This February/March 2021 market update is brought to you by LGT Vestra
Recent weeks and moves in the market have demonstrated the link between bonds and equities. Bond yields, particularly longer-dated bond yields, have risen sharply, and equity markets have given-up some of the gains made earlier this year.
Growth stocks that fared best during the pandemic, have suffered most as longer-dated interest rates have risen and the yield curve has steepened. On the other hand, businesses in relatively harder-hit cyclical sectors have seen their share prices rise.
With yields having risen across the globe, many central banks have expressed concern about the speed of the moves and its ability to slow the recovery. The European Central Bank (ECB), in particular, has promised to use its Pandemic Emergency Purchase Programme (PEPP) to maintain “favourable financing conditions”.
A notable exception, however, is Federal Reserve (Fed) Chair, Jay Powell, who has thus far continued to reiterate that rates will remain low for a prolonged period of time. The sell-off in bonds – that has pushed prices down and yields up – appears to be driven by rising inflation fears and an earlier tightening of loose monetary policy.
Much of the expected rise in inflation is simply due to the base effects from the low prices for oil and commodities, brought about by the drastic economic shutdowns last year.
However, these prices have since recovered to their pre-pandemic levels. Some investors are concerned that stimulus, on top of a post-pandemic recovery, will add to inflationary pressures over the long run. President Biden is still pushing through his $1.9 billion stimulus plan and is likely to follow this up with infrastructure spending plans.
Bonds have also sold off in the UK; however, Bank of England (BoE) Governor, Andrew Bailey, responded in a similar fashion to Powell, saying there would need to be “clear evidence” of sustainable inflation at the 2% target before raising rates.
Fiscal policy also remains loose in the UK, with Chancellor Rishi Sunak, in his Budget speech, emphasising that the government will continue to “do whatever it takes” to protect jobs and livelihoods during the pandemic, with a moderate pathway to fiscally tighten starting in 2023.
The talk of rates being low for a prolonged period of time has added to some investors’ fears that recent inflationary pressures will turn out to be more structural in nature.
As vaccines enable economies to reopen, consumer spending will pick-up. Coupled with continuing fiscal and monetary stimulus, this has fuelled the market’s expectation that inflation should continue to rise.
Powell has indicated that he is prepared to tighten financial conditions if inflation does indeed get out of hand, but that is not his, nor our, expectation. Our view leans towards inflation being more transitory in nature.
Whilst fiscal stimulus will continue this year, we expect the level of support provided during the height of the pandemic will not be repeated, which, in effect, will be a form of fiscal tightening.
Post-pandemic, we expect a return to a “low growth, low inflation” world. The pre-pandemic trends of technological advancements, aging populations, declining demand for oil and other fossil fuels, as well as globalisation, are deflationary forces that have kept inflation low despite historically low unemployment.
We therefore see sufficient reason for the Fed and other central banks to maintain low rates for some time to come; especially due to the great level of indebtedness amassed during the pandemic.
Overall, this should continue to be supportive for markets.
In the long run, taking into consideration that interest rate rises are still some way away, we expect growth stocks to outperform again. For now, the Fed, at least, appears willing to tolerate some steepening of the yield curve, in which case the sell-off in bonds may not be over.
However, we are beginning to see some value in the space. We also continue to encourage a selective approach to equities and corporate bonds, focussing on companies with attractive long-term growth prospects, robust business models and strong balance sheets.
Market View Changes
UK Inflation-linked gilts: ◄► to ▼
US dollar ◄►
The dollar has shown itself to be a safe haven currency throughout the pandemic. Looking forward, the dollar is likely to balance the rise in cases against fiscal policy and the rollout of vaccines.
The mutual fiscal programme has supported the euro; however, rising cases and relatively slow pace of the vaccine rollout in Europe have brought short-term concerns.
We expect the pound to remain range-bound as investors consider the prospects for growth in the UK, balancing continued Brexit-related infighting, with the speed of the vaccination programme improving the outlook for jobs and growth over the medium-term.
Government bonds Conventional Inflation-linked
UK Gilts ▼ ▼
US Treasuries ◄► ◄►
German Bunds ▼ ◄►
The pandemic has resulted in near zero interest rates across the developed world. Given the pushback on negative interest rate policy and the potential recovery later this year, gilts offer little value.
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. As the pandemic eases, there may be a pick-up in demand, giving a further boost to inflation.
However, higher unemployment, aging populations, and technological innovation, such as the use of robotics and artificial intelligence, are likely to keep inflation low longer term. 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. 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.
At current valuations, we cannot justify investing in conventional German bunds and retain our negative stance, but see some scope for inflation to pick up over the medium-term in light of fiscal stimulus.
Investment Grade Corporate Bonds ◄►
With central banks rushing to support 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.
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.
This has supported the market, although 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 ◄►
Whilst emerging markets typically benefit when the US loosens monetary policy and the headwinds from a stronger dollar fade, the concern is their ability to respond to further outbreaks of the virus, and the resilience of their economies to cope with the restrictions. 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, which has spurred some takeover interest, given the opportunity to pick up companies at discounted prices.
Concerns over the lack of Brexit deal for the service sector and trade frictions may weigh on sentiment. Given the counterbalancing points, we thus 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 and rising cases across many European countries, 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. Due to the pace of the vaccine rollout, these restrictions may be in place for longer in Europe than some other developed countries.
In addition, the rise in cases has increased the likelihood of renewed lockdowns being implemented. For these reasons, we retain our neutral stance on European equities.
US equity ▲
Over the last month, the US market has been hit hard by the rotation out of growth stocks, notably the large technology companies, and into more cyclical sectors.
However, 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.
Dividends have been cut in Japan, but not to the same extent as in many other regions. Whilst we recognise that Japanese equities rebounded strongly as investors have become more confident in a global recovery, we still prefer broader Asian exposure than country-specific exposure to Japan.
Asia ex Japan equity ▲
The recent sell off in growth stocks has also impacted Asian equity markets, particularly China’s technology sector, which had performed strongly in the first six weeks of the year.
However, pent-up global demand is likely to boost prospects for the region in the coming months. Many countries in Asia have come through the pandemic better than countries elsewhere.
Despite strong performance from many Asian equity markets, the valuations continue to look relatively attractive and the prospects for long-term growth are substantial. Given the growth potential for the region, we maintain our positive stance.
Emerging markets ex Asia equity ◄►
The difference between many emerging market economies remains stark; some are likely to be resilient, whilst others are likely to suffer. The robustness of their respective healthcare systems and the 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. 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, so 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 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 have the ability to 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; these developments have been widely accepted and have clouded the outlook for commercial property.
Although news of the vaccine has caused a reassessment of property investments, the longer-term trends still apply. Office rents are likely to remain under pressure until businesses decide how to balance the desires to work more flexibly, with the benefit of having employees collaborating in an office environment.
We expect demand for high quality office and retail space in city centres to recover from 2022 onwards; however, we are more cautious about space for back-office functions, where demand is likely to be undermined by new technology.
The impact of Covid-19 on future property demand remains ambiguous; therefore, it remains important to be selective and not chase the otherwise attractive yield when investing in this asset class.