Economic Performance & Outlook
“If you can show me one thing that’s cheaper today than it was before the pandemic I’d be surprised.” That quote from a fund manager in the Financial Times illustrates the spectre of inflation better than any textbook. And he’s right – price rises are accelerating.
However, it’s not quite as simple as prices climbing uniformly across the board and that might be the cause of some central bank hesitancy over what to do. A notable feature in the post-Covid recovery is that it’s extremely uneven – sectors such as health, transport and hospitality are facing significant labour shortages and yet elsewhere there are pockets of unemployment while many countries are still weaning citizens off Covid-related financial support. At the same time inefficiencies in markets are resulting in less-than-optimal conditions for recovery – consider significant increases in gas prices and, most notably in the UK, production and distribution shortages due to post-Brexit fractured supply chains.
All of this is resulting in increased inflationary pressures. The question is whether this trend is ongoing and entrenched or temporary. There have been mixed messages from central banks on this, with US Federal Reserve Chairman Jerome Powell indicating recently that increased inflation might be with us for quite some time. On our side of the Atlantic, European Central Bank President Christine Lagarde said that European policymakers shouldn’t overreact to what may be a temporary spike.
Add into the mix hugely increased government spending and the effect this has on the economy and this poses yet more questions. The Covid crisis has shown that governments can get away with ramping up spending with little consequence, at least for a time. However the largesse will have to be paid for at some time and there are already indications that taxes are going to rise – witness the UK adding to the burden of national insurance (ostensibly to cover the cost of care for the elderly).
What are central banks expected to do in such a scenario? Policymakers have signalled the wind down of the asset purchasing programmes they’d instituted to protect the economy, likely pushing interest rates higher. The Fed plans to reduce purchases from November, the Bank of England has specified a “modest” tightening of monetary policy as interest rates rise, and the ECB has said it will trim monthly bond purchases for the rest of this year. If central banks act more quickly, they risk spooking markets, already jittery with inflation fears.
Bonds
Bond prices are inextricably linked to inflation: because the payments are normally fixed (a small minority of bonds are inflation-linked), their relative value is determined by the acceleration and deceleration in prices. While economists are at odds on whether higher inflation is here to stay, it’s clear that it’s here now and is having an effect, particularly on government bond pricing.
The benchmark US 10-year Treasury yield has climbed to 1.53%, partly prompted by those comments from Jerome Powell referenced above. The advance from below 1.2% in August illustrates well inflationary concerns. The same has happened to the German 10-year Bund yield which has climbed from -0.5% to -0.2% over a similar period.
Despite rising yields, our opinion continues to be that most low-risk bonds remain uninvestable. Instead we see opportunities in emerging market debt, where additional yield sufficiently rewards investors for taking higher risk.
Equities
The ongoing low level of interest rates pushes up the value of all assets — not surprising as the low payout from cash increases the attraction of other holdings. In the case of equities, we believe this is particularly marked.
Indeed, the fallout from Jerome Powell’s comments about the prospects of inflation helped send the US market tumbling to record its biggest decline in five months on 28 September, with the S&P 500 falling 2% while the tech-focused NASDAQ dropped by 2.8%.
Overall our assessment of equities is that we are in for a bumpy ride. Our recommendation is to use a low-cost passive strategy for global stocks, although we are conscious that the likelihood of divergence in performance of certain sectors and countries may provide opportunity for good active managers to deliver outperformance over short to medium-term. In emerging markets there is a short-term case for increasing the weighting above that of the allocation in world indices.
European Property
Property continues to be a casualty of the Covid-19 crisis, particularly in areas such as retail, where the shift to online shopping has been massively accelerated by the lockdown restrictions of the earlier pandemic period. We are still finding it difficult to recommend property investment in the short term and are recommending our clients who are below target weight in this asset class to remain there for now.
Commodities
Commodity prices have taken off of late and are one of the best performing asset classes year to date. Our expectations for commodities remain muted – the prospects in China, a key driver of global demand, have become even more uncertain.
Hedge Funds
Currency Funds
Another useful form of diversification due to the broad range of investments and ability to rapidly shift their asset allocation in response to changing market circumstances. However we are cognisant that in many cases these funds have still to prove their worth from a return perspective, so where we utilise them in client portfolios we have an expectation that they will achieve returns of approximately half to two thirds of equities.
We recommend that some clients use currency funds for diversification, with the ups and downs of currency markets providing both gains and losses in a manner that is generally highly uncorrelated with equities and other asset classes.
Global Tactical Asset Allocation Funds
Another useful form of diversification due to the broad range of investments and ability to rapidly shift their asset allocation in response to changing market circumstances. However we are cognisant that in many cases these funds have still to prove their worth from a return perspective, so where we utilise them in client portfolios we have an expectation that they will achieve returns of approximately half to two thirds of equities.
Senior Loans
We appreciate the diversification that these investments offer, with a return over cash paid for their illiquidity and credit risk, in addition to the low interest rate or duration risk associated with the floating rate nature of their underlying assets.
