Record earnings meet the question of peak growth
Fears over the rapid spread of the Delta variant led to subdued price action during July, with indices gyrating either side of flat. Developed markets ended the month with small gains while emerging markets, which bore the brunt of the virus, closed between 3% and 7% lower. Government bonds rose by over 2%, confounding expectations as yields continued to slide despite elevated inflation readings.
Earnings season delivers, but markets shrug
A strong earnings reporting season helped US stock markets edge to new highs. Over 90% of US companies that reported second-quarter earnings had beaten analysts' estimates, and nearly 80% raised their future profit guidance. The subdued reaction to these reports illustrated both the already elevated level of expectations baked into valuations and growing fears that the rate of economic growth was possibly peaking.
With the focus on future growth, and more importantly on whether this would drive prices permanently higher, there was a growing acceptance that the elevated levels of inflation expected over the coming months would prove short-lived. The fall in government bond yields confounded many as they returned to the lower levels seen in February, perhaps reflecting belief in muted long-term inflation. In the United States, the real yield on 10-year bonds fell to minus 1.18%. To emphasise, holders of those bonds were happy to lock in a yearly return of 1% below the rate of inflation.
Developed economies robust, but growth begins to tail off
Developed market economies remained robust, but the rate of growth as measured by the Purchasing Manager Indices tailed off slightly. This was deceptive because further reading of the data showed that the slightly lower numbers were due to constraints on producing more goods, specifically supply bottlenecks and a shortage of labour, rather than falling demand. Survey data also revealed a widening disparity between growth in the developed world and a near-stalling of output in emerging markets, a divergence largely attributable to differing vaccination rates and further waves of the Delta variant.
Inflation at 5.4% but the transitory line holds
With US headline inflation remaining at 5.4% for a second month, several members of the Federal Reserve voiced support for a tapering of bond purchases before year-end. Fed Chairman Jerome Powell remained more cautious, emphasising that they were still some way off their other goal of maximum employment. In the United Kingdom, the Bank of England's Monetary Policy Committee warned that inflation could reach 4% by year-end but followed this with the familiar line that it was only transitory.
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
Why bond investors are accepting returns below inflation
Developed market government bonds have reversed much of their earlier rise in yield and now offer returns below the level of inflation. Fixed interest investors are not known for recklessness, and on the whole are more cautious individuals than their equity counterparts, so it is worth looking at what is driving them to buy bonds at close to record-low yields in the face of rising inflation.
In July the European Central Bank followed the US Federal Reserve by moving to a new inflation target. It went from targeting "below, but close to 2%" to having a target that centres on 2% instead, similar to that favoured by the Bank of England. What this means is that they now view 3% inflation as being no worse than 1% inflation. With the ECB joining the US Federal Reserve and the Bank of England in tolerating higher prices, the implication is that interest rates in these regions will be held low for longer and are likely to remain at or close to record lows for a few years yet.
The build-up of money looking for an above-inflation return will not prevent volatile markets, but it increases the likelihood of investors targeting sell-offs as an opportunity to boost their savings.
The conundrum is this: typically, the prospect of higher inflation leads to a rise in bond yields, to compensate for the fall in future inflation-adjusted returns. We saw this to good effect in the first quarter. But the steady and persistent global rise in Covid cases has created market jitters, and the uncertainty over whether the disease and its variants will allow the economic and corporate recovery already priced into stock markets is causing some to prefer the perceived safety of bonds. There is a further inconsistency in that corporate and high-yield bonds are at or close to record-low yields, and this does not reflect fears of an economic slowdown.
Perhaps a simple explanation is the search for returns in excess of cash deposits, which are standing at pretty much zero. In terms of risk, that search extends first to government bonds, then corporate bonds, followed by shares. The build-up of money looking for an above-inflation return will not prevent volatile markets, or the occasional correction, but it increases the likelihood of investors targeting sell-offs as an opportunity to boost their savings.
Portfolios remain built around a diversified mix of value and growth holdings, with limited bond duration and a broad allocation to alternative assets that provide additional sources of return and reduce volatility.
Limited exposure to rising yields
Our fixed interest funds continue to have limited exposure to rising yields, as we feel that current levels do not offer sufficient reward for the potential risk of capital loss.
A blend of value and growth
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 continued to enjoy 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. Some examples of these alternative assets are 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.
To discuss how this commentary applies to your own portfolio, we would welcome a conversation.
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