This July/August 2021 market update is brought to you by LGT Vestra
During the pandemic, as countries globally faced enormous restrictions, the extraordinary monetary and fiscal stimulus curtailed the economic damage. The vaccine rollouts have picked-up pace allowing economies to gradually reopen, and stock markets to continue on their positive trajectory.
The enormous support has seen the US economy surpass its pre-pandemic size at the end of the second quarter. The most recent employment data shows that the labour market recovery is steadily progressing posing more questions for the Federal Reserve (Fed).
Although headline inflation has printed above 5% for the past few months, looking at the underlying data in more detail reveals that much of the rise corroborates central bankers’ view that pressures are transitory and related to the reopening from the pandemic. In particular, second-hand car prices and energy base effects constitute a big proportion of the rise.
With the labour market strength and inflation above target, mostly due to transitory effects, several Fed members have advocated that they should taper asset purchases sooner rather than later. As such, the Jackson Hole Symposium at the end of the month could mark a slight shift in tone by the Fed.
In the UK, the annual rate of inflation recently exceeded the Bank of England’s (BoE) 2% target. However, the Monetary Policy Committee (MPC) still voted to keep interest rates and their bond purchase program unchanged.
For the time being, the MPC expects to raise interest rates very gradually, reaching only 0.5% by the third quarter of 2024. By contrast, the European Central Bank (ECB) said that they will not tighten interest rates until they see inflation consistently at 2% towards the end of their forecast horizon.
The implication is that rates will remain at or below their present level for the foreseeable future.
With the BoE and ECB signalling their intent to keep rates low, rate rises elsewhere could be constrained, as central banks may not wish to open-up too much of an interest rate differential, which could see their currencies appreciate and reduce their international competitiveness.
China has seen a number of unprecedented regulatory actions being taken by the ruling Communist Party, to regulate company activities more meticulously and align private businesses more closely with the long-term objectives of the party.
The initial actions have been particularly targeted at the technology sector, such as blocking the listing of digital payments group Ant Financial, ride-hailing company Didi being punished for not getting cyber security clearance before listing, and takeaway delivery giant Meituan being told to improve pay and conditions for its delivery workers.
The education sector has also been targeted in order to create an even playing field for all. They have reduced foreign involvement in the education sector and re-established it into a not-for-profit industry.
These actions came as a surprise and spooked the market, causing a sharp sell-off. Despite a reminder that investing in the region carries with it many political risks, the growth in China’s economy has provided huge opportunities for investors over the past and we expect it to continue to do so.
The disruption caused worldwide by COVID-19 and the associated lockdowns and restrictions may take a long time to work its way out of the system. However, the recovery from the pandemic has prompted a sharp pick-up in demand at a time when supply has been constrained.
As factory bottlenecks ease, supply should catch up with demand, reducing some of the transitory inflation pressures.
Prolonged stimulus measures should continue to support the market for some time to come. With central banks unlikely to raise rates any time soon, and any tapering of asset purchases likely to be a very gradual process, this should continue to support equity and bond markets.
Market View Changes
- No changes
US dollar ◄►
Whilst the dollar started the year on a weaker footing, more recently it has shown resilience. The fiscal support has led to a strong economic recovery leading to a healthy pace of job gains. This has in turn, increased expectations that the Fed will pair back its ultra-loose policy, thus providing support for the dollar tempered by future fiscal plans.
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, 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 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 bonds 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 ◄►
Throughout the pandemic central banks have supported this vital market in order to avoid further economic damage, credit spreads have retraced 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 ◄►
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 the market, longer term questions persist on balance sheet strength, should variants pose challenges to the 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, rising cases have accentuated divisions within Europe that are difficult to ignore. European manufacturing has fared better during the pandemic than the service sector, notably tourism and hospitality, which continues to be held back by travel corridors. 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 rising cases and restrictions, this has failed to materialise.
Japanese equities have underperformed global peers as the country’s recovery has been relatively subdued, despite strong international demand for manufactured goods. Japanese equities have not benefited from the global recovery relative to other industrial powerhouses, and 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, and has tempered our enthusiasm.
We continue to see potential opportunities in China and elsewhere, as some investment flows may feed through to other countries in the region following the clampdown. It is difficult to ignore the region’s growth potential, and broad valuations are not particularly demanding. Hence, we retain our positive stance; however, given the volatility we recommend positions be sized to reflect the risks.
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, 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. 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.