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Inflationary pressures return to the top of the agenda

 

This September/October 2021 market update is brought to you by LGT Vestra

 

Against a backdrop of a global economy that is recovering from the pandemic, propelled by enormous fiscal and monetary stimulus, inflationary pressures have returned to the top of the agenda.

Global equity markets gave back some of their gains in September, having performed well so far this year.

Fears of prolonged supply chain disruptions, the withdrawal of pandemic relief measures, at a time when interest rates may have to rise due to inflationary pressures, weighed on markets.

Elsewhere, the regulatory environment in China added to concerns.

Whilst the economic recovery from the pandemic has been welcomed, huge dislocations have become apparent. The rise in inflation beyond central banks’ 2% targets, has mainly been due to levels of demand, that have far outstripped supply.

In September, a number of central banks signalled that interest rate rises are getting closer. The difficulty for central banks is that fiscal support is also being cut.

As furlough and other employment protection schemes unwind, unemployment may rise. Should supply chain difficulties and higher energy costs slow economic growth, this may yet give central banks of some of the world’s largest economies a reason to delay action.

In the US, inflation remains at high levels owing to a surge in energy costs, but core pressures are more muted. Although supply constraints remain difficult, recently published data by the US Bureau of Labor Statistics demonstrated that some of the transitory effects have begun to abate.

During the Federal Reserve’s (Fed) September meeting, they provided the clearest sign yet that they are keen to pare back their ultra-accommodative monetary policy stance. Before year-end, bond purchases are expected to be reduced.

Meanwhile, in the UK, inflation continues to rise. Although only two of the nine-strong Monetary Policy Committee (MPC) members voted to reduce gilt purchases, the overall tone from the MPC has shifted, with some members expressing a desire to raise rates sooner rather than later. The gilt market has moved to reflect the possibility of earlier rate rises.

However, higher taxes and energy price rises may constrain economic growth and could give the Bank of England (BoE) reason to pause for thought.

Over the coming months, rises in gas and electricity prices will be felt by the consumer, and as a result, the peak in the Consumer Price Index (CPI) may be around the turn of the year.

Equity markets have continued to gyrate over the past month as tighter monetary policy has been priced-in on the back of prolonged inflationary pressures.

The sharp rise in the price of energy commodities over the past month has supported this trend. As such, investors’ favoured energy and financial stocks in September, relative to so called ‘growth’ sectors, like health care and technology.

Overall, central banks appear increasingly keen to step back from the emergency stimulus measures put in place to counter the pandemic, and now move towards a more ‘normal’ monetary policy stance. An important factor is the desire to increase monetary tools, should a future crisis occur.

Whilst cost pressures are rising, we continue to look for companies that are in a better position to pass on price rises, rather than have margins squeezed.

The essential nature of the activities carried out by the businesses we favour, generally makes it easier for them to adapt to inflationary conditions. Broadly, these companies were able to navigate well through the changes brought about by COVID-19, and we expect them to continue doing so over the long run.

Market View Changes

  • UK Gilts (Conventional): to ◄►

Currencies

US dollar             ◄►

Sterling               ◄►

Euro                    ◄►

Whilst the dollar started the year on a weaker footing, more recently it has shown resilience. The latest Fed meeting indicated the desire to pare back its ultra-loose policy, thus providing some support for the dollar. That said, this will be tempered by future fiscal plans and the trajectory of inflation.

The German election resulted in the need to form a coalition government, which will likely take months of negotiation to make up. This, and the upcoming French election, may add volatility to the Euro without any clear direction.

Sterling was strong following the rapid vaccine rollout in the UK in addition to the Brexit deal, however, the cracks in the Brexit deal are proving difficult to resolve and continue to weigh on the pound.

Fixed Income

Government Bonds                      Conventional                   Inflation-Linked

UK Gilts                                                  ◄►                                      
US Treasuries                                         ◄►                                     ◄►

German Bunds                                          ▼                                      ◄►

The pandemic resulted in near zero interest rates across the developed world, as well as rising inflation caused by base effects and supply chain disruptions.

Whilst the US may see some more upside price pressures due to low inventories, at the same time in the UK, long-term inflation expectations are being distorted by short-term effects.

Given the long average maturity of index-linked gilts, we remain cautious on the segment and many investors expect inflation-linked bonds to be one of the better hedges against a more inflationary environment.

Nevertheless, this does not consider how much inflation is already priced into these securities. More recently, this has weighed on conventional gilts, where we now see a more balanced outlook.

We retain our neutral stance on US Treasury yields given their ability to protect portfolios if growth were to disappoint. At current valuations, we cannot justify investing in conventional German Bunds whilst retaining our negative stance, hence we prefer inflation-linked equivalents.

Investment Grade Corporate Bonds ◄►

Throughout the pandemic central banks have supported this vital market, resulting in credit spreads declining 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 for now, albeit with much less attractive yields on offer, consequently tempering our enthusiasm. At current compensation levels, we expect returns to be driven by coupon receipts, rather than further capital returns.

High Yield Credit ◄►

Plentiful liquidity paired with a strong economic recovery, has driven a more positive trajectory in credit ratings. Default rates remain benign, and given yield scarcity, demand for the asset class remains strong.

Whilst this has supported developed market issuers, concerns surrounding the Chinese real estate developer, Evergrande, weighed heavily on Chinese and Asian borrowers. Thus far, contagion into the wider high yield market has been limited, demonstrating improved balance sheets and plentiful liquidity.

Nevertheless, central banks’ plans to reduce asset purchases may come to weigh on the broader market. As such we retain our neutral stance, and 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. However, stronger global growth prospects and high commodity prices will benefit some countries.

The ongoing battle between the Turkish government and its central bankers, highlights the additional political risks in many of these markets. Thus, we emphasise that selectivity remains as important as ever, and we retain our neutral stance across this diverse asset class.

Equities

UK Equity ◄►

The FTSE 100 index has been buoyed by its exposure to energy and materials. However, the market continues to trade at valuations that look cheap compared to markets elsewhere in the world. This has spurred takeover interest by overseas buyers, given the opportunity to pick-up companies at discounted prices.

Ongoing concerns over the disruptions ensuing the Brexit deal have continued to weigh on sentiment. The counterbalancing points make 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 relatively attractive, yet recent sharp rises in gas prices may weigh on margins. Furthermore, the divisions within Europe are difficult to ignore, as demonstrated by the so far inconclusive election in Germany and the upcoming election in France. For these reasons, we retain our neutral stance on European equities.

US Equity

While investment styles may fall in and out of favour, the US market continues to be a source of high-calibre businesses, and home to the highest quality companies with robust business models. We continue to expect these companies to display sustainable compound growth over the long term.

President Biden’s tax and infrastructure spending plans remain subject to debate, further complicated by the ongoing debt ceiling saga. While increasing corporate taxes may weigh on the market, increased investment will be welcomed.

Japan Equity ◄►

The vaccine rollout has picked up under Japan’s new Prime Minister, Fumio Kishida. Strong car prices, globally, should support Japanese exports, but the shortage of electronic components may weigh on their ability to take advantage of this.

In addition, rising energy costs may squeeze margins, given the country’s reliance on raw material imports. The general election is due at the end of the month, and despite the party dynamics in Japan, little material change is to be expected. As such, we maintain our neutral rating.

Asia ex Japan Equity

A strong backlog of orders is likely to boost prospects for the region over the coming months. However, the clampdown by authorities in China, on technology companies and the education sector, has accentuated the political risks that come with investing in the region. This clampdown, and the associated risks, have further tempered our enthusiasm.

Actions to contain the rising property market contributed to the gradual collapse of Evergrande and stoked fears of a broader contagion; however, the authorities are taking action to prevent any systematic risk.

We continue to see potential opportunities in China and elsewhere in Asia, as some investment flows may feed through to other countries in the region following the clampdown. The risk of political interference is always present, but valuations have adjusted to take this into account. As a result, we retain our positive stance, but given the volatility we recommend positions to be sized to reflect the risks.

Emerging Markets ex Asia Equity ◄►

The rise in energy prices will accentuate the bifurcated nature of investing in these markets. Commodity producing nations, such as Brazil, may benefit from their natural resources, whereas importers may face headwinds. Prospective moves by developed market central banks to cut back stimulus, may exacerbate these issues.

Despite this, long-term growth prospects for many emerging markets remains high. Hence, we continue to stress selectivity in this diverse region and maintain our neutral stance.

Alternative Investments

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, acknowledging that potential regulatory interventions may lead to bouts of volatility.

When using these strategies, we look for funds that could diversify returns away from the directionality of conventional bonds and equity markets.

In a low bond yield environment and when cash returns are meagre, the diversification offered by these strategies can be attractive. Nevertheless, we continue to stress the importance of finding the right vehicle and investment manager, which requires extensive due diligence on the strategy and fund.

Property

Whilst we acknowledge the yields on offer may look attractive relative to other sources of income, the outlook for retail and office segments remains challenged.

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, and although the vaccine rollout has caused a reassessment of property investments, these trends still weigh on the sector.

The impact of changing working practices 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.

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