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Economic disruption has not yet ended

This October/November 2021 market update is brought to you by LGT Vestra

As the world continues on its path towards post-pandemic normalisation, it is clear that the economic disruption has not yet ended.

Companies are still dealing with labour shortages, supply-chain disruptions and various other inflationary pressures that might reduce profit margins.

Consumer Price Index (CPI) data in the US and UK remains at elevated levels, rising 5.4%1 and 3.1%2, respectively, in the 12 months to September. This had raised expectations of monetary policy tightening from central banks in some of the largest developed economies.

Next month will see the Federal Reserve (Fed) start tapering its asset purchases. Currently, the Fed is buying a total of $120 billion a month3. Their intention is to reduce this by $15 billion a month before its expected conclusion next summer. They will be focusing on completing this taper first, before raising interest rates.

The Fed has set a higher bar for an actual rate increase, implying that one might not arrive until the second half of next year. Importantly, the move to taper was so well signalled in advance, that it had little impact on the market when it was officially announced. In fact, the US equity market made new all-time highs after the announcement. This has perhaps also been fuelled by progress on the Biden Administration’s infrastructure spending plans.

With inflation expected to top 4% at the end of this year, and to peak at around 5% in April 2022, the Bank of England (BoE) officials had started to talk up interest rates.

Despite raising market expectations, the Monetary Policy Committee (MPC) took no action at its November meeting. Whilst they held-off raising rates at this meeting, it is clear that the MPC are preparing the market for monetary tightening in the months to come.

Following the meeting, the gilt market rallied, moving expectations for a first rate rise firmly into the new year. The decision to raise interest rates was complicated by a waning economic recovery, tax changes and elevated energy costs weighing on consumer spending power.

The European Central Bank (ECB) also met recently, and at the press conference, President Christine Lagarde hit back at market expectations which had already priced in a rate rise before the end of next year.

She is firmly of the belief that inflation in Europe is transitory, and if they are to maintain inflation around 2% over the long-term, policy must remain accommodative.

We have some sympathy with this view; raising interest rates generally reduces demand but does not help if the inflation is driven by external factors and supply constraints. Nevertheless, some degree of tapering remains on the cards, as the ECB’s emergency bond purchase program is on track to end in March 2022.

Despite the raised inflation rate, we continue to view much of the inflationary pressures as transitory and supply-side in nature, caused by the responses to the pandemic.

We are keeping a close eye on whether wages start rising faster than inflation, risking an upward spiral in prices. The coming months will give a better picture of the labour market as most fiscal supports have ended.

While government spending may increase in many areas, tax is also likely to rise which may hamper future growth.

During the pandemic, central banks provided unprecedented support for the economy and financial markets. However, the strength of the recovery has reduced the need for such an accommodative stance.

For now, it looks like monetary policy tightening will start in the coming months, but the impact on markets is far from clear. Given central banks’ focus on employment, these data releases will determine the speed of tightening.

What is clear, however, is that pre-crisis trends have accelerated, whether it be digital investment, technological transformation, or environmental considerations; the strong are getting stronger and the companies we favour have been benefitting from these longer-term dynamics.

Market View Changes

  • No changes

Currencies

US dollar           ◄►

Sterling              ◄►

Euro                   ◄►

 

While the dollar started the year on a weaker footing, more recently it has shown resilience. The latest Fed meeting signalled the start of a reduction in its ultra-loose policy, thus providing some support for the dollar.

That said, this will be tempered by future fiscal plans and the trajectory of inflation. The ECB’s dovish commitment to its policy stance and sluggish implementation of the EU stimulus plans have provided headwinds for the Euro.

Sterling was strong following the rapid vaccine rollout in the UK in addition to the Brexit deal, however, the cracks in the Brexit deal are proving difficult to resolve and continue to weigh on Sterling. The BoE’s failure to tighten monetary policy as had been expected, resulted in some weakness in Sterling.

Fixed Income

Government Bonds                      Conventional                   Inflation-Linked

UK Gilts                                                   ◄►                                    

US Treasuries                                          ◄►                                  ◄►

German Bunds                                          ▼                                    ◄►

 

The pandemic resulted in near zero interest rates across the developed world, as well as rising inflation caused by base effects and supply chain disruptions.

Whilst the US may see some more upside price pressures due to low inventories, at the same time in the UK, long-term inflation expectations are being distorted by short-term effects.

Given the long average maturity of index-linked gilts, we remain cautious on the segment and many investors expect inflation-linked bonds to be one of the better hedges against a more inflationary environment.

Nevertheless, this does not consider how much inflation is already priced into these securities. More recently, this has weighed on conventional gilts, where we now see a more balanced outlook.

We retain our neutral stance on US Treasury yields given their ability to protect portfolios if growth were to disappoint. At current valuations, we cannot justify investing in conventional German Bunds whilst retaining our negative stance, hence we prefer inflation-linked equivalents.

Investment Grade Corporate Bonds                      ◄►

Throughout the pandemic central banks have supported this vital market, resulting in credit spreads declining from their widest point in March last year. As spreads on offer are now meaningfully lower, our stance has evolved to neutral.

This reflects the support that central banks continue to offer the market for now, albeit with much less attractive yields on offer, consequently tempering our enthusiasm. At current compensation levels, we expect returns to be driven by coupon receipts, rather than further capital returns.

High Yield Credit                                                        ◄►

Plentiful liquidity, paired with a strong economic recovery, has driven a more positive trajectory in credit ratings. Default rates remain benign, and given yield scarcity, demand for the asset class remains strong.

Whilst this has supported developed market issuers, concerns surrounding Chinese real estate developers weighed heavily on Chinese and Asian borrowers. Thus far, contagion into the wider high yield market has been limited, demonstrating improved balance sheets and plentiful liquidity.

Nevertheless, central banks’ plans to reduce asset purchases may come to weigh on the broader market. As such we retain our neutral stance, and stress selectivity.

Emerging Market Debt

Local currency denominated debt                          ◄►

Hard currency denominated debt                           ◄►

 

The news flow from many emerging markets highlights the difficulty of vaccinating everyone, and the dangers of potential new variants. However, stronger global growth prospects and high commodity prices will benefit some countries.

The ongoing battle between the Turkish government and its central bankers, highlights the additional political risks in many of these markets. Thus, we emphasise that selectivity remains as important as ever, and we retain our neutral stance across this diverse asset class.

Equities

UK Equity                                                                     ◄►

The FTSE 100 index has been buoyed by its exposure to energy and materials. However, the market continues to trade at valuations that look cheap compared to markets elsewhere in the world. This has spurred takeover interest by overseas buyers, given the opportunity to pick-up companies at discounted prices.

Ongoing concerns over the disruptions ensuing the Brexit deal have continued to weigh on sentiment. Given the bifurcated nature, we continue to advocate a neutral stance.

Europe ex UK Equity                                                 ◄►

On the grounds of valuation, the European market looks relatively attractive, yet recent sharp rises in gas prices may weigh on margins. Furthermore, the divisions within Europe are difficult to ignore, as demonstrated by the still inconclusive election in Germany and the upcoming election in France. For these reasons, we retain our neutral stance on European equities.

US Equity                                                                    

While investment styles may fall in and out of favour, the US market continues to be a source of high-calibre businesses, and home to the highest quality companies with robust business models.

Despite the relatively high valuations we still expect many companies to be able to sustain compound growth levels which should support future capital growth. Whilst the proposed tax increases may weigh on the market, increased spending on the other side may provide more sustainable economic growth.

Japan Equity                                                             ◄►

For much of this year, Japan’s low vaccination rate and unpopular government deterred foreign investors. This has changed more recently as the vaccine rollout has picked up under Japan’s newly re-elected Prime Minister, Fumio Kishida.

Strong global car prices should support Japanese exports, but the shortage of electronic components may weigh on their ability to take advantage of this. In addition, rising energy costs may squeeze margins, given the country’s reliance on raw material imports. As such, we maintain our neutral rating.

Asia ex Japan Equity                                                

The clampdown by authorities in China on technology companies and the education sector, accentuated the political risks that come with investing in the region. However, we continue to see potential opportunities in China and elsewhere in Asia, as some investment flows feed through to other countries in the region.

The risk of political interference is always present, but valuations have adjusted to take this into account. As a result, we retain our positive stance, but given the volatility we recommend positions to be sized to reflect the risks.

Emerging Markets ex Asia Equity                           ◄►

The rise in energy prices will accentuate the bifurcated nature of investing in these markets.

Commodity producing nations, such as Brazil, may benefit from their natural resources, whereas importers may face headwinds. Prospective moves by developed market central banks to cut back stimulus, may exacerbate these issues. Despite this, long-term growth prospects for many emerging markets remains high. Hence, we continue to stress selectivity in this diverse region and maintain our neutral stance.

Alternative Investments

Hedge Funds/Targeted Absolute Return

As economies around the globe recover from the pandemic, and interest rates remain low, we expect mergers and acquisitions (M&A) to continue to take place. We therefore favour event-driven strategies within this space, acknowledging that potential regulatory interventions may lead to bouts of volatility.

When using these strategies, we look for funds that could diversify returns away from the directionality of conventional bonds and equity markets. In a low bond yield environment and when cash returns are meagre, the diversification offered by these strategies can be attractive.

Nevertheless, we continue to stress the importance of finding the right vehicle and investment manager, which requires extensive due diligence on the strategy and fund.

Property

While we acknowledge the yields on offer may look attractive relative to other sources of income, the outlook for retail and office segments remains uncertain. We continue to suggest that any exposure to property should be selective and prefer closed-ended over open-ended vehicles, given the liquidity mismatch.

The pandemic accelerated trends towards online shopping and working from home, and although the vaccine rollout caused a reassessment of property investments, these trends still weigh on the sector.

The impact of changing working practices on future property demand remains ambiguous; therefore, it continues to be important to be selective and not chase the otherwise attractive yield when investing in this asset class.

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