February saw a transference of emotions as initial optimism over stronger economic growth turned into reflation fears, with evidence of rising industry prices sending bond yields higher; this in turn unsettled stock markets. In sterling terms, stock-markets retreated from mid-month gains of 5-6% to end the month barely changed; UK shares fared better rising by around 2%. Government bonds fell by up to 5% with corporate bonds losing around half of that amount.
A combination of factors helped to push inflation expectations higher; this was most prominent in the US but had global ramifications. President Biden’s $1.9 trillion fiscal stimulus package passed through Congress with only minor adjustments, just after US Purchasing Managers Indices showed prices in both the services and manufacturing sectors at their highest levels since before the Global Financial Crisis of 2007-8. Although a short-term increase in inflation was factored in, agricultural commodity and industrial metal prices touched multi-year highs, 30% above levels of the previous March.
Government bond yields spiked higher, the yield on the benchmark US Treasury 10-year rising by 0.5% to 1.60% before settling around the 1.5% level. The UK 10-year bond yield, which began the year at a lowly 0.2% ended the month at 0.8%. Although still at historically low levels, the magnitude of these moves took many by surprise. Within the bond market a few technical levels were breached; for example, inflation expectations hit a 13-year high and the yield difference between 2-year and 10-year bonds was the widest for 5 years.
Reaction to comments from Chairman of the US Federal Reserve, Jerome Powell, demonstrated the fickle nature of investors. Comments earlier in the month that the Fed’ were a long way from pulling back on stimulative measures, and that inflation and employment levels were a long way from target, eased market fears. Conversely, his response to rising bond yields that the move was not disorderly and was consistent with expectations of economic recovery disappointed many who were expecting the Bank to keep a lid on yields.
Not all central bankers were as nonchalant. President of the European Central Bank, Christine Lagarde, initially stated that they were ‘watching bond yields’, and when traders failed to take the hint, used the monthly ECB meeting to announce that bond purchases over the next quarter would be at a significantly higher pace. The Royal Bank of Australia also stepped-up purchases of its bonds.
New Covid mutations apart, it’s hard to argue with a rapidly improving recovery with the United States taking the baton from China, who recently announced moves to engineer a more restrained growth rate. Higher levels of household savings, further fiscal stimuli and pent-up consumer demand all point to a strong second half of the year as vaccine roll-outs allow a return to normal.
The tricky bit, of which we’ve recently had a foretaste, is if ‘good news’ becomes ‘bad news’. Governments and central banks have shown a preference for over-stimulating the economy to the point of tolerating a certain amount of inflation in exchange for getting people back to work. But this relaxed attitude has started to spook investors fearing that once the inflation genie is out of the bottle it won’t return. If central banks are seen to be too slow in withdrawing monetary stimulus then this will be reflected in higher long-term rates, signalled by bond yields.
The US economy had already been showing decent signs of recovery when Congress approved President Biden’s stimulus package to pump a further 10% of GDP into the mix, much of which is targeted for this year. Whilst the UK is lagging in terms of stimulus and growth there have been reports here that companies are increasingly seeing signs of shortages in the goods they need, given both better-than-expected demand and inability for supply chains to ramp up fast enough to satisfy this demand. If this continues for any length of time, it could lead to higher inflation.
To add some balance, currently markets are more concerned about the fear of inflation rather than the present level of inflation, which is still very low. The expectation is that the annual change in the oil price will drive inflation higher over the next couple of months but that there is still sufficient spare capacity in the economy to prevent a sustained rise. Time will tell!
We feel that market positioning and pricing continues to reflect the optimistic view, punctuated by bouts of volatility as this view is called into question. With short-term interest rates likely to remain at record lows for some time we will view these setbacks as further investment opportunities.
During the month we sold the M&G Global Dividend fund and the HSBC FTSE 100 fund across the portfolios, increasing cash by around 6%. We feel that there will be better opportunities ahead to re-invest the proceeds.
Our fixed interest funds were less exposed to rising yields so performed better than the market, with the exception of our global bond fund which suffered from its US dollar exposure.
We are holding a mix of value and growth stocks but have sought to minimize exposure to US listed FANGS, where valuations have become excessive. Our value stocks have enjoyed a strong recovery so far this year.
Our portfolios diversify risk by investing in a wide range of assets using actively managed funds with sound investment processes. Some examples of these ‘alternative’ assets are funds invested in gold & silver, infrastructure, agriculture and absolute return strategies.