Deep breath. One more time…
As it turns out, patience is a virtue.
My eldest daughter turned 17 this year, so I’ve been thrust into the world of learner drivers as driving instructors are currently a rare breed. Now, many in the investing world mention that they draw investing insight from their day-to-day world, somehow drawing comparison to how the supplies of tinned soup in the aisles of their local supermarket can explain forces as complex as globalisation, or indeed, the reverse. No such luck here dear reader, just that patience reaps its reward. Go Jess!
As marvellous as the development and roll out of the vaccine programme is, the Prime Minister’s announcement that the removal of lockdown restrictions is to be delayed means similar patience is required. The troublesome Delta variant is rightly a cause for concern but, at the time of writing, all seems set for an ending of restrictions in July. As a country, having seemingly got so much wrong in tackling the virus, and so much right in promoting and distributing the vaccine, by the time this Quarterly hits your virtual doormats, we will hopefully be almost there…
Interest Rates: Talking, but not yet turning.
We wrote in the last quarterly about the challenge central bankers face when looking at an economy showing signs of a strong early rebound, coupled with very strong forecast economic growth numbers for the rest of 2021 and 2022, whilst espousing the virtues of keeping rates lower for longer. The most recent meeting of the Board of the Federal Reserve brought a change in tone as the mood music went from Jerome Powell’s “we’re not even thinking about thinking about thinking about raising rates” to talking about how the committee will begin “talking about talking about” tapering the pace of asset purchases and reigning in some of the support measures. In a similar fashion, the expected timing for the start of an interest rate rise has been brought forward some months with 2023 looking very likely, and the direction of travel making 2022 less of an outlier than previously considered. The Fed’s own forecasts suggest by the end of 2023, US interest rates will be at 0.6%.
The curious case of rising inflation and falling bond yields
Inflation numbers are bouncing upwards more quickly than headline writers can make copy. Recent reports have shown strong economic numbers coming out of the States, whether it be employment, house prices or inflation, with CPI measuring 5% in May and 3.8% once food and energy have been stripped out (who needs those anyway?). This followed hot on the heels of April’s strong CPI number of 4.2%, far more than the 3.6% expected.
Similarly, UK CPI came in well above expectations in May too, coming in at 2.1% following April’s 1.6%. Whilst there is still some influence of base effects (12 months before inflation was falling), there is now a greater acceptance that more of this inflation is a result of the reopening of the economy and supply constraints. Shoppers are returning to the high street (clothes prices were up) and food and drink costs have risen too. Anyone who has ventured to a pub or restaurant in these past weeks will have noted the extra pounds on the bill, and anyone with the great misfortune, like yours truly, of requiring new fencing will have noted the eye watering rise in the price of timber of late. Pipeline pressures, such as input prices for raw materials going into factories are on the rise and these prices are being reflected in the output prices in the finished product costs too. As demand remains strong, companies can pass on more of these costs, which makes it likely these pricing pressures will ultimately be reflected in consumer prices too.
Despite this, long-term bond yields have recently drifted lower with the US 10-year Treasury falling below 1.5% and market expectations of future inflation levels look muted too, pricing for an inflation rate only just above the long-term target of the Fed. This is as unexpected as finding laughter and enjoyment in a programme where Jeremy Clarkson tries to farm.
There was movement in shorter dated Treasuries, which points to markets recognising the path to tightening policy may come sooner than expected, but in the context of better than anticipated growth numbers this doesn’t sound bad. The sum of all of this is whatever markets are currently pricing turns out to be right or wrong, the crux of the matter is the Fed is getting closer to the date that a mistake could, or could not, be made. This will continue to raise uncertainty which markets will find unsettling and could provide bouts of volatility.
Technical factors have also been at play. Whilst fiscal stimulus has been a forceful lever employed by the US government since the onset of the pandemic, the funding of that was largely raised through debt issued in the first half of 2020 and that has been steadily drip fed into the economy since. The $3 trillion in additional funding raised is still being drawn from and the amount of capital raised by the Treasury, outside of those hoovered up by the central bank, has been relatively low.
What is clear is central banks tolerance of higher inflation numbers remains robust under the pressure of early signs of rising inflationary pressures. However, the mood music is changing, helping to set the scene for a tapering of central bank bond purchases and ultimately to interest rate rises. The challenge for investors is how to manage this transition, which brings back memories of 2013’s Taper Tantrum, when markets got spooked that the support being provided by the US Federal Reserve in the wake of the Global Financial Crisis was being withdrawn.
With economies reopening, growth forecasts are being revised upward – particularly so for those countries whose vaccine rollouts moved the fastest, namely the US and UK. That being said, whilst the EU vaccine roll out launched slowly, vaccine distribution in Europe has come on at a pace, with a resulting positive impact falling mostly into next year’s growth forecasts.
As discussed above, with economies reopening and supply constraints appearing, inflationary pressures have gently risen versus the same data as shown in the previous Quarterly. As ever, with many thanks to our friends at Schroders for these latest numbers.
Our sense remains that we are at the beginning of a new economic growth cycle, but one with unusual characteristics. Firstly, after such a sharp recessionary period the consumer, who is such an integral part of our economy, has been relatively well protected through the use of furlough schemes or direct support payments in the US. The accumulation of additional cash buffers augurs well for a viable and sustained economic recovery.
Secondly, valuations across many asset classes remain challenging. Whilst equities are our preferred asset class that we expect to continue to deliver positive returns, there is little margin of safety should setbacks in either the vaccine or corporate earnings ensue. Corporate earnings growth remains strong for now, so the same broad trends in equities remain. Despite the starting valuation, momentum remains behind the equity market and UK equities have contributed positively too, (helped by a strengthening sterling) and value as a style edges growth, but this is less pronounced than at the end of Q1. We should continue to expect volatility along the way.
In fixed income, we are wary of long-dated bonds given the likelihood of rising yields in the coming quarters, which would result in declining prices. We see some limited opportunity in investment grade and high yield credit, and we use strategic bond funds and short-dated fixed income funds to shelter from rising yields.
The near-term outlook for growth remains strong and pent up consumer spending alongside strong fiscal stimulus should continue to help underpin equity markets, even when their current valuations look toppy. The big unknown lies in the medium term where the consequences of some extraordinary economic policy remain far away and are still to reveal themselves. Across portfolios, we are leaning into the positive growth story, rather than have our foot to the floor.
Conclusion – Smile like you mean it.
There are rarely any dead cert’s in life and investing is no different;, the only real certainty is uncertainty will always walk by your side. Being disciplined, avoiding knee jerk reactions to spikes of volatility and having the patience of a driving instructor will see you right over time.
Whilst equity valuations are relatively expensive versus history, they continue to remain the most attractive asset class and we continue to believe that the market conditions are not in place for an equity bear market. Conditions remain favourable for corporate earnings and time to combine to allow markets to grow into their valuations, with highly supportive central banks and governments with increasing amounts of fiscal stimulus to deploy. These are solid backdrops. Yes, there will be bouts of volatility, but then there always will be.
As we step out of this long period of restrictions, the comfort levels for all of us will be tested, sometimes breached. The memories of this most difficult of times, so very painful to so very many, will begin to fade. We continue to wish you and your families well.