with a bias to cyclical stocks and "value" names as earnings remain solid and monetary stimulus remains supportive.

With all that said, Don't blindly presume that all stocks set to benefit from an economic re-opening will be guaranteed "value" winners.

Strong free-cash-flow is the focal point here.

Take booking.com as an example. At first glance, nations full of holiday-deprived travel enthusiasts would suggest that the near-term future is bright for the travel conglomerate. However, The market already appears to have jumped the gun on this one. 'Bookings' current valuation is now above its pre-pandemic levels despite the company's 2021 revenue projections being roughly half the revenue earned in 2019. Now I'm not saying that booking is a bad long-term investment, but as a forward-looking machine, the stock market has already priced in much of the expected near-term optimism, and then some, for these better-known re-opening stocks.

Search for strong free-cash-flow, not just a compelling storyline.