Who wants to be a billionaire?
Some of the quarterly earnings reporting in the US have been quite staggering. Apple, Amazon and the like reported quarterly earnings in the billions of dollars and smashed even the most optimistic of analysts’ forecasts.
Closer to home, it has been reported that that shoppers had ‘rushed back’ to the national high street as it re-opened, with shoppers said to be making ‘revenge purchases’ – treating themselves to what they had always wanted as lockdown finally eased.
Markets were right to price in a rapid recovery as lockdowns ease and we can see that the outperformance of global equities over global bonds has been significant. As the chart below shows, global equities are up just over 54% in sterling terms, since the market lows on the 23rd March 2020 to the end of April 2021.
Government support for the economy
The US economy grew by 6.4% (quarter on quarter, annualised) in quarter 1 of this year and the consensus forecast is for 8.1% growth in quarter 2. However, it is highly likely that economic growth in the US and every other major economy will fall back down to more normal levels in the second half of the year.
Whilst monetary and fiscal policy remain highly accommodative, last month the Bank of Canada became the first major central bank to announce that they are taking the first step in removing monetary support for the economy. In the US, UK and elsewhere governments are proposing tax increases in order to pay for the support offered for the economy and workers. Added to this, investor sentiment towards equities is approaching record high levels on some measures:
These factors are warning signs that the outperformance of equities over bonds might not be quite as strong over the coming 12 months. Economic data and policy responses have surprised to the upside significantly as we have slowly emerged from the pandemic and it would be reasonable not expect the same level of positive surprise going forward.
Focus in on employment
However, the Federal Reserve gave no hint of a move towards tightening monetary policy at its April meeting. It remains focused on getting the economy back to “maximum employment” and takes the view that any rise in inflation must, by definition, be only temporary when the labour market is still far below its maximum level:
Therefore, the view is that the Fed is still in no hurry to tighten policy. However, some strategists think that the US labour market can recover rather more quickly than most expect. Both businesses and workers’ perception of the availability of jobs has increased rapidly. The dotted green line in the chart below shows whether workers believe jobs are plentiful or not. When the line is rising, the perception is that there are more jobs available. The darker line shows hiring plans of businesses. When that line is rising, more businesses are planning on hiring than not:
Given this confidence, there is a clear risk that the labour market recovery is so strong that the Fed starts to tighten monetary policy in early next year, albeit with plenty of forewarning, and that the first interest rate rise comes in about 18 months. This would likely cause a renewed sell off in bonds and shares of high growth companies that did so well during 2020.
However, the sheer number of jobs that would need to be created for this to occur is huge and the non-farm payroll numbers (the most commonly followed measure of US employment) would need to average 700,000 a month for the labour market to reach full employment by the end of the year:
Whilst a tall order, this is not impossible.
Keeping a lid on bond yields
After the steep increase in Government bond yields earlier this year, they have fallen back slightly more recently. But, the income yields on offer in the US are now at a level where they become attractive for overseas investors, after currency effects. Whilst this may help keep a lid on bond yields, if economic growth remains strong, the path of least resistance for yields is up. This suggests that returns from government and high-quality corporate bonds will be zero to mildly negative over the coming 12 months as bond yields are inversely related to their price.
So, where does this leave investors?
There are danger signs in both equity and bond markets so where can we turn?
Well, we need to come back to my old broken record I’m afraid. More often than not, the long-term benefits of proper portfolio construction outweigh the short-term market dynamics that may present themselves. Nonetheless, as I have warned before, it would be wise to be pragmatic in our expectations for portfolio returns over the coming period. Financial markets, except for last year and a handful of other periods, have been eerily calm since the Global Financial Crisis in 2008. Investors will need to work much harder to find opportunities from now on.
To clarify, we do see opportunities in some areas of financial markets. We just need, more than ever, to watch for renewed bouts of market volatility.
Until next time, stay well.