i-Wire: Market Update 26th May

Market Update: Floor Found

I’ve included the usual ‘what’s going on’ charts and tables but I’m not looking to overload you with too much ‘strategizing’ as we have reached something of an equilibrium in financial markets with far less volatility thank goodness. Instead I’ll look forward to one of the issues that will be influencing market sentiment as we slowly emerge blinking and a bit fearful out of lockdown, whether inflation may be due for a surprise comeback after all.

Markets

The chart shows the returns from markets in their own currency and the table the sector fund average return which for overseas sectors includes the translation back into sterling and, with the weakness of sterling this year, shows what a laggard UK equities have been compared to other asset classes.

Figures from Financial Express Analytics

This table, with data courtesy of the JPM Asset Management Weekly Brief, shows the winners and losers in terms of industrial sector and style:

The winners continue to be the sectors with companies that have visible, growing and consistent earnings streams, cash rather leverage on the balance sheet, resilient margins, and revenues that are less economically sensitive to changes to growth in GDP in an environment of super-low interest rates, recession and radical change to business and social behaviour.

Market Outlook: Trading range

If ever a sentence is a hostage to fortune then this is it,  but the markets seem to have settled into something of an equilibrium for now with volatility thankfully much lower. The positives are that the rate of infection in developed markets is now well past its peak and the easing of lockdown restrictions has begun, government and central bank policy remains very supportive, and there is  some optimism regarding trace and tracking mechanisms and the development of a vaccine. The negatives are that we fearful of a ‘second wave’ of infections as global lockdowns ease and remain very much in the unknown regarding the long term effects of the virus in terms of public health, economic damage and ‘new normal’ social and business behaviour. The absolutely dreadful economic data we are seeing now is the worst for a century but the market is ‘looking thorough’ this to a recovery in growth and earnings which may prove to be wishful thinking. The increasing  tension between the US and China is an echo of last year which the markets could really do without.

The rebound has been sharper than we expected but we do see the market as acting rationally. The share prices of companies that will survive and ultimately thrive in the ‘new normal’, predominantly in the technology, pharmaceutical, healthcare and consumer staples sectors are being rewarded with strong recoveries in their share prices. The market is continuing to penalise companies whose business models are weaker and in more economically sensitive sectors such as banks, energy, industrials, retail and travel.

The Greater Evil?

The decade since the great financial crisis of 2008 has been the era of the great deflation. Despite the longest economic cycle on record, inflation rarely got much above 2% in developed economies, interest rates remained low and bond yields fell, fell and then fell again. Globalisation and the 3Ds (debt, demographics and disruptive technology) kept the inflation genie firmly in the bottle. This dreadful pandemic has polarised opinions as to what happens next; some forecast a renewed disinflationary cycle and the onset of The Second Great Depression, others fear that we are entering a new era of inflation.

Inflation has been the boy crying wolf for the last three decades but for anyone of my generation who lived through the 1970s it is still seen as the greatest destroyer of wealth. Hence I have not been surprised by a fair number of clients asking for our view. This is a very valid question, even more so if I knew the answer…..but I’ll have a go.

This, in a nutshell, is how the arguments stack up.

The case for Inflation

As you can see from my somewhat simplistic table, much depends on two key elements

• the joint role of QE and fiscal policy
• the role of globalisation.

Post 2008 QE was aimed at the saving the financial system rather than the real economy per se and there was no fiscal support riding tag-team. The liquidity went into financial markets and equity and bond investors made out like bandits for many years.  With the  UK Government paying the wages of half the country and massive fiscal packages elsewhere, notably the US, to prevent long-term double digit unemployment  the money this time is very much aimed at Main Street not Wall Street. The fiscal backstop is being funded by the monetary backstop i.e. the Central Banks are underwriting the financial system and providing the money for governments to spend in the ‘real economy’. Government policy and spending, not Central Bank interest rate policy, will now be the most powerful tools in the hands of the authorities. This time it’s different…..as we are told never to say.

The other key issue is globalisation, the great disinflationary force of the last decade as China and the emerging world proved a vast new market for devoped world goods, services, and commodities and in return very kindly produced shed-loads of cheap goods for us all. Globalisation was already facing some headwinds from the increasingly nationalist and protectionist tone of the last few years, but it has been completely stopped in its tracks by the pandemic. If you think about what globalisation actually entails – the free flow of goods, people and services across national boundaries – you can see just why it will go into reverse.

As national policies and social behaviours change post the pandemic inflation could  become far more ‘local’, as in the 1970s, driven by domestic labour conditions, regulatory regimes and increasingly more nationalistic and  closed economies. Globalisation could be increasingly replaced by ‘slowbalisation’, a world of populism, protectionism and tariffs. Supply changes will become shorter with countries aiming to build up self-reliance in food production, healthcare, technology, security, and consumer basics. We will no longer wish to be so dependent on the munificence of others so supply chains will become shorter, more local and more controllable, onshoring will replace outsourcing and key workers will expect more than just a round of applause on a Thursday night. It will be politically very difficult not to reward NHS workers with a big pay rise (some bias here, my wife is a nurse!),   meanwhile, the delivery men, supermarket shelf-stackers, warehouse workers etc are amongst the lowest paid in the workforce yet have proven themselves to be the oil that has kept the wheels of the coronavirus economy turning. Amazon is virtually an essential public service these days! Costs of production will rise, resulting in cost-push inflation as I was taught in my A-level economics circa 1977.

But not yet…

Over the next couple of years we see the inflation/deflation argument as being pretty moot. The rate of inflation is currently plummeting from a huge demand shock and the collapse in the price of oil. Thereafter the inflation argument may well begin to play out but a lot of positive economic tailwinds need to happen before this is the case. The catastrophic economic fall-out from the pandemic, the collapse in oil and commodity prices, massive government borrowing and falling tax revenues  means that fighting deflation will remain front and centre for the Central Banks as interest rates look likely to be anchored close to zero for the next few years.

We have never experienced anything like the pandemic before, we have no idea how it’s devastating effects will ultimately play out and have very little faith in forecasts, especially those looking years ahead. The inflationary outcome in the medium and longer term depends on how quickly consumer and business behaviour adapts to the ‘new normal’ and to what extent governments continue with very expansionary fiscal plans or revert instead to higher taxes and reduced spending to control the mountain of public debt. Our sense is that the ‘scarring’ from the coming recession will be very deep but that fiscal policy will remain expansionary for a long time yet and that inflation numbers will eventually begin to rise. An inflation rate of around 2% is after all what Central Banks have been targeting for the last decade and seen as economically ‘a good thing’. It is only when it reaches mid-single-digit and beyond that the alarm bells ring, and we don’t expect to be hearing that for many years hence, if indeed at all.

We thus see deflation as the first and immediate enemy;  future inflation a possible though still distant threat. Our intention is always to be long term in our portfolio construction but the current lack of clarity this time means that horizons are shorter and we are not looking beyond the next few quarters. We made significant changes to portfolio in the immediate aftermath of the pandemic to reflect the current deep recession and uncertainty as to the future path of economic growth and corporate earnings. If and when we get a sense that the economic backdrop is shifting significantly then we will adjust portfolios accordingly.

As always, everyone at HFMC Wealth continues to wish you and your families the sincerest of good health in these challenging times.