This June/July 2021 market update is brought to you by LGT Vestra
At the start of the year, investors were encouraged by the pace of vaccination rollouts, which had the propensity to speed up the recovery from the pandemic. To a large degree, this has occurred across the developed world, but the spread of the Delta variant, combined with softening economic data, has given investors some pause for thought.
In broad terms, the data continues to show strong growth, supported by consumers spending some of their lockdown savings.
The economic backdrop paired with powerful policy support stoked inflation fears, driving a reassessment of equity exposure from technology stocks towards more cyclical stocks until late May.
The most recent Consumer Price Index (CPI) report continued to show second-hand vehicle prices, oil base effects and re-opening supply-demand imbalances (as was detailed in last month’s report) remain the key drivers for large price increases. This in turn supported the Federal Reserve’s (Fed) view that inflation is predominantly a result of ‘transitory’ effects.
As inflation fears have abated somewhat, this has supported Treasuries with bond yields declining considerably over the past few weeks. Thus, flows have started to move back into high-growth technology stocks and enthusiasm for value sectors has waned.
Given these gyrations in markets, investors were eagerly awaiting the latest Fed meeting, to get a sense of how they are poised to respond to a US economy that is recovering quickly from the pandemic, albeit with pricing pressures concentrated in a few sectors.
Investors sought clarity on when the Fed might contemplate tapering asset purchases, as well as its outlook for interest rates.
The Fed’s “dot plot” showed that the majority of their members now expect to raise interest rates in 2023, with median projections showing two 25 basis points rate hikes that year. Relative to no increases anticipated in March, this change in position was somewhat of a surprise.
Jerome Powell, Chair of the Federal Reserve, indicated that the Fed would provide advance notice before tapering asset purchases, and that these would occur at least several months before raising interest rates. This implies that tapering could occur during 2022 and that we could see the Fed announcing their intention to taper later this year.
Chair Powell continued to highlight that tightening is highly dependent on economic progress from here, particularly within the labour market. Hence, future job reports may have an outsized impact on rate expectations over the coming quarters.
The Fed has made it clear that they will only look to withdraw the pandemic stimulus so long as it does not upset the path to recovery. We expect the Fed will continue to err on the side of caution and only gradually shift their wording to prepare markets for a slow, gradual withdrawal of the support put in place during the pandemic.
On the other side of the Atlantic, the European Central Bank (ECB) has been conducting a comprehensive strategy review over the last eighteen months, paying close regard to the way it targets inflation.
Like many central banks, the ECB sets a target for stable prices, which was previously defined as “below, but close to, 2% over the medium term”. The ECB has stated that it would now be prepared to tolerate short periods of inflation above 2%. They have not gone as far as the Fed, which also recently redefined its inflation target, as an “average” of 2%. Whilst the change indicates that the ECB may be more tolerant of inflation, in practice, it makes little difference.
Core inflation, for the last ten years, has been well below 2%.
Pent-up demand, combined with supply-side constrains have lifted short-term inflation, as highlighted through sales of second-hand cars and domestic lodging costs. This broadly confirms the view that inflationary pressures will be transitory over the medium-term, albeit with inflation running above target in the near term.
In the near term, we may continue to see some inflation due to bottlenecks in supply and a pick-up in demand as we recover from the pandemic. However, the downward pressures on prices due to ageing populations, automation and other technological shifts are not going away, and the recent changes made by central banks simply enable them to keep interest rates lower for longer, which should continue to support both bond and equity markets.
Market View Changes
- No changes
US dollar ◄►
So far this year, the dollar has been generally weaker against other major currencies, driven by the reversal of safe haven flows and higher inflation expectations. Whilst we see scope for the dollar to weaken further, the make-up of growth and inflation, combined with potential monetary policy tightening may stem some of the weakness.
The ECB has indicated that it will not tighten ahead of the Fed, resulting in more moderate divergence going forward.
The pound has been strong following the rapid vaccine rollout in the UK and the Brexit deal; however, the cracks that are emerging in the Brexit deal may start to weigh on the pound.
Government Bonds Conventional Inflation-Linked
UK Gilts ▼ ▼
US Treasuries ◄► ◄►
German Bunds ▼ ◄►
The pandemic has resulted in near zero interest rates across the developed world.
In the short term, inflation is expected to rise as a result of base effects and supply chain disruptions. Inflation expectations have risen sharply in the UK and the US.
Whilst the US may see some more upside price pressures due to stimulus cheques, at the same time the UK market is putting too much emphasis on short-term effects.
Given the long average maturity of index-linked gilts, we have turned increasingly cautious on the segment.
Intuitively, many investors expect inflation-linked bonds to be one of the better hedges against a more inflationary environment. However, this does not consider how much inflation is already priced into these securities, and whether general bond yields may rise as a result, thus offsetting some of the benefits.
We retain our neutral stance on US Treasury yields given their ability to protect portfolios if growth were to disappoint. The Gilt market has not moved to the same extent and has scope for further corrections. Where there is bond exposure, we favour the US.
At current valuations, we cannot justify investing in conventional German bunds and retain our negative stance, but we see some scope for inflation to pick up over the medium-term due to extensive fiscal stimulus.
Investment Grade Corporate Bonds ◄►
During the pandemic central banks have supported this vital market in order to avoid further economic damage, credit spreads have retracted from their widest point in March last year.
As spreads on offer are now meaningfully lower, our stance has evolved to neutral. This reflects the support that central banks continue to offer the market, albeit with much less attractive yields on offer, thus tempering our enthusiasm. At current compensation levels, we expect returns to be driven by coupon receipts, rather than further capital returns.
High Yield Credit ◄►
The wave of defaults that investors expected at the onset of the pandemic has thus far failed to materialise, given the broad-based support that governments and central banks have provided.
While defaults were concentrated in the heavily affected retail and oil segments, the intervention of the Fed into exchange traded funds and newly junked bonds has seen liquidity conditions of highly indebted companies remain loose.
As economic growth is expected to be extremely robust this year, the market has seen a more positive trajectory in credit ratings. This has supported the market, although longer term questions remain on balance sheet strength, should there be a choppier economic recovery. Hence, we retain our neutral stance, but stress selectivity.
Emerging Market Debt
Local currency denominated debt ◄►
Hard currency denominated debt ◄►
The news flow from many emerging markets highlights the difficulty of vaccinating everyone, and the dangers of potential new variants. Whilst the G7 has pledged to provide one billion doses of the vaccine to emerging economies1, this falls a long way short of what is needed.
However, stronger global growth prospects and high commodity prices will benefit some countries. Thus, we emphasise that selectivity remains as important as ever, and we retain our neutral stance across this diverse asset class.
UK Equity ◄►
The FTSE 100 index started the year strong, buoyed by its exposure to energy and materials. However, the market continues to trade at valuations that look cheap relative to markets elsewhere in the world. This has spurred takeover interest, given the opportunity to pick up companies at discounted prices.
Continued concerns over the lack of a Brexit deal for the service sector and trade frictions may weigh on sentiment. Given these counterbalancing points, we find it difficult to justify anything more than a neutral stance for the time being.
Europe ex UK Equity ◄►
On the grounds of valuation, the European market looks attractive; however, the slow pace of the vaccine rollout and rising cases have accentuated divisions within Europe that are difficult to ignore.
European manufacturing has fared better during the pandemic than the service sector, which continues to be held back by pandemic restrictions. For these reasons, we retain our neutral stance on European equities.
US Equity ▲
As inflation fears have moderated and long-dated bonds have rallied, growth stocks have picked-up again. The US continues to be the market that we consider home to the highest quality companies, which have held up well during this turbulent time and should still be able to sustainably compound growth over the longer term. We continue to favour companies with robust balance sheets and competitive advantages.
Japan Equity ◄►
In general, Japanese companies have plenty of cash on their balance sheets and should be able to weather the storm.
Under normal circumstances, the Olympics would have given a boost to the domestic economy; however, due to the lack of international tourism, this will be limited. Whilst we recognise that Japanese equities rebounded strongly as investors have become more confident in a global recovery, we continue to prefer broader Asian exposure rather than country-specific exposure to Japan.
Asia ex Japan Equity ▲
As with the US, growth stocks in Asia have begun to pick-up again. A strong backlog of orders is likely to boost prospects for the region over the coming months.
China is heading towards becoming the largest economy in the world and, whilst the pandemic started there, they have recovered well. Given the growth potential for the region, we maintain our positive stance.
It is worth noting that the clampdown by authorities in China on some technology companies has accentuated the political risks that comes with investing in the region, and somewhat tempered our enthusiasm.
Emerging Markets ex Asia Equity ◄►
As emerging markets have been left behind in the global vaccination race, they have also been more exposed to the impact of the Delta variant. Whilst this variant initially stemmed from India, it has spread to neighbouring regions, such as Indonesia, putting further pressure on their economies and healthcare systems.
We recognise that current headwinds are significant, however, the long-term growth prospects for many emerging markets continues to be high. Hence, we continue to stress selectivity in this diverse region and maintain our neutral stance.
Hedge Funds/Targeted Absolute Return
As economies around the globe recover from the pandemic, and interest rates remain low, we expect mergers and acquisitions (M&A) to continue to take place. We therefore favour event-driven strategies within this space.
When using these strategies, we look for funds that could diversify returns away from the directionality of conventional bonds and equity markets. However, we continue to stress the importance of finding the right vehicle and investment manager, which requires extensive due diligence on the strategy and fund.
Whilst we acknowledge the yields on offer may look attractive relative to other sources of income, the property market remains challenged, particularly the retail and office segments. We continue to suggest that any exposure to property should be selective and prefer closed-ended over open-ended vehicles, given the liquidity mismatch.
The pandemic accelerated trends towards online shopping and working from home. Although the rollout of the vaccine has caused a reassessment of property investments, these trends still weigh on the sector.
The impact of COVID-19 on future property demand remains ambiguous; therefore, it continues to be important to be selective and not chase the otherwise attractive yield when investing in this asset class.