Market update report from Investment Director, Steven Lloyd

A moment of reflection

This Tuesday was national day of reflection as we marked one year since lockdown was first introduced. Back in March last year, who among us thought that our freedom of movement would still be restricted 12 months later? Certainly not I. The past year has been one of untold loss and hardships and our thoughts are with everyone who has suffered.

As I think back, this time last year, investors were coming out of a steep and vicious sell off in global financial markets as the pandemic shook investors to the core. At the time, our message was to try not to succumb to panic, stick with long term financial plans and have faith in tried and tested risk mitigation, in the form of portfolio diversification.

Again, thinking back, it is fair to say that many did not expect the recovery in financial assets to be quite as strong as it has been. Coincidentally, the anniversary of lockdown being introduced also marks a year since the bottom of the equity market and returns have been exceptionally strong since. As the chart below shows, regional equity returns have been anywhere between 34% and 52% in Sterling terms:

The bond market has also reflected a “risk on” attitude over the past year with riskier, high yield, bonds outperforming corporate and government bonds by a significant margin:

Bubbles don't burst by themselves

Investors who stuck to their mettle and stayed with it should have done quite nicely over the year. But now comes a word of warning. The strength of markets over the past year means that many financial assets appear expensive to the point that some investors are calling certain areas of the market a bubble.

Now, as I have written before, some corners of the markets which hitherto may have been thought of as niche, such as Bitcoin, may be exhibiting bubble like qualities. But, we do not believe the broad equity market to be in a bubble, yet. Although we could be wrong. But, again, as I have written before, bubbles throughout history have simply not burst by themselves. Some form of catalyst, usual central banks raising interest rates, is required to stop asset prices rising.

Research suggests that the price one pays for an asset has strong relationship with the subsequent returns that you might expect. I have shown this chart before, so please forgive my indulgence, but I feel it is worth reminding ourselves of just how expensive some markets have become. This chart shows a composite of various valuation metrics for the US equity market in black. The line is inverted so as it goes down, US equities are getting more expensive. The dotted green line shows the subsequent 10-year annualised return, net of inflation, from the market:

As we can see, the two lines follow each other very closely indeed. If we believe that this relationship will continue to hold, then the chart is telling us that an investor buying a US equity tracker fund, i.e. one that tracks the market, might expect returns of a little over zero, after inflation, each year for the next 10 years.

Investors will need to work harder to find opportunities

I appreciate that this sounds rather doom and gloom, but I don’t mean to say that there are no opportunities for returns. Investors will have to work that much harder to find opportunities from here, given stretched valuations, and I urge investors to be pragmatic in their expectations for investment returns going forward. The market environment since the Global Financial Crisis has been one of very strong returns with relatively surprised volatility (the amount prices move up and down) and we expect the next 10 years to be more challenging.

Interest rate projections from the Federal Reserve

Regular readers will know that 2021 has presented numerous challenges already with an aggressive rotation into economically sensitive areas of the equity market, followed rapidly by investor concern over rising inflation. I have written extensively about the prospects for inflation lately and so I will not labour the point here. However, I would like to briefly touch on the comments made by the Chair of the Federal Reserve, Jerome Powell, last week. He noted:

“The economy is a long way from our employment and inflation goals, and it is likely to take some time for substantial further progress to be achieved.”

Importantly, Fed officials’ interest rate projection continued to be at near zero through 2023. In terms of inflation, Powell commented:

“Over the next few months, 12-month measures of inflation will move up as the very low readings from March and April of last year fall out of the calculation.” But “these one-time increases in prices are likely to have only transient effects on inflation.”

So, the Fed is clearly signalling that it does not expect runaway inflation and, as a result, shouldn’t have to raise interest rates for another 2 years. Despite this, the bond markets sold off a little after his comments, indicating that the market simply doesn’t believe that the Fed is correct in its view on inflation.

Who is right remains to be seen. As I noted last week, tensions between the bond markets and central banks may keep volatility elevated in the coming weeks and months. Arguably then, investing now is more uncertain that it was 12 months ago.

As you know by now, we believe the best way to navigate uncertainty is to have a long-term plan, stick to it and have faith in proper portfolio construction and diversification.

Until next time, stay well.