Higher future inflation prospects have been the dominant theme of this quarter as the potential for a global synchronised economic recovery is now stuttering into sight. The UK is the focus of global attention, with 90% of all adults having had at least one vaccination and the highly transmissible Covid-19 delta variant in circulation. All […]
Higher future inflation prospects have been the dominant theme of this quarter as the potential for a global synchronised economic recovery is now stuttering into sight. The UK is the focus of global attention, with 90% of all adults having had at least one vaccination and the highly transmissible Covid-19 delta variant in circulation. All domestic restrictions were lifted on 19th July 2021 and the associated wave of infections has been manageable and begun to diminish towards the end of this reporting period. The next, and perhaps final, test will be schools returning in September followed by colder weather increasing indoor contact.
The UK is the leading global economy for vaccinations and high risk for Covid-19 infections due to the diversity and travel propensity of residents. If the UK demonstrates that Covid-19 can be effectively controlled, this will be seen positively for the many other global economies following a similar strategy.
During the reporting period, the Investment Association (IA) Europe (Ex UK) sector returned 4.53%, closely followed by the IA North America and IA UK Gilt sectors which returned 4.03% and 3.97% respectively. The IA UK All Companies sector returned 2.64% and the IA Sterling Corporate Bond sector returned 2.25%. The only mainstream sector to fall in value was the IA Asia Pacific (Ex Japan) sector, which fell by 4.98% due to concerns about China’s approach to regulating technology companies (source: Morningstar Direct).
Since the 2008/9 financial crisis and use of ‘printed money’ by central banks, the concern has been that eventually increasing the supply of money in circulation would prove to be inflationary. When the scale of the Covid-19 crisis became evident last year, central banks, again, hit “print” in order to preserve economies in stasis and protect against the financial consequences of lockdowns.
The US opted for helicopter money, directly putting deposits into the bank accounts of everyday Americans, and boosted unemployment benefits. The UK furloughed millions of employees, paying 80% of salaries for businesses forced to close or downsize during lockdown, and most EU countries opted for similar schemes. As a result, western economies moved closer to the Japanese model, with artificially low bond yields imposed as central banks drastically increased their ownership of government debt.
During last year’s lockdowns, inflation dwindled, with US CPI (a measure of inflation) reading 0.3% in May and 0.6% in June. A year later, these low figures have fed in as base effects to push inflation to 4.5% in May and 5.4% in June. UK CPI was similarly low at 0.5% and 0.6% in May and June last year and has now surpassed the BoE target by hitting 2% and 2.5% in May and June this year.
“Transitory” has been the buzzword when it comes to inflation. Jerome Powell has consistently sought to reassure investors that the pressures currently impacting inflation will equalise as the impact of Covid-19 on supply chains lessens. This terminology has spread to other central banks, with Andrew Bailey similarly expecting UK inflation not to persist. Central banks are navigating choppy waters, under pressure to keep borrowing costs low to allow historically high debt accumulation costs to be serviced, while hitherto unknown amounts of cash have been pumped into economies. So far, they are all holding the tiller steady, and markets are broadly convinced of their interpretation, with 72% of fund managers in June’s Bank of America Survey agreeing that they expect inflationary pressure to drop off next year.
The question for investors is how permanent will these inflationary pressures prove to be? Many businesses will see the chance to make up for lost profits by increasing prices, and with many households still holding on to savings forced upon them by the reduced ability to consume, there will be demand despite higher prices.
We expected that higher inflation would dampen the appetite of investors for bonds, but the juggernaut bond bull run has kept on running. In the US, the combination of rising inflation and falling junk bond yields has seen the yield on junk bonds fall below inflation for the first time on record during this quarter. Many companies have taken advantage of the conditions underpinned by the Federal Reserve to lock in debt at historic lows, with prospective investors often oversubscribing to new issuances. For companies in the travel industry, for example, whose business models ground to a halt, but were still stuck with fixed running costs, the ability to acquire sufficient cash buffers to last the pandemic was a welcome lifeline.
Part of the appeal of junk bonds (certainly to institutional investors) is the strategic opportunity that the pandemic offered. Credit ratings across swathes of companies were slashed, meaning that companies with a profitable business model pre-pandemic were forced to issue their debt as sub-investment grade, with some existing debt also downgraded. With the Federal Reserve indicating no imminent end to fiscal stimulus and its asset purchase programme at July’s Federal Open Markets Committee (FOMC) meeting, managers may have been emboldened with the expectation that these companies will be re-rated upwards, and, as a result their fallen angel bonds will turn into rising stars.
The Chinese government showed their hand in July, highlighting the significant political risk that investors must factor into their asset allocation. Chinese online tutoring companies, many of which had raised capital in US markets, found themselves overnight forced to become non-profit companies, and were not allowed to raise capital from overseas. Three of the prominent companies in the industry listed in the US saw their share prices more than halve in one day as the news of the Chinese government’s intentions leaked. Tencent also suffered sharp selloffs in July on regulatory concerns and has now fallen c.40% since early this year. Its flagship WeChat platform has suspended new user registrations in order to align with new government regulations, intended to improve data security and market stability. The fallout from this political intervention has now seen Chinese equities lose all the ground that they made in terms of outperformance against other markets since the start of the Covid-19 pandemic.
The G7 agreed a proposal that would see revenue taxed in the location it arises, rather than where profits are declared, with a minimum rate of 15%. 130 countries and jurisdictions, covering 90% of world GDP, have agreed to the plan in principle. The Republic of Ireland is one of the notable holdouts, as their corporate tax rate of 12.5% has attracted many businesses to set up European headquarters through which to declare tax.
This development represents one of two elements that we have long argued would become headwinds for high-flying tech companies, along with increased regulatory scrutiny. The latter issue came to the fore during the last US election, when Twitter was able to effectively silence Donald Trump, depriving him of his direct contact with supporters. Tech giants, which by nature are typically capital light businesses, have been the prime beneficiary of laxity in global taxation, with the ability to shift revenue to wherever is most appropriate to reduce their tax bills, and many of the 130 parties signed up to the global minimum tax will be looking forward to taking their share of tax revenues from these tech giants to shore up the holes in their finances caused by the pandemic.
The period from the 2008/9 credit crisis to the present has been a period of strong investment returns with mediocre global economic performance. A substantial element of the returns achieved have been due to lower interest rates creating capital inflation. The next cycle is expected to reverse this condition with stronger economic growth leading to higher consumer inflation, higher interest rates and therefore lower overall returns for global indices but opportunities for active managers.
Performance has been positive over the past three months, with each of the Future Money portfolios benefiting from the continued global economic recovery. While countries reopening has been a positive, inflation is increasingly an area of concern for markets and this prevented further gains from being achieved over the reporting period. Over the past 12 months Future Money Real Value grew by 10.39%, Real Growth by 14.90%, Dynamic Growth by 16.68% and Future Money Income grew by 15.40%. Since inception in December 2008, Real Value has achieved an average annual return of 4.89%, while its target benchmark has delivered 2.08% annualised, Real Growth has returned 6.25% against 3.1%, Dynamic Growth 7.53% against 5.14% and Income has delivered an annualised 6.45% while its target benchmark has returned 3.1%.
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