2021 Q1 Market Commentary
Chris Brown
Chief Investment Officer
This time really has been different
For this update we thought we would mix it up a little and take a (much) longer historical perspective on our current situation, including data on the Black Death and Napoleonic wars. None of us have (thankfully) lived through a global pandemic (and few through a global war) before but we have looked at the data from some of the previous ones to help think about what might happen as we emerge from this one. The risk front and centre in many people’s minds is inflation. How likely is this to happen and how bad might it get? A longer sweep historical view at least helps give some context for possible outcomes.
But first, a fairy-tale. We have written before about Goldilocks, the frankly badly-behaved little girl who invades the home of three bears while they are out. The baby bear’s porridge – which is not too hot or too cold – is the one she goes for. Not too hot or too cold is also the environment investors are looking for today. Not too hot so that interest rates have to rise to slow down the economy, but not too cold so that we don’t get the growth that drives business profits and your investment returns.
The story of the last 6 months has been one of a Goldilocks style recovery and global equities have continued their march higher. It is true that this quarter bond yields have risen to reflect the
impact of the ongoing vaccination programmes and the prospect of a return to normality, but they still remain very low. To illustrate this, even after the recent rise in market rates, the Bank of England base rate is still projected to be below 1% 5 years from now. This is not a world where higher interest rates are choking off economic growth. Partly because of these low rates, economies have recovered faster than anyone thought possible from what was the deepest recession since at least the 1930s. As an example, we show UK retail sales in Chart 1. These are now above where they were pre-pandemic and, with the easing of lockdown to come, we think they will be back on their long term trend later this year. This is pretty incredible when you think that large parts of the economy (including most retail, leisure and travel businesses) remain closed or severely restricted.
What has changed has been the speed and size of government support for the economy. This marks a revolution in what economists and politicians think can and can’t be done by government to support the economy. Interestingly, many in the UK feared what a Corbyn-led Labour government might do in terms of spending and borrowing to grow the economy and support the poor. What the UK’s Conservative government has done since the election is many, many times larger than even Corbyn’s most ambitious plans. One reason for this is that focus is now on growing the economy rather than shrinking the debt. This compares to the early part of the 2010s when the aim was to shrink the debt and hope the economy could cope with the austerity involved. Why are economists less worried abo
ut debt levels than they used to be? One reason is the realisation that it is the cost of debt that really matters rather than the absolute level. As interest rates have fallen steadily over time so has the cost of this debt (even as debt levels have risen). The cost of all this debt is (much) lower for us then for previous generations even as debt levels have risen. Through this lens, we can easily afford to take on more debt to support the economy at a time of crisis.
It is worth remembering, though, that support at this level has never been done before. Like all major changes in economic approach, this is ultimately a great experiment. We will only be able to judge its success many years from now. One risk is that interest rates rise enough that the absolute level of debt does eventually become a problem. Another is that governments are doing too much: economies overheat and inflation returns. Both of these scenarios would affect our investment strategy. But how likely are they to occur?
The risk of rising interest rates
We are really focussed on the next 2-3 years when thinking about positioning your portfolios. It can be informative, and interesting, to take a step back and think about the longer-term historical trends. Over the last 40 years, UK interest rates have fallen from 17% to 0.1% today. The US has seen a similar fall from 19% in the early 80s to 0.1% today. The longer term (40 year) trend is therefore down.
Is that just an aberration? Chart 2 shows data from the Bank of England for global real interest rates (i.e. the interest rate you get above inflation) since the 1300s. This is a period that includes the Black Death (which killed between 30% and 60% of the European population), the Napoleonic wars and both World Wars. Again, the (very long) trend remains down. It is interesting to speculate why this should be and we may do this in another quarterly update. But, for now you should know that the very long, the long and recent trends for interest rates are all down. If you have in your head that interest rates “must” return to some sort of longer-term average then at least be aware that this average is falling over time. Japan and more recently Europe have shown that economies can normalise, with low unemployment rates without interest rates rising much above zero. Interest rates might rise in the future but there is no natural mean reversion that we can see pushing them back to say, 5%. The government’s gamble that rates will stay low and that the interest rate cost on the debt we borrow will be manageable looks sensible to us.
The risk of higher inflation
Let us again start with the longer-term historical perspective. Table 3 shows the 12 largest wars and pandemics that have hit the global economy. Chart 4 shows that, on average, wars have been inflationary whereas pandemics have not. We should of course take this with a large pinch of salt. There was no quantitative easing or Rishi Sunak furlough schemes in 1918 when the
Spanish Flu hit. But it is worth noting that there was a large global boom after the pandemic ended (as we expect today) and this happened without a large inflationary problem (for the UK and US at least).
In the shorter term, we are, of course, expecting a bump in inflation. We would guess that the first drink you have in a bar or the first meal you eat in a restaurant will be a bit more expensive than it was 18 months ago. The same should be the case for hotels and leisure expenditure. But there are two reasons not to be concerned about these price rises. Firstly, the money we spend in restaurants will be in part financed by spending less money elsewhere (e.g. supermarkets) so we should see some price weakness in the losers from these readjustments. Secondly, what matters for inflation is sustained price rises. Will that meal or pint cost much more a year from now: i.e. in July 2022 vs July 2021? We’d be surprised if the retail and leisure sectors retain much pricing power after the initial end of the lockdown boom. And without this, we would be surprised if we have a sustained pick-up in inflation over 2-3 years.
The risk to this benign inflation view is that the government has in fact “done too much” and the various support schemes and loans distort the economy to create problems down the line. This may yet be the case but we will only be able to see this as and when these distortions emerge. We remain vigilant to them but for now we are positioned more for Goldilocks: a return to normal that proves to be not too hot or too cold for markets or inflation.
Vaccination
Part of the general economic optimism that is around today comes from the continued success of the global vaccination programmes. This is most visible in the UK but it is worth noting that the US is running at a similar pace. Chart 5 shows the combined number of people who have either been vaccinated and/or infected for major developed market economies. We are slowly closing in on herd immunity levels of 70%+ of the population
protected. Europe, as has been well publicised, has got off to a slower start but is still on track to have vaccinated 70% of its population by mid-July. Also, importantly, there is not much evidence (so far) that vaccine resistant strains are spreading in the broader population. Though there is likely to be one last wave as lockdown restrictions are lifted, the latest models suggest this should be comfortably managed by the NHS. Fingers and toes crossed, the UK’s target of lifting Covid restrictions by mid-June remains on track.
2021 outlook and investment strategy
As we have written in previous updates, even in the darkest days of March last year, we kept our main equity investments in place and added where we could. We did not know that the various support programmes would be as large and effective as they have been or that (several) vaccines would arrive as fast as they did. We did, however, know that we would eventually beat this pandemic and we wanted to make sure we captured the returns when we did. As part of this process, more recently we have rotated part of our equity exposure away from Covid winners and into companies more likely to gain from a return to normal. At the beginning of this year we also reduced our government bond investments as we saw (correctly) they were at risk from rising interest rates as the recovery progressed.
The question is why not go all in on recovery focussed equities and why not sell most if not all of our fixed income investments (which lost money in Q1)? The reason for keeping some of our more technology focuss
ed investments in the US and emerging markets is shown in Chart 6. Here we have a comparison of the US equity market between 1900 and today. You can see that in 1900 the sector that dwarfed all others (and made up over 50% of the market) was railways. No matter how attractive the valuations back then, the right investment strategy was to focus on change and the growth rather than railways (which are, of course, still around today and making money). Today we are in the middle of a similar revolution where software is taking over every industry from healthcare to banking to cars. As an example, the successful Moderna Covid vaccine was created in less than a week using data gleaned from an e-mail. As investors, we need to make sure we own the future as well as the past. This means we are maintaining our exposure to some of the (more expensive) growth markets whilst balancing this with (much cheaper) companies we expect to benefit most as conditions normalise. This approach has worked well over the last 12 months and we are optimistic it has more room to run for the rest of the year.
Finally, the size of our (now reduced) fixed income allocation remains under review. For now, though, it is earning its place in our portfolios. Firstly, as we state above, we think inflation risk is contained and there is no fundamental principle at work that says that interest rates must drift higher over time. Secondly, for most of our risk-managed models we are at or close to the risk levels we deem to be prudent after the strong run up we have had in equities. This pushes us to lower risk investments that should at least beat cash (which, these days, is fixed income and “real assets” which we discuss below. If the optimistic view on the virus we describe above proves to be wrong we should have some protection in our portfolios if the pandemic is not in fact over and growth falls again as a result.
Meanwhile, the “real asset” component of our portfolios (including renewable energy and specialist property) continues to generate the inflation plus returns we are looking for as well has having the benefit that many of the cashflows from these assets are, by their nature, inflation protected should inflation risks rise in the future. They continue to do the job they are there to do and to play an important role in our portfolios.
As ever, we thank you for your continued support of IPS and, if there is anything in this update you want to discuss in more detail, please feel free to get in touch.