12 July 2021
By John Husselbee, Co-Fund Manager WS Verbatim Portfolio Growth Funds
Central bank watching has become the markets’ favourite pastime and no comment or gesture, however miniscule, can escape forensic examination for signs of hawkish or less dovish leanings.
In the US, headline inflation has crept up to 5% – and core to the highest level since 1992 at 3.8% – and despite the US Federal Reserve’s calming attempts, there are growing calls for measures to douse these flames before they get out of control.
Anyone looking for a more hawkish tone from the Fed saw exactly that in June, announcing higher expectations for inflation this year and an earlier timeframe for potential interest rate rises. The Bank increased its headline inflation estimate to 3.4%, up a full percentage point from the March prediction, and admitted levels could end up ‘higher and more persistent’ than expected as reopening continues, with rapid shifts in demand plus bottlenecks, hiring difficulties and other constraints limiting how quickly supply can adjust. Meanwhile, its dot plot chart is now signalling two possible rate hikes in 2023; previously, this consensus forecast showed nothing on this front until 2024 at the earliest.
The pandemic remains the dominant story, however, and Fed chair Jay Powell advised investors to view the dot plot with a ’big grain of salt’, calling its forecasting capacity into doubt and claiming lift off on rates is well into the future. Even with the raised forecast for this year, the FOMC sees inflation trending down to its 2% goal and continues to claim it has the tools to stop things running too hot; the question, for many, is what exactly it would take for the Bank to actually use them.
Tapering still remains a discussion for the future, with the Fed reiterating the economy is not yet at the point where slowing asset purchases is appropriate.
In the UK, inflation also climbed to 2.1% in May from 1.5% in April, exceeding the Bank of England's 2% target for the first time in almost two years, with upward pressure from transport, motor fuel and eating out costs. Economists had expected an increase to 1.8%, again leading to speculation over when policy tightening may be needed, and, mirroring the Fed, the BoE also upped its expectations for inflation but insisted this does not pose a threat to growth. Short term, the Bank said CPI inflation could even breach 3%, mainly due to developments in energy and other commodity prices, but this should be transitory.
Predictions claim the UK will grow at the fastest rate since the Second World War this year, based on that cocktail of successful vaccine rollout, pent-up demand being released and ongoing fiscal and monetary support. The EY ITEM Club (standing for Independent Treasury Economic Model) expects GDP to grow by 6.8% in 2021 – a sharp upgrade on the 5% estimated in January – which would mark the fastest rate since 1941.
Despite Brexit being ‘done’ however, we saw ongoing fallout in May as China replaced Germany as the UK’s biggest single import market for the first time on record. Figures also revealed UK trade with the EU collapsed by nearly a quarter at the start of 2021 compared with three years earlier, as Brexit and Covid-19 disruption hit exports. As we have said before, the pandemic continues to dominate at present but as that recedes, over the longer-term the impact from Brexit remains the big unknown for the UK.
Our view is that we have already seen inflation in asset prices via the ‘gamification’ of investing, with huge rises in stocks like Tesla and corners of the market such as Bitcoin. Liquidity levels in markets (alongside the base effect of higher energy prices and pent-up consumer demand) are clearly creating a short-term warming up but we do not currently see conditions forming for persistently higher prices longer term. We therefore remain in the transitory camp, although admit the latest round of central bank statements jar with previous comments on the temporary nature of the spike.
For us, the situation appears to rest on how long we can call the current run up in prices as ‘positive reflation’ rather than ‘bad inflation’ and frame it as a return to more normal levels post-pandemic. While this makes sense for items in the goods basket such as air travel and cars, which clearly saw a huge drop off, inflationary pressure elsewhere is coming from more serious supply-side issues, which could ultimately weigh on growth.
Overall, there is a feeling markets had a fairly easy ride in the first stage of recovery from the pandemic but more volatility is expected over summer and equities could remain rangebound as investors wait to see what the Fed and other central banks decide.
Another strong quarter for equities amid the ongoing reflation trade drove a solid return across the funds, with bonds also enjoying better fortunes after an extremely difficult Q1.
As we reported in Q1, small caps and value continued their rally post-November’s vaccine announcements, with funds such as JPM US Equity Income and Fidelity Special Situations posting strong returns. Other more growth-focused funds such as Lindsell Train UK Equity had a better period after lagging in Q1, with this style rebounding in the UK and closing the gap on value.
European equities led the way over the quarter, as a broadly cyclical market amid global recovery, and several of our holdings in this area were among the top performers, including Liontrust European Growth and Baring Europe Select.
A number of funds focused on Japan were detractors after a strong Q1. Japan’s Nikkei Index hit a 30-year high in February and there are high hopes for the region given its value/cyclical profile. Over the second quarter, however, growing concerns about rising Covid-19 cases and the country’s slow progress on vaccinations hit sentiment, although the latter is starting to accelerate in the run up to the delayed Tokyo Olympic Games in July. Elsewhere, our emerging market exposure on the higher-risk funds was positive but the region lagged other equity markets, weighed down by slower progress on vaccinations and renewed outbreaks of the pandemic, as well as a tougher backdrop for growth.
As outlined, our bond funds were back to making positive returns after a challenging first quarter, with yields settling down for now despite lingering concerns about inflation.
Over the period, we made significant changes to property exposure across the funds. The M&G Property Portfolio was suspended on 4 December 2019 after a sustained period of withdrawals and resumed dealing on 10 May 2021, at which point we took the opportunity to redeem our holdings and invest in a selection of property vehicles with liquidity profiles more appropriate for the underlying asset class. As a result, we also sold the position in the L&G Property fund.
We believe retaining an allocation to property is appropriate for the funds as it should provide low-volatility returns and downside protection through stable, passive, high-quality income. By targeting specific sectors that have these characteristics over the long term, we can achieve a similar return profile to the MSCI UK IPD. Our property ‘portfolio’ is 25% each in healthcare holdings Assura and Primary Health Properties, 10% in Civitas (social housing), 30% in Tritax BigBox (logistics) and 10% in Supermarket REIT. The healthcare and social housing sectors benefit from long government-backed income while logistics and retail/supermarkets provide long duration income from investment grade-quality tenants.
REITs enjoy the benefit of being closed-ended and, as a result, will not have to deal with investor withdrawals from the capital pool. The compromise required for investing in REITs is due to the fact they are listed and their prices (like ordinary company shares) move daily based on supply and demand. This results in the appearance of holding a more volatile asset in the short term but, over the long run, we expect the return experience from REITs to be similar to directly invested property.
Across our portfolios overall, we continue to adopt a risk-on stance but acknowledge there are challenges to this view, from growth disappointments to virus mutations, with the terrible humanitarian news from India providing a reminder of the risks posed, especially in less-vaccinated economies. There remain plenty of positive drivers, however, such as monetary support, vaccine distribution and pent-up corporate and consumer demand being released.
This risk-on environment continues to favour equities. Markets have come a long way from 2020 lows but this is largely justified by government spending and decent corporate results, and we remain positive on valuations outside of US mega caps, favouring cheaper regions such as Europe, Japan, emerging markets and, increasingly, the UK. Our long-standing concerns about stretched valuations in the US remain intact, especially at the more speculative tech end, but 2021 earnings have surprised on the upside and even this market is starting to offer better value after a recent cooling off.
Since positive vaccine news late last year, there has been a far broader rally in markets amid an ongoing global rebound, and this has seen more cyclical and value companies starting to catch up with the growth names that dominated for most of 2020. Bond yields are also starting to rise after a long period of decline and the general perception is that this tends to penalise growth, or long duration, stocks. Areas like technology are thought to be under greater threat as they rely on future earnings and are therefore more vulnerable to an increase in the bond yield used to discount those earnings.
With bonds, we continue to be broadly bearish but always maintain exposure as zero weighting any asset class negates the long-term benefits of diversification. Bonds continue to meet four roles in our portfolios: providing some income, capital preservation, inflation protection and diversification from equities. At present, given challenging conditions for bonds, we are avoiding market beta and focusing on areas where there is more alpha available such as high yield (which offers a more attractive risk/return and greater yield than investment grade).
The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. The contents of this article should not be construed as advice and is for information only. Individual stock selection should only be performed by suitably qualified advisers.