August 2021
The ‘great reopening’ of developed economies in 2021 was expected to usher in a sharp rebound in activity – a boom to make good on the slump of 2020. While this was a welcome prospect in many quarters, it was accompanied by concerns that disrupted supply chains combined with a surge in demand as frustrated consumers were finally set free, would trigger a return to the good old/bad old days of surging prices. The reality has been different. This note explores why things have not turned out as expected, and what that means for the outlook for investment markets and our recommendations for portfolios.
The vaccine announcements in November last year turned investment markets on their heads. Overnight the working assumption became that the contraction of 2020 would be reversed in 2021 and that economic growth would boom as lost time and lost growth was recouped. In response, investors bought the lowly-valued shares of companies that had struggled in the lockdowns but were now expected to recover strongly – and sold the covid-beneficiaries. They also sold government bonds. These are much too dull and worthy for an economic boom and, more importantly, their fixed nominal cashflows were vulnerable to the higher inflation that was expected to accompany surging growth supercharged by continued monetary and fiscal largesse courtesy of the central banks and governments. Sovereign bond prices fell and economically sensitive stocks surged – this was the great reflation trade.
The hope, that rapid growth naturally follows a rapid contraction, has played out only in parts. It is certainly the case that recent growth and inflation numbers have been strong by historical standards. For example, the first estimate of US Q2 economic growth, released last week, was 6.5% (on an annualised basis). This followed 6.3% growth in Q1 and represents a decent pace of recovery after last year’s sharp declines. Similarly, on inflation, US headline CPI in July was a slightly scary 5.4%, with even the underlying number (excluding food and energy) at 4.3%. However, beneath the surface there is less cause for optimism.
While Q2’s US growth number looked good, it fell a long way short of the 8.5% forecast pencilled in by economists. Q1 growth similarly disappointed consensus estimates. On inflation, the US central bank, the Federal Reserve, has always preferred to focus on a measure called the Personal Consumption Expenditure price index (PCE), this stands at 4%, and 3.5% on an ex-food and energy basis. These readings are still elevated, but, given that we are passing the anniversary of the first lockdowns and the accompanying huge deflationary downdraft, they really aren’t of a magnitude that conjures up memories of the 1970s. Additionally, if we look elsewhere, we see the US unemployment rate struggling to move decisively below c6% compared to the 3.5% pre-COVID level. Wage increases, meanwhile, despite the stories of staff shortages, are fairly subdued – certainly for an economic recovery. In short, the reopening boom has been a disappointment and nowhere are the effects more apparent than in investment markets, to which we now turn.
For us the complete change of heart in bond markets since the end of March is hugely significant. As the chart shows, bond yields rose very sharply in the first quarter of the year as investors, fretting about the expected boom and a break-out in inflation, sold bonds aggressively. The bellwether US 10-year bond yield rose from 0.91% at the year-end to a peak of 1.73% in mid-March – an extraordinarily rapid move in a 10-week period, prompting FT headlines such as, ‘Long-term US government bonds endure worst quarterly fall since 1980’. Then, slowly at first, but later with gathering speed, those bonds were quickly bought back – driving yields down once more. The message from the bond market is very clear, ‘Boom, what boom? Our concern is quite the opposite.’
US 10-year government bond yields and the relative perfomance of value and growth stocks
Past performance is not necessarily a guide to future performance.
Equity investors have read the message. The outperformance of cyclicals – the ‘boom’ beneficiaries – ended as abruptly as it began, and leadership has once again been taken up by companies that have genuine secular growth opportunities. The blue line in the chart shows the performance of value stock versus growth stocks in the US. It declines as growth outperforms value and vice versa. Thus, we can clearly see outperformance of growth stocks against value up until late 2020, the point at which reopening optimism kicked in, the subsequent rise in value stocks, and finally the resurgence of growth once more from the start of the second quarter of this year. The most striking aspect of the chart, however, is the very close relationship between the performance of growth versus value, and the 10-year US government bond yield. When bond yields fall, growth stocks fare better. Thus, the view on bond markets is not just important for fixed interest positioning, it is also vital to the stock selection decision within equities.
This brings us naturally to our thoughts on asset allocation and the outlook for investment markets. As readers of recent notes will know, we believe that the global economy of the 21st century to be a brutally competitive place. Automation, innovation, globalisation and the almost total price transparency brought by the internet means that there is fierce competition and downward pressure on prices, jobs and wages in many areas of business. These trends have been compounded by ultra-low interest rates which foster still greater competition by allowing new, disruptive businesses to borrow at very low rates.
These headline ‘big picture’ views are reflected in recommended portfolios mainly through (i) the inclusion of high quality, longer duration fixed income assets – we believe that the risk of much higher bond yields is overstated and (ii) higher allocations to businesses with strong growth prospects, ideally with global footprints and effective defences against new competition. Towards the end of last year and through much of the first quarter of this, this positioning looked, to put it bluntly, wrong, and caused us to revisit our analysis and re-test our conviction. Recent months have seen a total reversal, with markets behaving as our research suggested they would once more; bond yields have turned lower and investors have lost patience with ‘value’ companies, that would benefit only from a sharp economic rebound, and instead refocused on long term growth prospects.
As we have said before, complacency often proves an expensive habit for investors, so we are paying very close attention to developments in markets as they unfold. However, the events of the first quarter of the year, when investors marched bond yields higher – only to quickly change their mind – has added to our conviction that our views are well grounded. We are pleased to report that this conviction has translated into performance. Following on from a very good 2020, the Heronsgate model portfolios are once again delivering strong relative performance over 2021 to date.
Economic data and market statistics all sourced from Refinitiv Datastream as at 16 August 2021. This document does not constitute advice or a personal recommendation or take into account the particular investment objectives, financial situations or needs of individuals. This document is not intended for further distribution. This document has been prepared with all reasonable care and is not knowingly misleading in whole or in part. The information herein is obtained from sources which we consider to be reliable but its accuracy and completeness cannot be guaranteed. No responsibility is taken for any losses, including, without limitation, any consequential loss, which may be incurred by anyone acting on information in this document. The value of investments and the income from them are not guaranteed and can fall as well as rise and clients may not get back their original investment. Where investments have particular tax features, these depend on the individual circumstances of each client and tax rules and are subject to change in the future.
The opinions and conclusions given are those of Heronsgate Capital LLP and are subject to change without notice.
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