More than 12 months on from the start of the coronavirus pandemic, investors have turned their attention to the path and pace of a return to economic normality, and the impact of government and central-bank action taken to date, particularly now that monetary and fiscal policies are strongly aligned in the same accommodative direction. Concerns of an inflationary consequence have unsettled bond markets, and as a consequence have the potential to upset the valuation of other assets too. Vaccine optimism is, depending on your location, growing, but pre-pandemic levels of global economic activity are likely to still be quite a distant target.
In considering our positioning for the period ahead, we recognise that we have no more insight than most on how the pandemic will pan out, and how investment markets will react to that direction in the near term. However, we can focus on other observable trends and themes, and – importantly – valuation, and position our portfolios accordingly.
While significant parts of the economy have been mothballed, other areas have had a pandemic turbo-charge. Pre-existing trends towards digitalisation have been accelerated, and appropriately exposed stocks have prospered. That trend is unlikely to be reversed, but the valuations that we are currently asked to pay for that exposure may become exposed.
Elsewhere in equities, we have seen some optimism return in areas dependent directly or indirectly on social interaction and a functioning economy, and therefore a broadening of the market advance across cyclical sectors. While economic hardship is far too widespread, there is pent-up demand, and recovery in the real economy should therefore be swift when society reopens. As a generalisation, while these sectors have had a better period, we believe that valuations in cyclically exposed stocks and sectors continue to offer scope for gains.
Bad for bonds?
The repression of interest rates and demand from price-insensitive buyers (central banks) has kept government bond yields ultra-low, albeit with yields rising in the early part of 2021 as expansionary policy has encouraged better expectations for economies. Rising yields do not make for a bond-friendly environment, leading some to the conclusion that these assets have no place in portfolios. We would agree that their diversification benefits are reduced, and return prospects are limited. Our government bond exposures are therefore significantly lower than they have been, but we are not ready to abandon them altogether. Risk is elevated across all asset classes, and in a real ‘risk-off’ environment investors will be glad for their protection and the liquidity they provide. We expect that yields will rise further, and flexibility to adopt a more positive stance towards bonds could then be valuable.
The outlook for commercial property looks to us to be challenged. Retail property remains under structural pressure, office real estate is uncertain while working patterns are reappraised, and valuations in distribution sheds appear generally to reflect demand. Investors need to be able to bear the illiquidity inherent in the asset class.
Rising inflation risk
The final, and perhaps most important, piece of the jigsaw, especially for long-term charities, is inflation. Pent-up demand and the spending of money saved during lockdown will provide reflation, but those factors are not in themselves sufficient to give rise to structural, year-on-year inflation thereafter.
Many predicted resurgent inflation as liquidity was pumped into the financial system after the 2007-8 global financial crisis, but we believed this was an unlikely outcome, given the deep structural deflationary counterforces (the impact of high debt, ageing populations, and the disruptive march of technology) and policies of fiscal austerity. The structural deflationary counterweights persist, and should not be underestimated, but expansionary fiscal policy has replaced austerity, and so the risk of inflation has certainly risen, and portfolio construction needs to be cognisant of that.
Valuation is key
Economic activity and growth should pick up from current, Covid-19-affected levels. Market valuations are ahead of that already, funded and encouraged partly by central-bank and government largesse, and so growth is required to justify current asset valuations. As much as we look for diversifiers and risk mitigators, we find risk (if only valuation risk) elevated in most areas. Appropriate positioning to us appears therefore to be: constructive on well-chosen equities, with attention paid to balance and valuation; light on government bonds (but we are not ready to abandon them from portfolios or benchmarks); and taking particular care in property and other alternatives, where illiquidity features need full consideration.
Alan Goodwin is head of charities, Newton Investment Management