Quarterly Commentary: 31 January 2021 – 30 April 2021

This reporting period has witnessed the eagerly anticipated global vaccine rollout beginning with the UK leading the way within G7 economies. The early evidence suggests that the vaccine is highly effective in reducing infection rates and severity. Countries with high vaccination rates, such as Israel and the UK, have been able to scale back restrictions without a further wave of infections, whilst economies yet to introduce effective vaccination programmes, such as the EU, have seen further waves of infections and lock-downs.

The vaccine success has boosted equity markets but caused bond markets to move lower due to inflation concerns being triggered by the prospect of a globally synchronised rebound in economic activity, fuelled by the massive stimulus deployed during economic lockdowns.

During the reporting period, the Investment Association (IA) UK All Companies sector returned 11.23%, closely followed by the IA North America and IA Europe (Ex UK) sectors which returned 10.63% and 8.88% respectively. The IA Asia Pacific (Ex Japan) sector returned 2.28% whilst the IA Sterling Corporate Bond and IA Gilts sectors fell by 1.84% and 5.45% respectively.

Reflecting on the year 2020, investors holding the average medium risk portfolio measured by the IA Mixed Investment 40-85% Shares sector, would have seen a return of 5.32%, belying the significant swings during the period. At the worst point, this sector recorded a loss of 19.71% (to 23rd March 2020) before recovering 31.18%. With equity markets having achieved the perfect ‘V’ shaped recovery, economic growth is also rebounding, with China already ahead of pre-Covid levels of economic output.

The UK is predicted to achieve this by the end of 2021 with growth expected to hit 7.25% for the year, the highest level since 1941.

During the early stages of the pandemic, there was a shortage of personal protective equipment and various hoarding strategies were employed by countries to ensure their needs were prioritised before production rose to meet demand. Similarly, base materials for Covid-19 testing also experienced acute supply difficulties before global production rose to meet the high levels of demand. The same pattern is now occurring in relation to vaccines, however the number of vaccines approved for use is growing and production is also increasing, so we expect this shortage will also be temporary.

Economies currently leading global vaccination efforts have been able to remove restrictions sooner and benefit from an earlier economic recovery. As vaccine manufacturing and deployment accelerate, the recovery will broaden. The risk of variants also believed to be manageable, as vaccine technology has demonstrated, it can be refined and modified quickly and effectively as needed.

During the pandemic, global banks and governments have injected huge quantities of cash to protect the economy from collapse. In the UK, this has included cheap loans, paying wages of furloughed workers, grants and extending the purchase of government bonds by the Bank of England. Notably, consumer savings increased during 2020, as many workers maintained their income but were unable to spend as usual due to economic restrictions.

As investors begin to look forward to a post-Covid environment, concerns about inflation are beginning to increase. There are already signs of inflation due to ‘base effect’: the distortion caused by abnormally low levels of inflation one year ago as the price of base goods fell dramatically during the first lockdowns. For example, last year oil prices briefly turned negative on some exchanges as pipeline deliveries overwhelmed demand leading to shortages of storage. Prices have now re-bounded causing inflation measures to jump upwards.

Base effect is a temporary factor, but longer-term signs of inflation are emerging, and a synchronised global recovery could also squeeze supply, pushing prices higher. The risk is further amplified as government bond yields were deliberately reduced through quantitative easing following the 2008/9 credit crisis. As yields are already below expected inflation, and with the prospects of inflation rising, the potential for an upward move in bond yields is growing, with signs this is already occurring. When bond yields move up, the value of bonds goes down leading to capital losses, and the consequential impact on other markets can be even more dramatic.

Taking UK Government bonds and inflation in numbers, the current yield on 10-year Government bonds is approximately 0.8% whereas the Bank of England target for inflation is 2%. The Bank of England is purchasing around £5bn of bonds per week under the current quantitative easing programme and owns just over 30% of the entire market. Without this support it is unlikely investors would be willing to maintain a yield below inflation given the loss that would occur in real terms and yields would likely drift towards, or above, the inflation target.

In addition to the Bank of England inflation target, the Government bond market also provides an estimate of future inflation through the difference between traditional bonds and index-linked bonds, where performance is directly linked to inflation. This so-called breakeven rate is currently around 3% and well ahead of the Bank of England forecast.

This all becomes quite sticky if inflation rises, as the ability of the Bank of England to maintain bond purchases is curtailed, perhaps causing 10-year bond yields to head above 3%. The expected capital loss of a 10-year Government bond if the yield rose to 3% is around 17%, which is a significant loss for an asset that is considered low risk, and the effect on other markets could be more significant.

The sensitivity of Government bond values to a change in yield is a function of the annual return and the redemption date. The longer the redemption date, the greater the sensitivity, therefore longer dated bonds are much more sensitive than bonds that mature in a year or two. Some equities are also very sensitive to yield changes, particularly growth stocks which require capital investment to execute their business plans and expected profits many years in the future.

As an example, the leading manufacturer of electric cars, Tesla, is reliant of continued capital investment while current profits are very small compared to the share price. Investors are looking a considerable way into the future to justify the current value, so rising borrowing costs and inflation present downside risk to the share price.

The triangular relationship between inflation, yields and growth stocks has caused a recent spike in market volatility. The elements have worked together positively since the 2008/09 credit crisis to create a steady increase in the value of bonds and growth equities, with the US market being the key beneficiary due to the high prevalence of growth/technology companies. Covid-19 added a further leg to this trend due to the upswing in the virtual economy caused by lockdowns and further stimulus. It is now worthwhile considering the effects of these trends beginning to unwind.

The notable area of vulnerability to a change in a long-term trend is index tracking strategies. Those strategies with an allocation to government bonds are particularly vulnerable as government borrowing has increased since the credit crisis and into Covid-19. Governments have been issuing longer and longer dated debt, keen to lock in historically low borrowing costs for as long as possible. This has skewed the market towards more interest rate sensitive holdings and, of course, tracking funds are obliged to follow the market.

If this trend reverses, these funds must continue to hold their positions and track the market, whilst their equity weightings have also become interest rate sensitive due to the dominance of US growth stocks over the past decade. Since yields peaked last year, the popular Vanguard Lifestyle strategies have been underperforming following multi-year outperformance. The question is, will low costs remain attractive if multi-year underperformance now occurs?

This all bodes well for value equity markets which feature fewer growth/technology stocks and more mature businesses; especially the UK. Without Covid-19, the recent reporting period would have recorded a relative drop in UK economic activity as the implications of leaving the EU were initially felt. This has been offset by the success of the UK designed Oxford AstraZeneca vaccine and rollout of the vaccination programme, with the UK expected to move out of Covid-19 restrictions shortly and leap ahead in terms of economic growth. Given the years of uncertainty after the Brexit referendum, many international investors avoided UK assets but, with a potential rotation to value markets and the UK leading the post Covid-19 recovery, there is scope for re-allocation, pushing share values higher.

Although the US/China relationship appears to be souring once again and there has been an escalation of hostilities between Israel and Palestine, the path out of Covid-19, vaccination efforts, inflation, and the effects of yields on growth/technology stocks are expected to dominate market sentiment in the short term. Looking slightly further ahead, the question of increased taxation will arise, and we expect businesses that benefitted during the pandemic to be targeted, as occurred following the 08/09 credit crisis. Many of these companies are also facing the prospect of increased regulation, as governments seek appropriate tools to ensure the virtual economy has appropriate levels of governance, creating a series of potential headwinds for growth stocks.

Outlook

We remain optimistic that Covid-19 risks will diminish throughout 2021 as the vaccine response accelerates and science is able to develop successful responses to variants, if needed. Stock markets are largely pricing in a ‘V’ shaped economic recovery and this is supported by the current evidence.

We expect inflation concerns to spike occasionally, causing speculation that central banks may reduce their support of bond markets. This is expected to lead to rocky periods as bond market yields gradually rise.

This outlook will lead to clear winners and losers with some expensive growth stocks potentially vulnerable to higher future borrowing costs, even though they may continue to grow revenues. Despite the anticipated volatility, quality assets are preferred to protect against rising inflationary pressures and the prospect of a downward trend in bond markets. Diversification is important to reduce the risk of exposure to equities having high correlations to bonds, as they may be difficult to identify ahead of losses being incurred.

We expect lower average returns from global assets over the next decade with higher levels of volatility.

Important Information

Please note that the contents are based on the author’s opinion and are not intended as investment advice.

Any research is for information only, does not constitute financial advice or necessarily reflect the views of the author and is subject to change. It remains the responsibility of the financial adviser to verify the accuracy of the information and assess whether the fund is suitable and appropriate for their customer.

Past performance is not a reliable indicator of future performance. The value of investments and the income derived from them can fall as well as rise and investors may get back less than they invested especially in the early years.