The economic upturn is coming along nicely; an increasing number of people have been vaccinated against Covid-19 and investors seem confident that recovery will take hold. But will an abundance of positive sentiment backfire in the form of inflation?
History lends some comforting context here: the downturn brought on by the coronavirus pandemic is the third such incident to infect financial systems since the turn of the century. In each of these instances, we’ve witnessed a strong bounce-back following each deep recession. Currently, equities are fairly rich and pricing in the economic revival that is expected to happen.
The chart below tracks earnings per share of the constituents of the MSCI World Index over the past 25 year — a period that comprised the dot-com bubble of 2001, the credit crunch of 2008-09, and the all-too-familiar ongoing Covid crisis. Also in evidence is the dramatic oil-price slump of 2016. The dotted line represents earnings trends over the same time frame. As you can see, the line moves along a steady upward trajectory. There is every reason to expect companies to generate above-trend earnings, just as they have done in each prior recovery.
Government bonds are suffering a divergent fate: as investors have become more confident in the global recovery (their sentiment buoyed by vigorous vaccine rollouts in the US and UK) their appetite for risk has resumed, and they have unloaded sovereign credit. Yields have spiked as prices fell, leading to losses of up to 8% for government bond holders and stoking fears that inflation could be breaching the horizon.
However, all this is actually normal market behaviour and indicative of well-functioning markets that are coping admirably with the chaos that has been thrown at them. (Explored further in Investment View).
We believe the best thing to do in a climate like this is sit back and take a long-term view. We don’t mimic the index or let ourselves be influenced by what everyone else is doing: each holding must earn its way into our portfolios on its own investment merit.
“Historically, earnings have bounced back strongly following severe down markets, such as the dot-com bubble or the financial crisis of 2008. It’s perfectly realistic to expect that to happen again.”
Phil Smeaton, Chief Investment Officer
Investment View: How concerned should I be about inflation?
The story of the year—from an investment perspective—has been the US government bond yield. When Covid descended in the winter of 2020, the perceived safety of government bonds was highly sought after, and bond prices went up as investors bought in, driving yields down. As we approached 2021 and learned how to live with the virus—and discovered that vaccines were on their way—the safety of bonds became less paramount.
As though investors said in unison, ‘Why are we holding these things?’, government bonds began to sell off in January in favour of more volatile, but potentially more rewarding, assets. Fairly relentless selling ensued, which caused prices to fall, and yields to rise. While central banks have cushioned the fall with accommodative monetary policy and hefty bond purchases, questions have crept their way in: Is all this indicative of inflation? Will equities be the next to sell off? At what point does the yield rise such that it will put the brakes on recovery?
These are interesting questions, but you need to have the right context for them. Let’s zoom out and look at a broader time frame:
Once we’ve reached the point in an economic cycle where the market can see through towards the end of a recession, it no longer needs these safe assets. While the current spike in yields has garnered attention in the press, it is actually small compared with recoveries past (2002, 2009). Inflation and bond yields are indeed rising, but this should be viewed as a return to normality rather than a cause for panic. Around 1.5% is the standard shift that you would expect to see going into a recovery. There’s no reason to think this time will defy history.
There’s a pointed difference between a reflating economy, in which demand rises as people return to work and their spending power rebounds, and an inflationary problem where prices are consistently rising because of excess money in circulation. Current market movements are consistent with a reflating economy.
All this is not to say that inflation isn’t a longer-term problem; it is a key issue for us, and one that we think about deeply when constructing our portfolios. We may see some ‘transitory inflation’ as expansion takes hold, but this will be due to positive growth factors such as people going back to work, earning better wages, and regaining purchasing power: all signs of an economy on the rise.
The information and opinion contained in this Monthly Commentary should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.