Much has been written on Covid-19’s economic impact and the associated challenge for investors since the implementation of emergency pandemic measures in early 2020. Back then, few thought that these measures would still be in place 12 months later, let alone that they would be further tightened (as parts of continental Europe have been experiencing). Had this trajectory been forecast in February and March of last year, our guess is that few would have foreseen equity markets pushing new highs at the same time. Now, consensus would be high on three things:
- The economic challenge is without precedent in peacetime history
- The outcome (thus far) for investors has exceeded expectation given that backdrop
- Decisive government and central-bank monetary and fiscal action has been the driver behind asset markets.
The major variables in the next phase are the path and pace of a return to economic normality, and the impact of government and central-bank action taken to date, particularly now that monetary and fiscal policies are strongly aligned in the same accommodative direction. Concerns of an inflationary consequence have unsettled bond markets, and as a consequence have the potential to upset the valuation of other assets too. Vaccine optimism is, depending on your location, growing, but pre-pandemic levels of global economic activity are likely to still be quite a distant target. While the UK, US and many Asian economies have cause for local optimism, the sluggish rollout of vaccines in continental Europe, and slower progress allied with new variants in Latin America, mean that international travel and trade will be constrained for some time yet.
Looking a little further out, the extraordinary fiscal largesse will need to be paid for. Traditionally, an increased tax take, inflation (to reduce the real value of the debt), or a combination of the two have been the routes to that rebalancing. Given how resilient markets have been to developments so far, judging how they will react to the characteristics of the next phase is far from straightforward. Calling the economic direction correctly won’t necessarily lead to successful investment positioning, especially as, once again, it feels that the direction of investment markets will depend significantly on the actions of fiscal and monetary authorities.
In considering our positioning for the period ahead, we recognise that we have no more insight than most on how the pandemic will pan out, and how investment markets will react to that direction in the near term. However, we can focus on other observable trends and themes, and – importantly – valuation, and position our portfolios accordingly.
While significant parts of the economy have been mothballed, and the path to normality remains uncertain, other areas have had a pandemic turbo-charge. Pre-existing trends towards digitalisation have been accelerated, and appropriately exposed stocks have prospered. That trend is unlikely to be reversed, but the valuations that we are currently asked to pay for that exposure may become exposed. In particular, the continued suppression of interest rates and lack of return on ‘safer’ assets has been supportive of high valuations on many secular-growth companies, but conversely leaves them exposed to future increases in interest rates. We remain committed, but have taken care to take profits, invest in companies whose valuations we can understand, and watch position sizing and portfolio risk.
Elsewhere in equities, we have seen some optimism return in areas dependent directly or indirectly on social interaction and a functioning economy, and therefore a broadening of the market advance across cyclical sectors. While economic hardship is far too widespread, there is pent-up demand, and consumers and businesses in aggregate have been saving cash during lockdown phases. Some structural unemployment may result, but, equally, income in the pockets or bank accounts of those most affected is likely to be spent quickly in the real economy. As a result, recovery in the real economy should be swift when society reopens. As a generalisation, while these sectors have had a better period, we believe that valuations in cyclically exposed stocks and sectors continue to offer scope for gains.
UK equities – better times ahead?
The UK, perhaps with modest Brexit impacts aside, fared no worse than other European economies through 2020. However, the UK stock market has a peculiar and biased make-up, which has exposed it disproportionately to the Covid-19 downturn. Portfolios that have a UK bias, which is often the case for investors who favour income, underperformed last year, although vaccine optimism has encouraged outperformance towards the year end and into 2021. The income advantage of the UK market is diminished by pandemic effects, but not extinguished. The presumption in favour of a fuller global opportunity set in stocks (without a UK bias) has increased and is increasing, particularly for those happy to rely on total (capital) return, but the timing of moves in that direction requires care. A move on the back of the divergent performance of last year and differing valuations requires careful thought, not least in understanding income impacts. Additionally, conditions and valuations may support relative recovery in the fortunes this year of UK equities, and good global companies with attractive valuations could be additive to 2021 performance.
The repression of interest rates and demand from price-insensitive buyers (central banks) has kept government bond yields ultra-low, albeit with yields rising in the early part of 2021 as expansionary policy has encouraged better expectations for economies. Rising yields do not make for a bond-friendly environment, leading some to the conclusion that these assets have no place in portfolios. We would agree that their diversification benefits are reduced, and return prospects are limited. Bonds historically have helped reduce risk in portfolios. Portfolios without exposure to safe government bonds are (we would argue) riskier, but we recognise that even if your portfolio owns government bonds, at such low yields and with the likely correlation to equities, portfolios are ‘riskier’ than when bond yields were more ‘normal’. Our government bond exposures are significantly lower than they have been, but we are not ready to abandon them altogether. Risk is elevated across all asset classes, and in a real ‘risk-off’ environment investors will be glad for their protection and the liquidity they provide.
The outlook for commercial property looks to us to be challenged. Retail property remains under structural pressure (elevated by pandemic effects), office real estate is uncertain while working patterns are reappraised, and valuations in distribution sheds appear generally to reflect demand. Investors need to be able to bear the illiquidity inherent in the asset class. We will hold property, but for specific client reasons.
Rising inflation risk
The final, and perhaps most important, piece of the jigsaw, especially for long-term charities, is inflation.
Inflation numbers will rise this year, with annual figures now describing a rate of change from a depressed data set from the spring and summer of last year, as economic activity and demand dropped sharply. Pent-up demand and the spending of money saved during lockdown will provide reflation, but those factors are not in themselves sufficient to give rise to structural, year-on-year inflation thereafter. Deep deflationary forces will, we think, continue to act as a counterweight, and we are yet to be convinced that the future environment is one of high inflation.
Many predicted resurgent inflation as liquidity was pumped into the financial system after the 2007-8 global financial crisis, but we believed this was an unlikely outcome, given the deep structural deflationary counterforces (the impact of high debt, ageing populations, and the disruptive march of technology) and policies of fiscal austerity. The structural deflationary counterweights persist, and should not be underestimated, but expansionary fiscal policy has replaced austerity, and so the risk of inflation has certainly risen, and portfolio construction needs to be cognisant of that.
Inflation is the enemy of fixed-coupon bonds, especially when yields are so low, and we are accordingly light in those. Higher interest rates (and bond yields) may upset highly rated growth equities more than those in consumer-facing areas with pricing power (and consequent ability to protect margins), so careful balance in equity selections around valuations and pricing power is key.
Risks around environmental (climate change), social and governance (ESG) factors remain key in the assessment of investment opportunity. The environment has been very much at the forefront of investors’ minds, but social factors (such as forced labour and human rights in supply chains, and fair treatment of workforces) are increasingly prominent. Deep integration of ESG research is as necessary as ever in fully understanding the true extent of the financial risk in a company, and highlights opportunities for improvement too. Over and above ethical standards and values, the ability to assess and manage ESG risks and opportunities in portfolios will be ever more important in the achievement of good investment outcomes.
Valuation is key
Economic activity and growth should pick up from current, Covid-19-affected levels. Market valuations are ahead of that already, funded and encouraged partly by central-bank and government munificence, and so growth is required to justify current asset valuations. As much as we look for diversifiers and risk mitigators, we find risk (if only valuation risk) elevated in most areas. Appropriate positioning to us appears therefore to be: constructive on well-chosen equities, with attention paid to balance and valuation; light on government bonds (but we are not ready to abandon them from portfolios or benchmarks); and taking particular care in property and other alternatives, where illiquidity features need full consideration.
Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.
This is a financial promotion. These opinions should not be construed as investment or any other advice and are subject to change. This document is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those securities, countries or sectors. Please note that portfolio holdings and positioning are subject to change without notice. Issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN and is a subsidiary of The Bank of New York Mellon Corporation.