This August/September 2021 market update is brought to you by LGT Vestra
Whilst progress in fighting the pandemic varies from country to country, the vaccine rollout has provided much needed light at the end of the tunnel, with life in some places gradually returning to normal.
Nevertheless, the rise of the Delta variant and rumours of further lockdowns later in the year remind us that the pandemic is far from over.
Throughout the pandemic, governments and central banks have worked together to pump money into economies in order to see them through the crisis.
The experiment has staved off permanent economic damage, with growth this year having been stronger than expected in many parts of the world. Hence, on both sides of the Atlantic, there has been talk of tapering asset purchase programmes.
Before the annual Federal Reserve (Fed) symposium in Jackson Hole, a number of Fed members increasingly voiced their support for reducing asset purchases before the end of the year.
As the US economy is now larger than it was pre- pandemic, representing a rather swift turnaround compared to recessions in recent decades, it is harder to justify its current ultra-accommodative monetary policy.
Whilst Chair Powell indicated that the Fed could reduce purchases later this year, this remains data dependent and is not an indication of the future path of interest rates. Tapering would involve buying fewer US Treasuries and Agency Mortgage Backed Securities over time, rather than winding down the Fed’s balance sheet.
In Europe, European Central Bank (ECB) President Christine Lagarde took a different stance, insisting that the “lady isn’t tapering.”
In any case, the ECB has a flexible programme, and has decided to moderately reduce the pace of its Pandemic Emergency Purchase Programme (PEPP), justifying the decision by saying the region’s increasingly advanced rebound could be maintained with less monetary help.
The ECB has continuously raised its economic growth forecasts for this year, and as such, is reconsidering its monetary support.
The Bank of England (BoE) has also been talking of reducing its purchase programme, but at the last Monetary Policy Committee meeting voted 7-1 to hold it at the same level.
Whilst tapering is clearly on the cards, interest rate rises are still pending, and central banks may have further reasons to be cautious.
As the Delta variant continues to cause global concern whilst we recover from the pandemic, fiscal tightening (in particular tax rises) may restrict central banks’ ability to tighten monetary conditions.
In the US, President Biden has been proposing tax rises to pay for infrastructure spending and, in the UK, the Government announced an increase in National Insurance to fund the NHS and social care.
Equity markets have delivered solid returns on the back of strong earnings, further supported by fiscal and monetary stimulus. Whilst the path to recovery from the pandemic may be facing further bumps along the road, central banks will factor in the potential fiscal support.
Labour markets have seen a strong recovery, and the economic reopening has led to more spending. However, with furlough schemes ending, the easy gains for the economy may be coming to an end, and progress from here may be slower.
If the Delta strain continues to put pressure across global supply chains and restrictions are reimposed, this could result in further constraints on the economy.
As ever, the age-old advice of keeping one’s head when others are losing theirs, remains as relevant as ever. Investors should avoid getting caught up in the short-term noise and focus on long-term business models, and the valuations applied to them.
Market View Changes
- No changes
US dollar ◄►
Whilst the dollar started the year on a weaker footing, more recently it has shown resilience. The Jackson Hole symposium has cemented expectations that the Fed will pair back its ultra-loose policy, thus providing support for the dollar, although this has been tempered by future fiscal plans.
The upcoming German elections may result in more left leaning government and provide further economic stimulus. However, it is likely to be a close call resulting in months of negotiation on the future government 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 are weighing 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 in the UK, long-term inflation expectations are being distorted by 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. Nevertheless, 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, 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, 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 economies, 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 relatively 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.
The potential for further lockdowns continues to weigh on these sectors. For these reasons, we retain our neutral stance on European equities. The outlook for Europe may be further complicated by upcoming elections in Germany and in France next year.
US Equity ▲
As inflation fears have moderated and longer-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, whose robust business models have held up well during this turbulent time and these companies should continue to sustainably compound growth over the longer term. President Biden’s tax and infrastructure spending plans remain subject to debate, and whilst increasing corporate tax may weigh on the market, increased investment will be welcome.
Japan Equity ◄►
After difficulties dealing with the pandemic, Prime Minister Suga is stepping down. Japan has been slow to rollout the vaccine, and the infection rate as a result remains high. As such the Olympics was a very subdued affair. His resignation was generally received favourably by the stock market on the expectation of stronger measures to counter the pandemic. However, given the party dynamics in Japan little material change is expected, 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. As a result, 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. 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.
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 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.