Investment Update – 19th November 2021

Overview

Equity markets rallied at the start of the third quarter, but faltered toward the end, as economic risks increased.  In the US and UK, although economic activity continued to expand, with consumers continuing to spend and employers hiring, the momentum of the recovery slowed.  The virulent Delta variant of the coronavirus caused a larger spike in cases, and has lasted longer, than initially anticipated.  In the US, government shutdown and debt ceiling uncertainty caused concern towards the end of the quarter, although these issues were ultimately resolved.

Developments in China worsened towards the end of the quarter, as real estate developer China Evergrande Group struggled with $300bn of liabilities.  There was concern that a default would expose a systemic problem in the country’s property sector and wider economy.  However, Beijing has demonstrated that it is prepared to do what is necessary to avoid the risk of contagion in property and financial markets.

Given the events over the past 18 months it is worth taking a step back to consider the positive and negative influences on markets, which can be summarised as follows.

On the positive side, the equity market has been supported by:

1. Easy financial conditions, and supportive monetary policy (including near zero interest rates).
2. Pent up demand, which has been building during lockdown and will take many months to work through the system.
3. Corporate earnings results, which have been strong over the summer.  Companies across a wide range of industries reported strong demand and healthy margins.
4. Companies buying back their own shares with surplus cash, which has the effect of underpinning share prices.
5. Booming acquisition and merger activity, especially in the UK.

Meanwhile, the following potential challenges continue to be a source of concern:

1. The likelihood that global economic growth has peaked for the post pandemic recovery phase.
2. The withdrawal of government lockdown support measures, which will turn a tailwind into a headwind.
3. The expectation that corporate earnings won’t continue rising at the same pace as they have done for the last 12 months.  Persistent supply chain and input price pressures are a common theme and companies have started to moderate their outlook for profits.
4. The pressure building in labour markets.  The recent hiring boom is positive, but employers in certain sectors are struggling to attract workers willing and able to fill vacancies, which is naturally pushing wages up.  Growth at the lower end of the pay scale bodes well for the strength and resilience of the economic recovery, as those workers are more likely to spend, rather than save.  However, although a rise in spending boosts economic activity, it will also drive inflation up.
5. Upward pressure on inflation, which is now running above long term target rates in the US and the UK.  The US Federal Reserve asserts that when an economy restarts almost as abruptly as it halted, it will take time for the bottlenecks to work through the system.  Indeed, some areas of the initial ‘bounce back’ pricing pressure have already begun to abate.  However, if inflation pressure persists and central banks need to raise interest rates to contain it (raising borrowing costs), the economic recovery risks being derailed.
6. The potential for interest rates to rise rapidly, which would be disruptive for financial markets as well as the economy.  Ultra low interest rates over the last few decades have supported the rise in price of a wide range of assets, and specifically equity markets.  Indeed, historically low rates are partly why markets have risen strongly in spite of the global pandemic.  A sharp increase in rates could cause wobbles in stock markets, and other asset classes.

Outlook

As detailed above, the economy and financial markets face a wide array of positive and negative pressures.  On balance, we expect economic growth to continue well into 2022, despite the uncertainties.  In the US and the UK, the focus must be on the future path of the virus, inflation, and both monetary and fiscal policies.  In China, the Evergrande episode still has some way to go and is of interest for indications of how the Chinese government might evolve its management of the private sector and economy in the future.

In general, we are positive on the outlook for global equity markets, with a tilt toward the relatively undervalued UK, and minimal exposure to China.  Government and central bank policies around the world are likely to remain supportive, albeit at a slower pace relative to that experienced earlier in the year.  Compared to equities there is a dearth of other viable investment options.  Cash will be increasingly unattractive as inflation rises and bonds are likely to face price pressure as interest rates rises (as a result our bond investments are predominantly short dated and therefore less sensitive to interest rate rises).  That said, we also expect swings in markets as supportive policies begin to be withdrawn and the world transitions to a more ‘normal’ market environment.

Within equities we continue to focus, as ever, on long term fundamentals and target companies with sustainable business models and strong financials.  The pandemic has accelerated some long term trends which bodes well for certain sectors and companies.  In addition, given the risk posed by inflationary pressures and rising interest rates, we have been increasingly tilting portfolios toward companies that, firstly, have significant pricing power (ie where customers won’t stop buying the product if the price goes up), and secondly, have a strong balance sheet which can withstand increases in borrowing costs (as interest rates rise).  Love it or loathe it, Microsoft is a classic example.  The company has an extremely strong balance sheet, and it remains the IT infrastructure king of business activity around the world.  It will continue to benefit from a long term trend which has been accelerated by the pandemic, and it has pricing power over consumers and corporates who are often locked into a subscription model.  There really aren’t any viable alternatives.

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