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26th February 2021
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Market update

Markets are pricing in expectation of higher inflation

My last couple of updates have discussed the outlook for inflation and the growing calls of an equity market bubble. Over the past few weeks, financial markets have been pricing in the expectation of higher inflation and have come under some pressure as a result. Does this mean we are on the verge of a meaningful correction? Possibly, but our central view is probably not. Let me explain.

Firstly, we need to look at Government bond prices, which have fallen (as income yields rise) as bond markets attempt to reconcile the impact of higher inflation on the real value of the available income stream. Here we can see that the yield on the 10-year Government bonds in the US and UK have risen substantially over the past 6 months and, particularly, year to date:

g1 25Feb2021

Bond market reaction

This fall in the prices of the “safest” area of the bond market has, naturally, had a knock-on effect on other types of bonds such as Corporate and High Yield.

As regular readers will know, there has been a consensus view that bonds are both fully priced and represent relative high downside risk for some time now. Whilst we concur with this opinion, we also value the diversification benefits that some types of bonds can offer in time of extreme market stress and so continue to hold them in portfolios. We also mitigate some of the risks, as much as we can, by carefully selecting proven fund managers who have a long track record of delivering consistent and attractive risk adjusted returns.

Nonetheless, with UK Corporate Bonds down over 2% year to date (as shown in the following chart), we are watching this element of portfolios very closely to ensure that our chosen managers are managing the risks well.

g2 25Feb2021

Opportunity for investors?

Clearly, when prices fall, this creates opportunity for investors who wish to buy these instruments and, so, the question is now whether buyers will step in and cap the rise in yields. This is a distinct possibility. It is also worth remembering that central banks are very keen to avoid yields riding too high and too fast, resulting in another “taper tantrum”. Therefore, we might see further action from central banks in order to stop bond yields rising.

Now, as yields in bond markets rise, this makes equities relatively less attractive. After all, why would investors take on the addition risk of equities if they can secure a return from, much safer, bonds? This can be seen in the volatility of equity markets year to date:

g3 25Feb2021

Inflation expectations

However, whilst markets have been under pressure, we should remind ourselves that rising inflation is not necessarily a bad thing if it is on the back of stronger GDP growth. Also note that I've been careful over my choice of words, I would stress that the expectation, at least in the next year or two, is for higher, not high inflation.

The next question is, can equities withstand a further rise in bond yields if inflation expectations continue to rise? Well, as I have previously discussed, inflation only really becomes a big problem for equities if it gets so high that it forces central banks to raise interest rates. The chart below shows one measure of future inflation expectations in the US and, as we can see, they are well short of the target range, despite the notable increase year to date:

g4 25Feb2021

This leads us to believe that equities can continue to do well. However, rising bond yields makes the future earnings of high growth companies (emerging technology) relatively less attractive and so, the change in market leadership is expected to continue. The chart below shows that, here in the UK, more economically sensitive areas of the market, such as Basic Materials (miners), Oil & Gas and Banks have materially outperformed traditionally defensive areas such as Utilities and Healthcare, since this “cyclical rally” began in early November last year:

g5 25Feb2021

Regular readers know that we don’t take a tactical approach to try and time these events and, instead, prefer to ensure that portfolios are well diversified within asset classes. This means that client portfolios should be able to perform relatively well through market rotations, such as these.

We’re only two months in to 2021 but markets continue to develop in challenging ways as we move through the market cycle. Thankfully, there appears to be a light at the end of the pandemic tunnel, but we continue to take a pragmatic, proactive approach to managing portfolios.

Until next time, stay well.

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