Ahead of the Curve | Friday, 11th June 2021

Inflation surging in the US on the back of labor shortages – with rates market shrugging off for now.
In the US, the reopening is well underway and while the labor supply is constrained, there is a clear surge in demand with job openings at multi-decade highs and small businesses reporting the highest ever difficulty in filling positions. This is leading to a sharp acceleration in wage growth, particularly among lower-income workers. Meanwhile, the bond market is shrugging off clear signs of inflation, fully accepting the Fed narrative of transitory factors despite the fact that “sticky” inflation drivers such as cost of housing continues to surprise to the upside (+0.31% m/m in the May reading, the highest level in over two years). In our view, it will take several months at least before the debate is settled on whether or not job creation is as strong as it looks and if the inflationary pressures we are seeing are sustainable. But the risk to the bond market looks increasingly asymmetric as real rates go more and more negative with inflation expectations continuing to tick higher. Over the past three decades, nominal 10 year yields of ~1.4% (where the US Treasury is currently trading) are consistent with core CPI in the ~1% range. This week’s core CPI print was 3.8% – even if this is at or near a temporary peak, real rates look entirely too low and high duration assets look vulnerable. Financials, of course, would benefit from a rate selloff but even in a lower-for-longer rate environment would stand out positively as 8-12% payout yields look increasingly compelling on both a relative and absolute basis.

Asset management flows remain elevated in Europe, with pockets of acceleration.
Flows into the European asset management sector have been strong since November 2020, when the vaccine announcements kicked off the value vs growth rotation. They remain elevated seven months later, with active equities growing at 5% annualized in May – a sharp contrast with the US where active equity saw outflows of 2% annualized. In addition, we are seeing pockets of even further strength, most notably in Italy where inflows have started to accelerate among the wealth and asset managers, with some firms seeing 10% annualized growth in May. We expect this trend to continue as excess savings are deployed and risk sentiment returns. Italian asset managers in particular is a space we are focused on given accelerating organic growth, attractive valuations, and the scope for market share gains via bank consolidation.

Vaccine progress picking up in Asia – South Korean banks poised to benefit.
Although most Asian countries navigated the COVID pandemic relatively well, their progress on vaccinations has lagged the West. This is now starting to change, with China, South Korea, Japan, Australia seeing an acceleration in their daily rate of vaccinations over the past month. South Korea stands out, with the pace now on par with the European countries’ current pace and the US’ pace at its peak. The setup for the banking sector looks very attractive today, with valuations under 0.5x book value for banks that will produce ROEs of 9-10%. There is also scope for rate hikes to occur by the end of this year, which should push returns even higher. For a country that weathered the COVID crisis better than most countries globally, resulting in less of a halt to economic activity and prospective NPLs for banks, we believe these valuations are highly compelling and conservatively see 50%+ upside.