Recent central bank commentary, notably from the US Federal Reserve and Bank of England, has focused on the maintenance of easy monetary policy through low interest rates and quantitative easing (QE).
This has continued to help asset prices, especially equity markets, amidst talk of bubbles. The amount of government spending through expansive, supportive fiscal policy should also support ‘risk’ assets.
These twin boosters to economies at a time when vaccine roll-outs are providing light at the end of the tunnel, are continuing to assist equity performance in the face of some challenging valuations and setting new records for some stock market indices outside the UK.
The monetary policy mix in existence since the Great Financial Crisis of 2008/9 has been one of extremely low short-term interest rates plus QE that helps to keep a lid on longer-term interest rates. This has helped buoy price performance across all asset classes and facilitate a fast recovery from the pandemic induced bear market a year ago.
Over the past year and previous decade, those with financial assets have been the wealth beneficiaries of monetary policy whereas those without have felt little change. Indeed, the gap between the have and have-nots has continued to widen. So, because monetary policy can do little to address the imbalance between those two groups, fiscal policy will be the key determinant in dealing with the social imbalance that monetary policy has exacerbated.
In less than a month, Chancellor Rishi Sunak will deliver his budget. Talk of increased taxation – not least, an increase in capital gains tax to narrow the gap with the higher levels of income tax, is something that is circulating within the financial press.
It might be the time to improve tax receipts given the Bank of England’s recent forecast of a strong economic rebound pointing to the amount of savings that have built up during lockdowns. However, tax receipts will increase markedly if the Bank’s growth rebound forecast becomes reality.
When the economic rebound has been firmly established and less likely to be interrupted might be a better time to increase taxes rather than acting too soon. But the focus would seem to be on those who have benefited from asset price revaluation.
On both sides of the Atlantic, monetary policy makers have expressed their wish to keep interest rates low and see unemployment drop even if inflation picks up. The theory being that as inflation has been running significantly below the 2% target, it can run hotter for an extended period of time, to compensate.
Does loose monetary policy and the current expansive fiscal policy provide a floor for equity and credit market valuations or a flaw which will be exposed by a hike in inflation?
Inflation and Timing
Inflation rates will pick-up as year-on-year numbers reflect last year’s falls in inflation. Can equity prices accommodate rising government bond rates that are reflecting increased supply and inflation risks? Central banks’ purchases should moderate any rise in bond yields to deliver a more even rise so for now the answer would suggest they can.
Ten-year UK Government Bond (gilts) yields have risen appreciably as the graph below from Investing.com illustrates.
This doubling of yields also represents a significant capital hit to holders of those bonds. Despite the doubling of yields from January’s lows, they are still well below the 2% inflation rate target. Also known as negative real yields – the real value of your money increases below inflation and therefore decreases in real terms.
Index-linked gilts, designed to give investors some inflation protection, also have negative real yields. As we have said many times before, bonds remain a borrower’s market and do not offer the hedge against inflation they historically have. The bond bubble may have already burst for government debt with central banks aiming to let the air out slowly. Corporate debt offers no appeal in absolute or relative terms.
Many pundits are predicting an equity market fall in 2021 of some significance. There is a temptation to call the current environment a bubble. The more trading oriented might want to get out to re-invest at a lower level. Amateur traders might feel they can do that but history argues against timing as it has incurred a relative cost to the benefits of remaining invested.
With bonds being unattractive, investors have sought other forms of diversification particularly with inflation protection in mind.
Gold has been popular and more recently, Bitcoin. Bitcoin gets a lot of press. It’s a great story for journalists and also a great promoter for Elon Musk and others. However, it is early days and central banks are keen dissuaders of investing in it.
Longer-term, digital assets will become more mainstream when the respective authorities can properly oversee the marketplace. Bitcoin is one of those digital assets, there are others with greater applications which we think should get more ‘air’ time and understanding.
We are not market timers but we are investors in longer-term demand and growth themes, prepared to shift emphasis between themes as circumstances dictate – as happened last year. We remain focused on delivering above inflation returns for you and your clients, exercising caution along the way, cautious of both left and right tail risks (melt-downs and melt-ups).
From time to time, some of our themes, such as nutrition may fall out of favour and others like energy transition may occasionally look overbought but, both are key investment themes for the foreseeable future – in years not months.
There has been little activity in the first half of February. In Dynamic, we exchanged one of the few remaining credit allocations in favour of a fund focusing on opportunities arising from macro-economic analysis.
As ever, we thank you for your continued support. We hope that you remain safe and well both physically and mentally.