Economic & Market Overview
- US Treasury yields rose at a rate not seen since the early 1980s on the positive growth outlook and heightened inflationary risks.
- Economically sensitive stocks outperformed, whilst companies whose earnings grew during lockdown came under pressure.
- Chinese equities fell as the backdrop of strong growth raised expectations of the withdrawal of stimulus.
Despite an acceleration in Covid-19 cases in many countries, investors began the quarter still focused on the acceleration in economic growth expected as economies emerge from lockdown, especially following the passing of President Biden’s $1.9 trillion fiscal stimulus package. US Treasury yields rose sharply as the bond market priced in the prospect of rising inflation. More economically sensitive stocks outperformed, including companies that had been hit hardest by lockdowns in sectors such as travel and leisure, but financials and energy stocks rose too. By contrast, the valuation of companies whose earnings had continued to grow in 2020, including many in the technology sector, came under pressure, as investors increasingly focused on cheaper stocks with the prospect of recovering earnings.
Investment Grade corporate bonds suffered too, as the additional yield on offer over government bonds was insufficient to cushion investors from losses, although more risky High Yield bonds, that correlate more strongly to equities, eked out a modest return. However, enthusiasm waned somewhat later in the quarter as markets began to question the will of the US Federal Reserve to keep interest rates on hold against the possibility of increasing inflationary pressures being more than just transitory, and the growth to value rotation reversed.
Within equity markets, Asia and Emerging Markets (EMs) led the way initially as beneficiaries of reviving global growth through the exporting of manufactured products and commodities. However, as projections rose for an economic boom in the US, the US dollar strengthened. Dollar strength is a headwind for emerging economies dependent on overseas funding, and EM equities went from leaders to laggards, although performance varied sharply at a country level. At one end of the spectrum, Chile performed strongly, benefitting from the revival in the copper price and a very effective Covid-19 vaccination programme. At the other extreme, President Erdogan sent the Turkish stock market and currency into a nosedive by sacking the central bank governor for raising interest rates to contain increasingly rampant inflation. Despite having been one of the few economies to record growth last year, Chinese equities fell as the backdrop of strong economic growth raised expectations of the withdrawal of stimulus, and this cooling of sentiment towards China was further compounded by investors seeking out more profitable reflation opportunities elsewhere.
Within Developed Markets, the encouraging outlook for the US was in direct contrast to continental Europe, which suffered from a stuttering vaccine rollout programme and rising Covid-19 infections. European countries began to reimpose lockdown restrictions to prevent hospitals being overrun, with service sector industries once again bearing the brunt of the pain. However, whilst they lagged US markets, European equities still made gains as investors looked though shorter-term issues, as the region will still benefit from a revival in global growth, whilst the relative absence of inflationary pressures means monetary policy is likely to stay accommodative for longer.
Finally, to the chagrin of the European political class, the recently ‘Brexited’ UK showed that, whilst it may have made a number of mistakes earlier in the pandemic, it had certainly got its act together in respect of the procurement and administration of vaccines. Although in its third lockdown, the UK’s Covid-19 infection rate moved sharply lower as the vaccination programme rolled on. With the country on track, or even ahead, of its roadmap out of lockdown, this was reflected in the strength of both the stock market and the value of sterling.
The lower risk models delivered negative returns over the quarter, of -0.5% to -1%. Whilst the news of further US fiscal stimulus alongside the roll out of vaccines would normally be taken as positive, as it increases global growth, investors worried about the prospect of higher inflation as a result. Yields on Fixed Interest (FI) rose across the board, meaning capital losses for investors and a poor quarter for the asset class. The uncertainty spilled over into equities, with markets searching for a clear direction, and the lower risk portfolios’ limited exposure to equities was not enough to offset the significant headwind in FI.
The medium risk models delivered returns from 0.8% to 2.4%, whilst the higher risk models delivered good returns from 3% to 3.7%. Unlike the lower risk models, again whilst markets were searching for clear direction, these models did have enough exposure to equities, which was enough to offset the significant headwind in FI thanks to strong fund selection. Some of the standout performers include MI Chelverton UK Equity Growth and LF Lightman European, delivering 13.0% and 11.8% respectively. Man GLG Japan CoreAlpha Equity also had a strong quarter, returning 15.3%.
Tactical Asset Allocation
- Reduced Corporate Bonds.
- Reduced Property.
- Increased Absolute Return & Cash.
Across the models we reduced our property exposure as the asset class is undergoing a regulatory review, the result of which may make holding such funds problematic. Proceeds were invested in absolute return strategies, which whilst they do not have the same returns profile as a ‘bricks and mortar’ property fund, are managed to generate a steady return in excess of cash that is similarly lowly correlated.
We also took the decision to reduce our UK corporate bond exposure, reversing the increase to the asset class in Q3 2020. The rising yield environment brought about by the vaccine rollout gathered pace and made it a challenging environment for the Fixed Income asset class as a whole. Proceeds were reallocated to cash.
Evidence suggests that the rollout of Covid-19 vaccinations will allow a return to some sort of normality, even within the European Union, whose vaccination programme has been a notable laggard to date. Having learnt from the mistakes of the financial crisis of 2008/09, many wealthier countries provided financial support to those adversely impacted through lockdown. By limiting the economic damage of the virus in this way whilst the ability to spend was severely curtailed, personal savings rates in many of these countries have been supercharged. Over the coming months, this pent-up demand is expected to be unleashed, often on sectors that have suffered most during the pandemic, such as travel and leisure.
In the US, where measures have included the posting out of cheques to much of the population, economists are forecasting GDP growth rates above 5% for 2021, a level not seen since the early 1980s, with some even predicting growth above 7%. Whilst unemployment is running at close to double its pre-pandemic level, job creation is expected to be robust, with many of the jobs lost from industries most negatively impacted by Covid-19 expected to be prime beneficiaries of the recovery. Whilst the US may be at the upper end in terms of the level of economic growth due to the sheer quantum of stimulus and the speed of their vaccination programme, the same effect is expected elsewhere. Even though Emerging Markets were unable to provide the financial support of the developed world, many of these countries will be direct beneficiaries of faster economic growth through the exporting of manufactured goods.
From an investment perspective, despite economically sensitive companies having outperformed year to date, these recovery stories may well have further to run given the level of underperformance during the pandemic. That does not mean that last year’s winners will automatically be this year’s losers, as many such stocks are in long-term structural growth sectors. However, their earnings may have to catch up with their valuations before they can make further gains.
The most obvious risk to markets is a mutation against which vaccines are unable to protect. That aside, the inflation conundrum is key, as it is critical for the direction of interest rates. Investors are pondering whether the period of faster economic growth will mean a shorter, ‘boom and bust’ economic cycle, or we will see a return to the same low inflation, low growth environment of recent years.
We have maintained a geographically diverse approach towards asset allocation, ‘leaning into’ the recovery story without staking everything on it and preferring to hold on to what we see as the long-term winners, even if they come under pressure in the short-term. We continue to favour Absolute Return strategies over Fixed Income, where we remain underweight. However, after the large upwards move in bond yields, we may be approaching a point at which that could change.