Economic Performance & Outlook
It would appear that the Covid era of economic malfunction is nearing its end – for much of the economically developed world at least. With an advanced vaccination programme taking place, businesses are reopening and restrictions are being unwound. While there remains much concern about new variants, the tentative evidence thus far seems to be that vaccines provide valuable protection against them. The overriding fear of a breakdown in our health services seems to be receding.
Of course, the point we have already made clearly is that the response to Covid, like antibodies, is now very much running through the veins of the global economy. The questions we must therefore ask ourselves are about the effect of the economic stimulus on the economy and government finances, and the ensuing impact on share valuations.
First, are stimulus levels too high, and for how long will they continue? The Covid-stimulus injections into our economies have given governments a taste, and a desire, to do more of this in the future to target other policy areas. The Biden administration in the US is implementing a package so vast as to have been unimaginable years ago – $1.9 trillion – paving the way for a more European-style approach to intervention in its economy. And where the US goes the rest of the world tends to follow, so expect a similar spending splurge across other developed nations. In short, spending levels are high and likely to continue so for some time.
Will this lead to higher taxes? A few years back, then UK Prime Minister Theresa May got herself into a spot of bother by saying there wasn’t a “magic money tree” while at the same time trying to get the DUP to support her government with a significant financial inducement for Northern Ireland. A “magic money tree” appears to have been found and has come of age during the Covid pandemic, giving the impression that governments can just spend and spend more without comeback. While the rules for finances differ between governments and households, with countries enjoying more leeway to borrow well into the future, money eventually has to come from somewhere. It’s likely therefore that tax rises will become more generally accepted – particularly on easy targets such as global tech firms, where G-7 leaders have agreed in principle to establish a minimum corporation tax level. It may however be difficult for governments to impose taxes elsewhere, so we may see higher deficits for a while.
Finally, what does this mean for inflation? Pumping more money into the economy chasing ‘sticky’ levels of goods and services pushes inflation up. That’s evident in data from the US, where consumer prices soared 5% year-on-year in May. While this is a snapshot against a pricing low point, indicators in many countries are also starting to point to rising wages, exacerbated by Covid-driven negative immigration. Certainly something to keep a close eye on, particularly for those pension schemes exposed to inflation risks.
Bond performance over past year
All bonds 10+ years, 10/06/2020 – 10/06/2021, local pricing
Some things in finance are complicated or difficult to get your head around. Not so the relationship between inflation and bonds. If inflation goes up, the value of fixed payments goes down. If the outlook for inflation rises, bonds will decline in value.
Bonds also face a squeeze because of widening government deficits. Just like an individual, governments are judged on their ability to repay money – the more they borrow, the less likely they may be to repay those sums.
The benchmark for global government debt is the US 10-year Treasury yield, which stood under 1% at the start of the year. Since March it’s been hovering around 1.5%, meaning the value of those bonds has declined significantly. The amount of QE and other stimulus ongoing may well support rates at close to current levels for some time yet, but over the longer term we think interest rates are likely to rise which will possibly further dint those valuations. As such, we are generally advising clients to remain underweight long bonds (except where held for liability-matching purposes). We retain the view there may be opportunities in emerging market debt, which has moved less than other forms of debt and is still paying relatively attractive interest rates.
It’s clear that the overall judgement of market participants is that the money being pumped into the economy is good for companies and therefore for equities. Markets have continued to march higher, with the benchmark US Standard & Poor’s 500 index now up close to 85% from the level it reached in March 2020. The technology-heavy Nasdaq index has more than doubled over the same period.
It will be fascinating to see the long-term effects of the heightened intervention by governments and central banks on equities in the months ahead, with a number of competing factors at play in different sectors. Increased spending might be seen as a boon for companies, supporting current valuations. Climate change considerations are starting to bite at both consumer and investor levels – pushing some values higher and dragging others down. Technology company valuations appear speculative, to say the least. Our opinion is that valuations are looking a bit stretched relative to historic levels, which will be a headwind to future return levels, but that they do remain attractive relative to bonds with low to negative yields, so we are cautiously recommending that clients are neutral in their equity weighting.
It’s clear that amongst those who’ve suffered most in the last year are high-street retail businesses, and that the outlook for city centre offices remains uncertain as businesses start to explore what their post-lockdown office / remote balance will look like and the space it will require. Downward pressure from the retail sector is likely to weigh on property prices, and as a result we still find it difficult to recommend increased investment into traditional property investment funds in the short term. As before, we believe the Irish property market is looking slightly expensive but we also recognise there are some positive attributes within many property holdings and our clients may want to hold onto assets that may be generating strong yields with good downside protection for the time being.
Where is all that stimulus money going? Often into building new things and making stuff, and in order to do that, you need raw materials. One would expect the prices of commodities, such as iron ore or copper to have risen in value, and indeed they have. The S&P World Commodity Index has climbed almost 60% over the past year.
However, we believe that some of these increases are likely to be driven by supply / demand imbalances that can be attributed to kinks in the global supply chain as restrictions on activity are reduced in an imbalanced manner from place to place, and may prove to be temporary in nature. We do not believe that we are in a sustained bull market for commodities for a number of reasons, including lower longer-term growth expectations for China, which had in the past been a voracious consumer of commodities to sustain its rapid development.
We continue to believe the absolute performance of hedge funds has been disappointing. However they may well come into their own should equity markets turn, where their defensive qualities should become evident.
As we have said before, these funds continue to provide useful diversification against other asset classes and therefore should be considered for this benefit.
Global Tactical Asset Allocation Funds
Again, these funds should be able to offer diversification against other asset classes, because their managers tend to zone in on themes that may not necessarily be reflected throughout traditional markets. Recent experience for these funds has been quite good.
The diversification benefit of these securities is their attraction, with the return for investors based on their illiquidity and credit risk. The risks to borrowers in this space have increased since the start of 2020, with the prospect of increased default rates once government supports start to be reduced, however the yields have remained strong relative to cash and core bonds and we believe they retain a role to play within a diversified return-seeking investment portfolio.