Market Update from Jilly Mann
Market Update – 13th July 2021
With “Freedom Day” pending, this market update covers some significant and perhaps unexpected changes we have made to our portfolios since our last update. Whilst putting this together, I realised that Covid has seemingly become the new Brexit, a divisive theme that I would dearly love to move away from, but which continues to hover over global markets as the world tries to wrestle with the resurgence of trade and economic activity.
In this update, we will cover:
- Inflation and Central Bank interest rate expectations
- Value strategies versus Growth strategies
- Large cap investments versus small cap investments
- Sustainable investment opportunities
- The “Thucydides Trap”
Inflation and Central Bank interest rate expectations
Future inflation has become an all-consuming area to monitor this year and shows little signs of abating. The mechanics of inflation are quite complex, but, these days, Central Bank policy holds the key to how high potential future inflation could be. Equally, Central Banks can largely control whether in fact deflation or perhaps stagflation, an economic state in which Japan has been during the last couple of decades, should be the overriding policy.
Inflation can quickly grow out of control and often this isn’t helped by extraordinary market events which distort annual figures. The concern at the moment is that unprecedented levels of Government intervention has been required to steady economies across the globe and at some point, the theory suggests, this can only lead to rampant inflation. Were that to happen, the cost of living will inevitably rise, potentially faster than commensurate wage increases. As interest rates go up, mortgage payments will rise along with other general costs and, surprisingly quickly, people can find themselves in an unsustainable financial position.
The US generally leads the way as a global indicator of future inflation. Concerns were generally eased in June when the perception of the latest Federal Reserve (America’s central bank) discussions was that interest rate rises would be some way off and would be well documented when they came. Rising inflation was discussed, but again they didn’t deem it necessary to give any indication that they were about to start to slow down the support for the economy, which had been provided through the pandemic.
However, the minutes of the latest Federal Open Market Committee (FOMC) have just been released and they have painted a slightly different picture. The FOMC have clearly stated that they need and want to be ready to act if inflation picks up sooner than anticipated. The action they would then take would be to slow down the amount of Treasury bonds they are purchasing and effectively start to reduce liquidity within the market.
This was a scenario the world contended with in the aftermath of the Global Financial Crisis of 2008/09 and so it is not a new thing. Perhaps because nobody expected a pandemic to thrust the globe into such a scenario again quite so soon after the last time, inevitably, any uncertainty over the Federal Reserve potentially acting sooner than expected, causes jitters in the stock market.
What we have seen to date, is that the Federal Reserve are almost testing the waters to see how markets react and whilst they have carte blanche to act in whatever way they deem fit, it would not be in anybody’s interests to act prematurely in such a way that brings back a widespread global market downturn.
The FOMC meet eight times a year and they have agreed to review any decision over interest rates and the tapering of economic support in the wake of the pandemic on a monthly basis. The minutes of the latest meeting indicate quite a split in views and it is fair to say that the Committee aren’t yet close to a consensus on the matter, but uncertainty does affect markets and is causing some of the negative days of trading on global stock markets at the moment.
There are supportive signs as to why the Federal Reserve feel they need to act sooner rather than later, but even they are conflicting. There are concerns that the US housing market is starting to overheat with an increasing dispersion between those who can afford property and those who cannot. Whilst the pathway to this housing market boom has been led by Central Banks rather than direct lenders creating the problem, there are echoes of the 2008/09 Global Financial Crisis and any correlation between the two events causes heightened concern, whether vindicated or otherwise.
Recent data also shows that total wage bills are inflating ahead of the number of people actually in work. In the UK, we are facing the double whammy of dealing with employment and necessary wage inflation on the back of both Brexit and the pandemic. The UK hasn’t really experienced a “normal” working environment post Brexit, but add in the effects of the pandemic and there does appear to be far fewer workers available, leading to wage inflation for those willing and able to work.
A consequence of higher wage bills is higher costs to run businesses, which in turn leads to reduced profits. It is at this point that earnings multiples also start to fall. Earnings multiples is a techy phrase, but essentially, many businesses are valued based on future earnings and so this is where inflation ultimately affects stock market valuations.
Companies which have low cost bases, and which keep a sharp focus on the bottom line and can manage staffing tend to do well in that environment, but businesses with excess costs built into the running of the business and which are labour intensive, tend to struggle in an inflationary environment.
I realise that despite my lengthy conclusions on inflation and interest rates, nothing has really changed in the last few weeks. However, we are now seeing a global alignment on inflation policy, albeit that exactly when each Central Bank decides to change course, will depend on the speed of the vaccine rollout and the prospects for recovery from there. It is worth keeping in mind that although the inflation debate rumbles on, to date this is causing temporary disruption to markets, a situation which will only likely change if there is firm evidence that Central Banks have been holding back on their real intentions and thus markedly changing the timescales and extent to which markets have already priced in the tapering of support post-pandemic.
Value versus Growth
In the last update we spoke extensively about value investments versus growth investments and how we were tilted quite heavily towards value in our portfolio allocations. Value stocks were outperforming growth areas of the market and typically perform well in an environment where inflation is expected to rise.
As explained above, the inflation debate is disturbing markets at the moment, but when the Federal Reserve underpin their strategy with a view that they will do what is necessary to avoid rampant inflation, value stocks can tend to underperform relative to growth stocks. It is a fine balancing act at the moment, but we have taken the opportunity to rebalance our portfolios, reduce some of our UK value exposure and also reduce our global value exposure in lieu of more technology, growth and small cap investment.
We haven’t removed our value exposure entirely as the argument is not linear one way or the other, equally some of the value stocks we hold should still perform reasonably well irrespective of inflation in a recovering market, but we felt there was an opportunity to see some strong returns from areas of the market we had sold out from in the latter part of 2020. We predicted last time that we could foresee a situation where we would be increasing and decreasing our value/growth bias as time passed, the moment came perhaps a little sooner than anticipated, but it has been vindicated thus far.
At the start of June we decided to start rebuilding our position in Baillie Gifford American. We have previously held this fund and it performed exceptionally well, however, it had taken quite a dip since then and we decided that perhaps it had fallen too much and there was an opportunity to buy back in and benefit from some uptick in performance. We have spoken at length in the past about the fund’s focus on technology and how this can be a double-edged sword. At times it massively outperforms the market, but in a value driven world with regulatory and fiscal threats to technology companies, it can drop back quite easily as well. Since the start of June, when we bought back in, the fund has returned over 14% to the portfolio. The chart below shows the Baillie Gifford American fund’s performance since the start of 2021. You can clearly see the rise and falls within the fund, over an admittedly short time frame, but you can also see points where we sold out earlier in the year and why we then rebuilt our position in early June as the fund recovered.
We made further changes to our portfolios towards the end of June and the chart below shows the performance of the Baillie Gifford American fund, the Liontrust Sustainable Future Global Growth fund and the Schroder Global Recovery fund. At the end of June, we sold the Schroder fund (a value biased fund), increased our allocation to Baillie Gifford and bought back in to the Liontrust fund (a growth biased fund).
The chart below shows the red line of the Schroder Global Recovery fund falling marginally (-0.89%) since the 24th June 2021, with both the Liontrust (green line) and Baillie Gifford fund (purple line) rising by 2.48% and 4.09% respectively. The chart albeit shows modest numbers over a short time period, but we made these changes at a point when economic commentary was signalling a potential market shift that would reward growth focused stocks. It is this sort of activity that we want to try to keep capturing as the world recovers from Covid 19 and such marginal gains should hopefully keep bolstering portfolios.
Large cap investments versus small cap investments
When looking at growth opportunities in markets, stocks which are exposed to smaller companies often offer the most potential upside. They can provide market surprises as they are typically under-researched compared to large cap FTSE 100 companies. They can also be the target for acquisition by larger companies, which is generally positive for their price and prospects on the stock exchange.
With this in mind, we have increased our allocation to smaller companies in the UK, Europe and the US in lieu of less large cap exposure, particularly in the UK. It is relevant that we aren’t suddenly negative on the UK, we continue to think that the market is undervalued versus the rest of the globe, but we are also cognisant that the quicker an economy seemingly opens up again post Covid, the quicker some hard economic decisions need to be made to offset the increased national debt which has been run up through Covid recovery schemes.
The smaller companies which have survived thus far offer lots of potential to thrive irrespective of fiscal impositions, as typically they won’t be the prime targets for increased tax grabs from Central Government and they will have the ability to adapt as the environment changes.
The chart below shows the performance of larger companies versus smaller companies since the start of June. The US is perhaps an anomaly in the sense that the Baillie Gifford American fund is larger cap in nature, but has significantly outperformed both the major US large cap index, the S&P 500 (yellow line) and Premier Miton US Smaller Companies (blue line). This shows the benefit of good stockpicking as well as how active fund management can outperform the associated benchmark.
The UK is more typical of what has happened in Europe as well, in that the Marlborough UK Micro Cap Growth fund (red line) has outperformed the larger cap holdings of the JO Hambro UK Equity Income fund (green line) and the Schroder Recovery fund (turquoise line). We think this trend will continue in this sort of environment, hence our move towards increased small cap exposure.
Sustainable investment opportunities
As mentioned earlier, we have bought back into both the Liontrust Sustainable Future Global Growth and the Liontrust Sustainable Future Corporate Bond funds in the recent rebalance. Sustainable investments had performed well through 2020, however, we sold out of them when prices fell and sentiment towards such assets declined in an inflationary environment. Again, though the sentiment has changed and as can be seen from the graph below, the Global Growth fund is up just shy of 10% since the start of June 2021, a recovery we hope to see continue.
The “Thucydides Trap”
I confess to a vested interest in this topic. A number of years ago I read Thucydides’ History of the Peloponnesian War and so when economists now draw analogies with ancient text, I do find it fascinating. It is relevant, because we have increased our exposure to Asia, Emerging Markets and China, all areas which should do well without an imminent threat of inflationary concerns. They are also well positioned now that we are starting to emerge from the pandemic and supply chain issues are becoming quite pervasive. From food to car parts, the world has now run out of stockpiles and there is a struggle for suppliers to meet demand, which ironically in turn leads to price inflation. If the suppliers come from the emerging world though, that is good news for stocks emanating from there.
The Thucydides Trap as identified by the American historian Graham Allison, relates specifically to China/US relations and one of the reasons we decided to buy back into China, at a relatively modest level, was a slight thawing in relations on the 10th June. Prior to that point, there had been some fairly frank and disruptive trade talks between the two at Anchorage in the US which really damaged confidence in the Chinese stock market.
The net result was that amongst other measures, the US continued on their path of increased accounting standards for Chinese companies which effectively was designed to remove some technology stocks in particular from their stock market listing in the US.
The Peloponnesion War was fought between Sparta and Athens, the old order and the new order effectively. For Sparta, read America, for Athens, read China. Thucidydes’ book was written in 5BC and charts the cause of the war, the war itself and consequences of war through the text. In Thucydides’ view, the predominant reason for war between the two nations being inevitable was “The growth of the power of Athens, and the alarm which this transpired in Sparta”. One isn’t suggesting that the US and China are on the verge of World War III, but if we apply this theory to economics, they certainly are at war on trade. It is convenient for President Biden that Donald Trump effectively took the role of Sparta and picked a fight with China in an attempt to maintain the current world order, with the US as the world’s number one global superpower. Whether President Biden would have started the fight himself is one for debate.
Market commentators interpret recent Chinese data as indicative of a market slowdown, but the Chinese are quite canny when it comes to managing their economy and often when the market is written off, they rise like a phoenix. The Baillie Gifford China fund has dropped by 30% year to date and so we feel that it won’t take much of a rapprochement between the US and China to see some of those losses reverse. We see this as a good buying opportunity from a relative low point, accepting there may be some bumps along the way.
Interestingly, it is widely known that President Xi Jinping is well versed on the Thucydides Trap, so how far he intends to push relations to achieve the trade deals he sees fit with US will be interesting to watch in the coming months.