This May/June 2021 market update is brought to you by LGT Vestra
Whilst we understand the temptation to react to short-term numbers, we encourage investors to focus on longer-term trends. We continue to urge investors to look through any short-term noise. What matters most of all is owning good companies that can compound over time, whatever the economic weather.
In the space of 16 months, we have experienced one of the sharpest recessions in history, followed by one of the strongest expected recoveries. Details of this have emerged in the economic data published over the last month.
Many people have predicted that the enormous stimulus, both monetary and fiscal, applied to counter the pandemic’s effects, will lead to a steep, permanent rise in inflation. However, central banks on both sides of the Atlantic continue to express the view that inflation this year and next year will be transitory.
The most closely watched employment report in the US, the nonfarm payrolls, caused investors confusion over the last two months, coming in much lower than expected. The headline numbers disappointed in terms of job gains. The pandemic has completely warped supply and demand dynamics, and the labour market has not been immune to this.
Many investors questioned whether the low job gains were a reflection of a low supply of labour, or a low demand for labour. The US job openings report released in early June indicated that employers are still looking to fill a record high 9.3 million jobs1, which suggests that the issue is one of supply, rather than of demand.
However, the number of unemployed workers also totalled around 9.3 million implying that people do not have the right skills, or are in the wrong place, to take advantage of the job opportunities.
Generous fiscal packages may also explain some of this inertia, with certain states looking to curtail additional unemployment benefits.
As one of the Federal Reserve’s (Fed) objectives is full employment, and with this being some way off, the data continues to support the Fed’s ‘wait and see’ approach.
The Fed’s additional objective is stable inflation, and the market’s concerns over higher prices seems a common narrative. It is not difficult to understand why these concerns have arisen.
Enormous fiscal and monetary stimulus, combined with speedy vaccination rollouts, has resulted in the economic recovery from the pandemic arriving faster than most had predicted at the start of the year.
Inflation has come under close scrutiny over the last couple months, with analysts pouring over the latest consumer price data for signs that price pressures are becoming more embedded.
We advise investors to take a more nuanced approach by looking at the breakdown of the data and examining it in more detail.
The data remains prone to large base effects, with the headline Consumer Price Index (CPI) of 5% well above market predictions. Most of the rise came from factors related to reopening the economy.
The largest increases have been seen in transportation, eating out and lodging costs, as well as second-hand car and truck prices.
Limited supply coupled with soaring demand, as a result of the pandemic, have distorted these markets. Used cars, for example, have not just benefitted from the stimulus cheques, increased level of savings and higher demand for a private means of transport, the supply of new cars is also more challenging due to a shortage in semiconductor chips.
Given that price pressures have been concentrated in a few sectors, this lends credence to the Fed’s view that inflation may well be transitory. These views have been echoed by both the European Central Bank (ECB) and the Bank of England.
Our central view is that demographic shifts, automation and other technological developments will continue to moderate long-term inflation, and that the present spike will indeed prove to be transitory. Thus, we expect interest rates to remain lower for longer.
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, particularly in Northern Ireland, 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 some of the price falls last year drop out of the annual inflation rate figures.
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 take into account 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.
US Treasury yields have risen since the start of the year, as supply is likely to increase under the Democrats; however, prices have moved rapidly and could correct if the economic outlook deteriorates.
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 economies2, 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 spurred some 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 hard 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 has 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 ▲
The last earnings season showed companies beating consensus expectations; but in many cases, expectations were high, so price changes have been muted.
As inflation fears moderated and long-dated bonds rallied, growth stocks have begun to pick-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 in less economically sensitive areas.
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.
Pent-up global demand 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; however, rising cases of COVID-19 in some countries warrant a selective approach.
Emerging Markets ex Asia Equity ◄►
The difference between many emerging market economies remains stark. The robustness of their respective healthcare systems and speed of government action is likely to determine how these countries fare.
On the vaccine front, it is likely they will not be able to inoculate their populations as quickly as the more developed economies, which is likely to delay their economic recovery.
Whilst we recognise that current headwinds are significant, the long-term growth prospects for many emerging markets continues to be high. 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.