#WellSaid

The Wellington Blog — A diverse marketplace of ideas, where our investment professionals share and challenge each other’s views. They decide independently how to draw on those ideas to sharpen their investment decisions, unconstrained by any single “house view.”

Whiffs of the long-awaited “taper talk” around US monetary policy are finally in the air. The Federal Open Market Committee’s (FOMC’s) June 2021 statement and press conference indicated that the FOMC has discussed when it ought to start tapering its large-scale asset purchases amid the ongoing economic rebound and mounting inflationary pressures.

The FOMC upgraded its US growth and inflation forecasts, yet kept its unemployment rate forecast unchanged, as labor supply shortages in an environment of strong consumption are leading to higher inflation than the FOMC previously anticipated. The increasing inflationary risks also resulted in the median FOMC participant now expecting to hike interest rates twice during…

MACRO
Jeremy Forster
Jeremy Forster
Fixed Income Portfolio Manager
Boston

The “plum rains” of Taiwan’s monsoon season, or Meiyu, have started to fall, bringing a modicum of relief to the island’s worst drought conditions in over 50 years and enabling manufacturers and technology investors to exhale — at least temporarily. While the weather forecast in Taiwan would not normally make financial headlines, the island’s exposure to climate risk, current severe water shortage, and reliance of its large semiconductor industry on water have the global business and investment community on alert.

Global semiconductor hub

Taiwan produces 50% of the world’s semiconductors and 92% of the high-end transistors used in advanced technology applications like autonomous driving and high-performance computing. Any disruption in local manufacturing could short circuit the global technology supply chain. The overarching risk to semiconductor fabrication in Taiwan is lack of water. Semi fabrication requires enormous amounts of water: the typical chip factory consumes between two and four million gallons of water per day; larger companies use even more. Without sufficient water to power and cool chip fabrication, production…

SUSTAINABILITY
Santiago Millan headshot
Santiago Millán
CFA
Macro Strategist
Hong Kong
Jenny Xie
Jenny Xie
Climate Physical Risk Analyst
Boston

As I consider various potential sources of market volatility over the coming months, the one I believe poses the biggest threat to today’s constructive backdrop for risk assets is so-called “bad inflation.” The costs of intermediate goods and inputs to production are climbing at their fastest pace in decades, which presents a likely headwind to corporate profit margins. Additionally, commodity prices are all rising in unison, be it coffee, corn, lumber, sugar, wheat, or gasoline, further straining corporate and consumer budgets.

Where the Fed may be wrong

The US Federal Reserve (Fed) has repeatedly stated its intention to “look through” the inflationary surge we’re seeing today, which it views as transitory. The Fed seems to assume that supply will quickly come back online as the economy reopens and recovers, allowing pricing pressures to abate. I hold a different view. I suspect that productive capacity for commodities in particular will not bounce back as swiftly as the Fed is forecasting. To be clear, I believe much of today’s bad inflation is being driven, either directly or indirectly, by these rising commodity prices and will therefore prove “stickier” and more stubborn than the Fed expects.

A paradigm shift in the making

As I see it, the public companies that have been rewarded the most over the past decade have behaved more or less like rent-seeking monopolies. Many investors covet steady, predictable cash flows to which they can apply a low discount rate. Conversely, some of the best…

MACRO
Connor Fitzgerald
Connor Fitzgerald
Fixed Income Portfolio Manager
Boston

The job gains cited in the May 2021 non-farm payrolls release fell well short of what the market had hoped. A fluke? Maybe, but this disappointing jobs report suggests to me that US inflation dynamics are beginning to shift from “demand-pull” to “cost-push” inflation.

The perils of cost-push inflation

Demand-pull inflation is the upward pressure on prices that occurs when aggregate demand outpaces aggregate supply. Cost-push inflation, by contrast, is caused by increased costs for raw materials, wages, and other inputs to production. The latter type of inflation tends to be much more harmful to an economy, as it forces companies to choose from among three distinct (and all undesirable) options:

  1. Seek to cut their capital costs elsewhere to preserve profit margins
  2. Invest in productivity-boosting solutions to reduce their labor costs
  3. Pass their increased costs on to consumers in the form of higher prices

The most probable scenario, in my judgment, is…

MACRO
Brij Khurana
Brij Khurana
Fixed Income Portfolio Manager
Boston

I think one of the biggest catalysts behind the general rise of the US dollar (USD) over the last 10 years or so has been the marked improvement we have seen in the US energy trade balance.

The so-called “shale revolution” has benefited the US economy in myriad ways, from enhanced productivity to higher levels of employment and increased tax revenues. However, the degree to which it has helped to moderate the underlying deterioration in the US current-account deficit has gone largely underappreciated. That, in turn, has been a tailwind for the USD for most of the past decade. I’m just not sure how much longer…

MACRO
MARKETS
Brian Garvey
Brian Garvey
Multi-Asset Portfolio Manager

The US stock market appears dramatically different to me now than it did just 12 months ago. Equity issuance by US-listed firms has gone up since then, while cash returned to shareholders has gone down. Based on net cash flow, I believe the market is starting to look overvalued and even bears some resemblance to the tech-stock bubble of 1999 – 2000, with stocks offering little reward potential but plenty of risk. As of this writing, I would suggest that US equity investors consider overweighting defensive, cash-producing stocks.

Is it 2000 all over again?

For 10 years following the 2008 global financial crisis, the US equity market was more or less a “cash cow,” reliably returning cash to shareholders via dividends and share repurchases. Broadly speaking, the market’s annual cash yield was around 3%, with a dividend yield of 2% and net repurchases of 1%. That changed in recent months, with net cash flow turning…

MARKETS
Owen Lamont
Owen Lamont
PhD
Associate Director of Quantitative Investment Group Multi-Asset Research
Boston

The November 2020 election of US President Biden and a Democrat-led Congress rekindled many health care investors’ fears of sweeping drug-price reform that could be an albatross around the neck of the pharmaceutical industry. So far in 2021, there has been some legislative movement by Congressional Democrats to address drug pricing, but little more than lip service in terms of support from the Biden administration. For now anyway, it seems that other pressing matters — battling the COVID-19 pandemic, supporting the US economy, and improving the nation’s infrastructure — have kept the administration from pushing for drug-cost legislation.

Of course, that could change going forward. Or perhaps not. In the meantime, the market does not like the ongoing uncertainty around the fate of US drug prices, which has recently pressured many pharmaceutical stocks and may continue to do so (not unlike the struggles of HMO and health care services stocks when Obamacare was in progress). Here’s my latest take on the risk facing the industry in the form of three possible scenarios to consider, including the…

MARKETS
THEMES
Wen Shi
PhD, CFA
Global Industry Analyst
Boston, MA

A climate-driven capital cycle is underway, and we believe companies must invest in low-carbon solutions to protect and grow the value of their assets and strengthen competitive positions. In our view, companies that prioritize environmental stewardship and establish clear climate strategies can be first movers and market leaders that profit from the low-carbon transition and deliver value for investors.

Identifying — and encouraging — climate leadership

We want all portfolio companies to achieve net-zero greenhouse gas (GHG) emissions by 2050 and set science-based targets to accomplish this. We look for companies that view climate planning as a strategic priority. We seek businesses adapting to changing regulations and positioning themselves to capitalize on evolving governmental incentives and consumer preferences. During our engagements, we ask boards and management teams to embrace low-carbon practices and align business plans with the Paris Agreement to cap global temperature rise to 1.5°C. We seek leadership on supplier practices and sustainable product innovation as a way to reduce indirect emissions. Our proxy voting policies are aimed at…

SUSTAINABILITY
Mark Mandel
Mark Mandel
CFA
Equity Portfolio Manager
Boston
Yolanda Courtines
Yolanda Courtines
CFA
Equity Portfolio Manager
London
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