Bank Of England raised its forecast of economic growth, in the UK, this year to 7.25% from 5%, just three months earlier.
Mark Harries – Chief Investment Officer
Let’s begin with what’s been happening in the world
Expectations of global economic growth in 2021 continue to be revised higher and even now may prove to be conservative. The release of pent up demand as vaccines are rolled out and economies reopen while some monetary and fiscal taps still remain in full flow is a heady mix.
Since winning the election last November, President Biden has announced the pandemic relief American rescue plan, the infrastructure-related American jobs plan and the welfare focused American families plan totalling $6 trillion in additional spending. At the same time, the US federal reserve continues to pump $120 billion into the economy each month through quantitative easing. The widely respected US conference board is forecasting that the US economy will have grown by 9% on an annualized basis in the second quarter of 2021.
Similarly in May, the Bank Of England raised its forecast of economic growth, in the UK, this year to 7.25% from 5%, just three months earlier. In the Eurozone where vaccination rates have lagged significantly behind those in the UK and the US causing restrictions to remain in place for longer growth of 4.3% is now expected in 2021.
Despite this, and as in the US neither the Bank Of England nor the European Central Bank seemed keen to begin the pullback from quantitative easing. The main focus of attention over the last few months, however, has not been excitement about the rebound in economic growth, but worries about the threat of inflation. In the US the annual inflation rate CPI has sored from 1.7% in February to 5% in May its highest level since August 2008. In the UK inflation rate has tripled from just 0.7% in March to 2.1% in May and the Bank Of England expects it to rise above 3% in the months ahead.
In China, for long a byword for the cheap manufacturing that has helped keep global inflation at bay, factory gate prices rose by 9% in the year to May. Interestingly China is now seeing the same demographic trends as much of the developed world with an ageing population, declining birth rate, despite the abolition of first its one-child policy and then its two-child limit and a shrinking workforce. Commodity prices are soaring with the price of oil up 45% in the first half of 2021. The prices of Iron Ore and copper are up by 39% and 20% respectfully.
Supply bottlenecks, which exert upward pressure on prices are commonplace, spanning semiconductors for use in computers chips to lumber, to labour. The trillions of dollars and pounds being earmarked for infrastructure and environmental projects, as well as to address social inequality may also be inflationary in nature.
Central bankers, however, remain steadfast in their assertion that the inflationary spike we’re seeing is transitory and not the beginning of something more structural. To be clear at this time, there is insufficient evidence to determine if the upward trend in inflation is indeed transitory or not, but it is something we’re watching, especially closely as it could have very important implications for investment portfolios.
What’s happened in the bond markets over the second quarter?
Inflation is bad news for investors in bonds because it erodes the real value of interest payments and capital return, both of which are fixed. You might’ve thought therefore that the sharp increases in inflation seen in the second quarter would have caused bond prices to fall and yields, therefore, to raise. However, 10-year Gilt yields fell from 0.85% to 0.72% in the period, so gilts provided a positive return.
Despite a much bigger jump in inflation, it was the same in the US where 10-year US treasury bond yields declined from 1.75% to 1.47%. Of course, it should be remembered that yields soared in the first three months of the year from 0.2% to 0.85% and from 0.91% to 1.75% for gilts and US treasury bonds, respectively. So government bonds have still been a very poor investment year to date.
Indices representing the return of the broad Gilt market are down by about 6% in the first half of the year. The slight recovery in the second quarter of the year, therefore suggests that the set off early in the year was overdone or that for now, at least investors believe that the current bouts of inflation will indeed be transitory. Against a backdrop of economic optimism and bullish stock markets, it is no surprise that corporate bonds, again, provided better returns than government bonds in the second quarter.
In the US credit spreads on high yield bonds have fallen to their lowest levels since before the financial crisis. In a financial world, in which investors remained starved of income-generating investments we certainly understand the attraction of a high yield bond, which yields 3% more than a government bond, but the question is whether this is sufficient compensation for the risk of default.
Is the rate of the vaccine rollout impacting the equity markets?
It was another barnstorming quarter for stock markets. The UK stock market made more than 5% taking its year to date advance to just over 11%. However, the performance of UK stocks was eclipsed yet again by their counterparts in the US the main benchmark rising by over 8% to take its year to date return to more than 15%, including dividends.
The only notable stock market laggard in the second quarter was Japan, which was broadly unchanged. Japan’s vaccine rollouts has been much slower than many other developed countries with only just over 10% of its population, fully vaccinated, which compares with figures of approximately 50% in both the UK and the US. As a result, restrictions have lingered for longer causing the Japanese economy to contract by almost 4% in the first three months of the year.
The last few years have witnessed an extraordinary divergence between the performance of usually high priced and often technology-related gross stocks and cheaper, more economically sensitive value stocks in sectors, such as commodities and financials. The former have trounced the latter. In the first three months of 2021 value stocks, at last, had their day outperforming growth stocks by almost 10% as economic growth surged. The recovery accelerated in the second quarter. So it would be rational to expect value stocks, to continue to have done better than growth stocks, but the opposite happened with growth stocks outperforming value stocks by about 6%. Now the explanation probably lies in the bond markets where yields are unexpectedly declined in the second quarter, making the future cash flows and valuations of growth stocks, more attractive to investors.
Actively managing the tilt between growth and value in a portfolio might seem like a perfectly valid investment strategy, but the experience of just the last two quarters shows just how easy it is to be wrong-footed. We, therefore, prefer to maintain a balance in the portfolios we manage.
Stock markets are revelling in a Goldilocks set of circumstances. Economic growth is buoyant and corporate profits will benefit accordingly. Inflation is going up, but it’s not out of control according to central banks. In any case, stock markets have historically taken modest, say low to mid-single-digit inflation in their stride. As it allows companies to increase their revenues.
Similarly, bond yields have risen, but not by too much. So why are we not overweight in equity exposure in our portfolios? Well, firstly, there is the risk that central banks are wrong about inflation and the interest rates have to rise considerably. Secondly, share valuations are expensive, even allowing for the anticipated bounce in corporate profits and there is therefore little or no margin of safety, if for example, profit margins begin to be squeezed by higher labour or other costs. One other area of concern is the degree of speculation evidence in stock markets. One example has been the recent investor mania for special purpose acquisition companies or so-called SPACs, which have enabled a string of private companies to become publicly listed some on the basis of heroic assumptions about future prospects.
One such company was Nicola an electric truck maker, which was valued at $12 billion when it listed on the US stock market in March 2020. Some months later, it was exposed that the movement of a prototype vehicle in a promotional video was not self-powered, but was because it was rolling downhill?
And what happened in currencies?
Year to date, the pound remains the strongest currency up by a little over 1% against the dollar by 4% against the Euro and by nearly 9% against the Japanese Yen. The strength of the pound in the first quarter, and therefore year to date reflects expectations of an earlier and stronger economic recovery following the world-beating rollout of Corona-virus vaccines, and also the removal of uncertainty about the UK’s trading relationship with the EU following Brexit.
What is our positioning and outlook?
We remain underweight government bonds and duration due to low yields and fears of resurgent inflation. We remain constructive on equities, however, our enthusiasm is tempered by demanding valuations and the risks that the rise in inflation does not prove so transitory resulting in interest rates being raised faster than expected.
This year swings between value and growth supports are broadly neutral stance on investment styles. We remain conscious that sizable gains have already been made in many stock markets this year and a lot of good news is priced into stock prices. As such it would likely take a reasonable correction to tempt us moving overweight equities.
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