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

Having started November well, equity markets experienced a retracement going into December following the news of the Omicron variant. At present little is known about it, however it appears to be more virulent, albeit potentially less severe. New versions of the vaccines are already being worked on, but it appears as though this may take several months before they become available.

At the same time, inflation continues to rise in many developed economies, appearing more persistent than many had originally expected. Continued supply-chain bottlenecks, freight pressures and rising energy and raw material costs have all contributed to inflationary pressures.

The re-election of Federal Reserve (Fed) Chair, Jerome Powell, and his subsequent hawkish rhetoric has signalled that the punch bowl will gradually be removed going into the festive period.

Throughout the pandemic, central banks have sought to loosen policy when fresh restrictions on economic activity were imposed. As consumers have learned to adapt to changing conditions, the impact of restrictions on the economy has become less severe.

Conversely, with a greater degree of constraints, this puts more pressure on central banks to reduce their support for the economy as consumers substitute goods for services when restrictions are imposed.

This may exacerbate supply-chain pressures and hence central banks may not loosen policy, even if the economy temporarily loses momentum again.

Over the past year, the market narrative has been very much focused on inflation. The most recent data for inflation in the UK, as measured by the Consumer Price Index (CPI), shows that it is up 5.1%¹ over the past year, and more than two-and-a-half times the Bank of England’s (BoE) target. This has been fuelled by higher energy prices and supply shortages.

Inflation is high in other developed economies too, with CPI in the US up 6.8%² over the last year; energy again being the main culprit. This has put pressure on the BoE and the Fed to pare back their accommodative stance at a faster pace than previously envisaged.

At this week’s meeting, the BoE’s Monetary Policy Committee (MPC) decided by eight votes to one, to raise interest rates by 0.15% to 0.25%. A tight labour market following the end of the furlough scheme drove them to tighten now, despite the rapid spread of the new variant.

While the Fed had announced a $15bn a month tapering program at the start of November, Chair Powell decided to speed up the pace of tapering, doubling the program to $30bn a month. As such, tapering will now conclude in March, rather than in June 2022. Fed members expect to hike rates three times next year, given limited spare capacity in the economy.

While the European Central Bank (ECB) is reducing its asset purchases, they will still increase their balance sheet albeit at a slower pace; this means that interest rate increases are some way off.

China is currently grappling with a deterioration of its property sector, brought on by a tightening of lending conditions. This has culminated in the high-profile defaults of Evergrande and Kaisa.

To prevent the economy falling into a recession, the People’s Bank of China (PBOC) cut the Required Reserve Ratio (RRR), encouraging more lending in the economy through a reduction in the amount banks have to set aside.

While not broad-based stimulus, it is a sign that China is seeking to ease credit conditions moderately. That said, there may be more to come in the new year.

While those companies that were hit hardest by the pandemic have had a strong recovery on the back of reopening economies, the Omicron story hit these pandemic sensitive stocks, highlighting the risks associated with these investments.

We continue to favour companies with high margins, strong balance sheets, relatively low labour and capital intensity, with recurring revenues and growing earnings.

While there remains uncertainty surrounding the trajectory of the pandemic and inflation, interest rates are only likely to rise moderately. As such, businesses that can generate long- term sustainable compound returns will continue to make selective equities attractive.

Market View Changes

• No changes

Currencies

US dollar             ◄►

Sterling               ◄►

Euro                    ◄►

While the dollar started the year on a weaker footing, it has since shown resilience. The Fed has signalled its intent to reduce 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. Following the BoE’s decision to raise interest rates, Sterling rallied marginally.

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.

While 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. Many investors expect inflation-linked bonds to be one of the better hedges, against a more inflationary environment. However, this does not consider how much inflation is already priced into these securities.

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 while 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.

With central banks paring back support and disruption caused by the new variant, spreads have widened from their lows. Given the demand for yield and a positive ratings trajectory, we still believe there remain some selective opportunities.

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.

While 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 geopolitical tensions surrounding Russia and its impact on gas supplies may act as a drag.

While we finally have a coalition government in Germany, political difficulties in Europe are far from over, with elections in France a particular point of tension in the new year. 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 have sustainable compound growth, which should support future capital growth.

While the future tax increases may weigh on the market, increased government spending on the other side may provide more sustainable economic growth. Discussions over raising the debt ceiling have finally concluded, removing at least one uncertainty ahead of the mid-term election next year.

Japan Equity      ◄►

For much of this year, Japan’s low vaccination rate and unpopular Government deterred foreign investors. This has since changed as the vaccine rollout picked-up pace under Japan’s new 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. Still, we continue to see potential opportunities in China and elsewhere in Asia, with the latest easing supporting broader financial conditions.

The risk of political interference is always present, but valuations have adjusted to consider this. De-listings, such as Didi, from the US market, highlight the importance of distinguishing between onshore and offshore investment. 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 has accentuated the bifurcated nature of investing in these markets.

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

Alternative Investments

Hedge Funds/Targeted Absolute Return

Providing 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 closed-ended over open-ended vehicles are preferred, 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. Consequently, it continues to be important to be selective and not chase the otherwise attractive yield when investing in this asset class.