Good news risks becoming bad news as rising prices unsettle markets
February saw a transference of emotions as initial optimism over stronger economic growth turned into reflation fears, with evidence of rising industry prices sending bond yields higher and in turn unsettling equity markets. A combination of factors helped to push inflation expectations higher, most prominently in the US but with global ramifications, as President Biden's $1.9 trillion stimulus package passed through Congress alongside evidence that prices in both the services and manufacturing sectors had reached their highest levels since before the Global Financial Crisis of 2007-08.
Equity gains evaporate as bond yields spike
In sterling terms, equity markets retreated from mid-month gains of 5-6% to end the month barely changed, with UK shares faring better at a rise of around 2%. Government bonds fell by up to 5%, with corporate bonds losing around half of that amount. Agricultural commodity and industrial metal prices touched multi-year highs, 30% above levels of the previous March, adding to the reflationary pressure.
Government bond yields spiked higher, with the yield on the benchmark US Treasury 10-year rising by 0.5% to 1.60% before settling around the 1.5% level. The UK 10-year bond yield, which began the year at a lowly 0.2%, ended the month at 0.8%. Although still at historically low levels, the magnitude of these moves took many by surprise. Within the bond market, a number of technical levels were breached: inflation expectations hit a 13-year high and the yield difference between two-year and 10-year bonds was the widest for five years.
The Fed holds steady while Europe steps in to calm markets
Reaction to comments from Chairman of the US Federal Reserve, Jerome Powell, demonstrated the fickle nature of investors. Comments earlier in the month that the Fed were a long way from pulling back on stimulative measures, and that inflation and employment levels were a long way from target, eased market fears. Conversely, his response to rising bond yields, that the move was not disorderly and was consistent with expectations of economic recovery, disappointed many who had been expecting the Bank to keep a lid on yields.
Not all central bankers were as relaxed. President of the European Central Bank, Christine Lagarde, initially stated that they were "watching bond yields," and when traders failed to take the hint, used the monthly ECB meeting to announce that bond purchases over the next quarter would be at a significantly higher pace. The Reserve Bank of Australia also stepped up purchases of its bonds.
A rapidly improving outlook, with the US taking the baton from China
New Covid mutations apart, it was hard to argue with a rapidly improving recovery, with the United States taking the baton from China, which had recently announced moves to engineer a more restrained growth rate. Higher levels of household savings, further fiscal stimuli and pent-up consumer demand all pointed to a strong second half of the year as vaccine roll-outs allowed a return to more normal conditions.
The US economy had already been showing decent signs of recovery when Congress approved President Biden's stimulus package to pump a further 10% of GDP into the mix, much of which was targeted for 2021. In the UK, while lagging in terms of stimulus and growth, there had been reports that companies were increasingly seeing signs of shortages in the goods they needed, given both better-than-expected demand and the inability for supply chains to ramp up fast enough. If this continued for any length of time, it could lead to higher inflation.
A note from the desk
I am pleased to share our monthly update on market events. The overview seeks to summarise market movements together with our views and the rationale for the positioning of investments going forward. As always, should any aspect of this commentary prompt a question, we would welcome the conversation.
Martyn Charlwood · Managing Director
Once the inflation genie is out of the bottle
The tricky part, of which February offered a foretaste, is when "good news" becomes "bad news." Governments and central banks have shown a preference for over-stimulating the economy to the point of tolerating a certain amount of inflation in exchange for getting people back to work. This relaxed attitude, however, had started to spook investors fearing that once the inflation genie is out of the bottle, it will not easily return. If central banks are seen to be too slow in withdrawing monetary stimulus, this will be reflected in higher long-term rates, signalled by bond yields.
To add some balance, markets at this stage were more concerned about the fear of inflation rather than its present level, which remained very low. The expectation was that the annual change in the oil price would drive inflation higher over the next couple of months but that there was still sufficient spare capacity in the economy to prevent a sustained rise. Time would tell.
Governments and central banks have shown a preference for over-stimulating the economy to the point of tolerating inflation in exchange for getting people back to work.
We feel that market positioning and pricing continues to reflect the optimistic view, punctuated by bouts of volatility as this view is called into question. With short-term interest rates likely to remain at record lows for some time, we will view these setbacks as further investment opportunities. The key question remains whether the reflationary impulse proves temporary, as central banks maintain, or becomes more persistent, requiring a policy response that markets have not yet priced in.
During the month we took some risk off the table, raising cash by around 6% across portfolios. We feel there will be better opportunities ahead to redeploy the proceeds, and continue to favour undervalued areas of the market alongside broad diversification.
Reducing overseas risk and raising cash
During the month we sold the M&G Global Dividend fund and the HSBC FTSE 100 fund across portfolios, increasing cash by around 6%. We feel that there will be better opportunities ahead to re-invest the proceeds.
Fixed interest positioned defensively
Our fixed interest funds were less exposed to rising yields, so performed better than the broader market, with the exception of our global bond fund which suffered from its US dollar exposure.
Value and growth, with limited FAANG exposure
We are holding a mix of value and growth stocks but have sought to minimise exposure to US-listed FAANG names, where valuations have become excessive. Our value stocks have enjoyed a strong recovery so far this year.
Alternative assets for diversification
Our portfolios diversify risk by investing in a wide range of assets using actively managed funds with sound investment processes. Examples of these alternative assets include funds invested in gold and silver, infrastructure, agriculture and absolute return strategies.
Important information
This article is a marketing communication intended for general information only. It does not constitute personal advice, a recommendation, or an offer to buy or sell any investment. If you are unsure whether an investment is suitable for your circumstances, please seek personal advice.
Past performance is not a guide to future performance. The value of investments and any income from them can fall as well as rise. Capital values are at risk and not guaranteed. Forecasts and views expressed in this commentary represent our assessment at the time of writing and are subject to change.
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