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May was a miserable month for UK weather - perfectly timed to accommodate the lifting of restrictions on indoor hospitality - but nevertheless a remarkable one for our shoppers. Data released in May on retail sales showed a 9% rise in April, as non-essential retail stores reopened. Highest growth was in clothing (up an astonishing 69%) and other non-food stores (25%), representing the release of pent-up demand, with savings accumulated during lockdowns fuelling a short-term boom.
The FTSE-All-Share index rose a little over 1%, bringing its total return (ie including reinvested dividends) this year to almost 12%. That number incidentally hides the remarkable performance of UK Smaller Companies funds, on average up 20% this year, and over 100% since the market 'bottom' in March last year.
Disruption in economy
However, as I warned last month, many businesses have struggled to cope with the demand. The monthly Purchasing Managers' Index (PMI), which surveys supply chain managers across major industries, measures economic trends in manufacturing. The May numbers confirm 'bottlenecks', ie suppliers' delivery times are getting longer, while input costs - the prices of anything related to production of goods or services, eg wages, components etc - have been rising. Meanwhile, goods imported from some COVID "red" states eg India have slowed dramatically as their exporters struggle to maintain staff numbers and hence production and transport are disrupted.
Figures released in May showed house prices rose by over 10% in the year to the end of March, the fastest growth for 14 years, as the COVID-inspired stamp duty holiday fuelled demand. Alongside an uptick in inflation of 0.6%, this puts the UK's inflation rate at 1.5% - still below the Bank of England's target of 2% but seeming likely to breach that target in the coming months. The Bank's Deputy Governor still expects these price pressures to be temporary, but clearly the Bank cannot be complacent.
A similar story in the US
Although retail sales did not grow at all in April, the economy is still growing rapidly and facing the same supply issues. US PMI numbers also tell a story of rising input costs, but the impact on inflation is higher. The rate in the US is now 4.2% for the year to April, including a higher-than-expected month-on-month rise, although this includes a base effect due to the fall in prices last April. As I've said in this commentary before, the data might be transitory, but there are signs of upward pressure on wages as smaller businesses find it difficult to fill job vacancies. This almost certainly reflects the enhanced unemployment benefits being distributed; since those are due to conclude in the Autumn, this effect should dissipate.
Despite this, US companies' first quarter reported earnings were significantly higher than expected - up almost 50% - although those expectations were perhaps over-pessimistic. Investors seemed to recognise that, with the S&P 500 rising less than 0.7% in dollar terms but falling 1.5% for sterling investors.
Vaccination programmes have caught up with the UK's current rate of almost 1% of the population per day. This is good news for markets, and consequently the FTSE Europe ex-UK index grew by 3% in Euro terms through May.
Finally, a word or two about inflation and portfolio diversification. Most client portfolios feature combinations of company shares (equities) and debt issued by companies and governments (bonds). Bonds' returns carry more certainty; they pay you a fixed amount of interest on the debt you bought and make a capital repayment at maturity. Equities on the other hand are not obliged to pay you a dividend, while shares are worth whatever someone else will pay you for them. When investors worry about companies' earnings and share prices are falling, bonds become more attractive, and vice versa. When prices fall, yields rise because you're paying less money for the same income stream, consequently the relationship between bond and equity yields is typically negative - if bond yields rise (because their prices have fallen) then share prices rise (and their yields fall). It is almost axiomatic that diversification of a portfolio between equities and bonds should lower overall risk. This has been the experience for the last 20 years, with bond yields tending to move in the same direction as share prices - both up and down. Recent news on rising bond yields has thus led to positive views on future share prices, ie a justification for continued optimism.
However, there are periods when this relationship doesn't evidence itself, most notably the last 30 years of the 20th Century, when inflation was a real concern. Inflation affects bond prices because it eats into the value of the future interest payments; yields rise to compensate as prices fall, but also because interest rates generally rise to keep inflation in check. Under the relationship described above, rising bond yields should mean rising share prices. However, in inflationary times I should expect to pay less today for my future inflation-eroded earnings and dividends. News about significant rises in inflation can consequently cause investors to reassess equity valuations. Bonds and equities can therefore move in sync.
Transitory inflation continues to be the most likely scenario, but we remain vigilant. Our primary goal is to ensure portfolio risks remain stable, while nevertheless continuing to generate long-term returns in excess of inflation - whatever that rate may be.
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