Commentary on July 2021
Fears over the rapid spread of the Delta variant led to subdued price action with indices gyrating either side of flat. Developed markets ended the month with small gains whilst emerging markets, which bore the brunt of the virus, closed between 3% and 7% lower. Government bonds rose by over 2%.
A strong earnings reporting season helped US stock-markets edge to new highs. At the time of writing, over 90% of US companies that reported second quarter earnings had beaten analysts’ estimates, and nearly 80% raised their future profit guidance. The subdued reaction to these reports illustrated the already elevated level of expectations in valuations, but also fears that the rate of economic growth was possibly peaking.
With the focus on future growth and, more importantly, whether this will drive prices permanently higher, there was a growing acceptance that the levels of inflation expected over the next few months would be short-lived. The fall in government bond yields confounded many as they returned to the lower levels seen in February but perhaps reflected belief in muted long-term inflation. In the United States, the real yield (adjusted for inflation) on 10-year bonds fell to –1.18%; just to emphasise, holders of those bonds are happy to lock in a yearly return of 1% below the rate of inflation!
Developed market economies remained robust but the rate of growth, as measured by the Purchasing Manager Indices, tailed off slightly. This is deceptive because further reading of the data shows that these slightly lower numbers were due to constraints on producing more goods (supply bottlenecks and shortage of labour), rather than falling demand. Survey data also revealed a widening disparity between growth in the developed world and a near-stalling of output in emerging markets; this can be largely attributed to differing vaccination rates and further waves of the Delta variant.
With US headline inflation remaining at 5.4% for a second month, several members of the Federal Reserve voiced support for a tapering of bond purchases before the year-end. Fed’ Chairman, Jerome Powell, remained more cautious, emphasising that they were still some way off their other goal of maximum employment. At its August meeting, the Bank of England’s Monetary Policy Committee warned that we could see inflation at 4% by the year-end but followed this with the ‘it’s only transitory’ line.
Developed market government bonds have reversed much of their earlier rise in yield and now offer returns below the level of inflation. Fixed interest investors aren’t daft, and on the whole are more cautious individuals than their equity counterparts, so it’s worth looking at what is driving them to buy bonds at close to record low yields in the face of rising inflation.
In July the European Central Bank followed the US Federal Reserve by moving to a new inflation target. It went from targeting “below, but close to 2%” to having a target that centres on 2% instead, similar to that favoured by the Bank of England. What this means is that they now view 3% inflation as being no worse than 1% inflation. So, with the ECB now joining the US Federal Reserve and the Bank of England in tolerating higher prices, the implication is that interest rates in these areas will be held low for longer and are likely to remain at or close to record lows for a few years yet.
The conundrum is this, typically, the prospect of higher inflation leads to a rise in bond yields (to compensate for the fall in future inflation-adjusted returns); we saw this to good effect in the first quarter of this year. But the steady and persistent global rise in Covid cases has created market jitters, and the uncertainty over whether the disease and its variants will allow the economic and corporate recovery already priced into stock-markets is causing some to prefer the ‘safety’ of bonds. However, there’s a further inconsistency in that corporate and high-yield (junk) bonds are at or close to record low yields, and this doesn’t reflect fears of an economic slowdown.
Perhaps a simple explanation is the search for returns in excess of cash deposits (pretty much standing at zero) which, in terms of risk, extends first to government bonds, then corporate bonds, followed by shares. The build-up of money looking for an above-inflation return won’t prevent volatile markets, or the occasional correction, but it increases the likelihood of investors targeting sell offs as an opportunity to boost their savings.
How are we currently positioned?
Our fixed interest funds continue to have limited exposure to rising yields as we feel that current levels don’t offer sufficient reward for the potential risk of capital loss.
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 continued to enjoy 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.