Our portfolios have been caught by a twin migration.
- Tuesday, March 9, 2021
Global stock markets have suffered a significant correction over the past three weeks, a correction that has particularly hit US tech stocks.
Ironically, the reasons why we have seen such a concentrated fall in value is a result of the recent success of global stock markets and the expected recovery. Normally strong economic growth is good for equity markets but markets have been underpinned by exceptionally low government bond yields and the prospect of future inflation has caused yields to rise in order to compensate investors for a reduced real return.
A reasonable level of inflation is welcome to stock markets as goods and service providers can increase prices and maintain profit margins. High inflation does however impact the real value of dividends. Inflation has a negative impact on fixed interest securities as it will reduce real returns and this is why bond yields have risen in expectation.
The US 10 Year treasury bond yield is the global setter of interest rates. The 10-year treasury yields have risen from 1.4% to 1.6% in recent days but have fallen back to 1.5% today. US inflation is currently 1.4%. The Federal Reserve is expected to try to ease inflationary pressures with the continuation of their quantitative easing programme, however markets are expecting the Fed to start reducing the monthly bond purchases as the economy recovers.
As 2013 showed, getting the timing of a taper right can be critical. After then-Fed chairman Ben Bernanke suggested in May of that year that the central bank might soon begin to rein in QE, long-term interest rates shot higher, restraining the US economy.
It would appear that the expectation of a reduction of Fed support in the next two years, both through a reduction of quantitative easing and eventually an increase in interest rates, is already being priced into markets although there have not been any announcements and this is not expected to occur this year. This has caused price changes we thought would be gradual to occur rapidly and in the past few weeks.
Our portfolios have been caught by a twin migration of the movement of equity to bonds and the movement of tech stock to value stock.
As bond yields rise so bond values fall in order to facilitate the new yields. Therefore, there has been a general fall off in bond values. This has been particularly the case for long dated gilts as these are particularly sensitive to future inflation. Last week we recommended the removal of our longer-term government bonds to focus on short-dated bonds. This decision was based on the future expectations of the impact inflation may have on government bonds. We had continued to hold a modest position in long dated credit markets as an underpinning protection against a heavy recession and a slow vaccine role out. The path to recovery was not so clear as it is now, back in December. These positions are now not needed and detrimental, hence our recommendation to switch funds.
As bond yields start to rise, money will flow from equity to bonds creating a selloff in equities. The markets that have been particularly hit over the past three weeks have been the high value tech and green energy stocks that did so well in 2020. The US Nasdaq index has been the index most effected falling -10% in the past 30 days.
Our portfolios have overweight exposure to US equity and tech stock so have been impacted by these movements. It was these sectors that drove our recovery in 2020 and are now giving back some of those gains. Markets have started to stabilise and it is not our plan to sell out at a loss but wait for a recovery as these markets are expected to return to growth as the world returns to normal economic activity.
With the rotation out of tech stocks money has gone to so called ‘value’ stocks. Those companies that fared poorly last year due to lockdown restrictions but are now with the vaccine roll out, looking to recover. The return to a normal life means that traditional business will recover and investors are moving money to these sectors in anticipation. We can see this with recent improvements in UK and European stock markets.
Our portfolios have also been impacted over the past three weeks by the sudden shift in equity prices and concern over bond yields. As investment funds are long term investments, they can be volatile in the short term but are expected to perform well over long time periods. We believe that the funds which we have invested into will recover. We still expect equity markets to be poised for growth over the next year as economies open up and government stimulus continues. Although the markets are concerned about inflation, the Fed has signalled that it will continue to support the economy and appear to be more concerned about labour markets than interest rate hikes at this time.
Concerns over US inflation come as the new Biden Administration enact into law the new US$1.9tn stimulus package. However, Treasury Secretary Janet Yellen says fears that the administration’s relief bill could trigger a rapid rise in inflation are misplaced.
In an interview on Monday, Yellen said the measure, which will provide US$1,400 cheques to millions of American along with other assistance, will provide needed relief and help the economy return to full employment by next year.
Asked about concerns by some economists that the measure could over heat the economy and trigger higher inflation, Yellen said, “I really don’t think that is going to happen. We had a 3.5% unemployment rate before the pandemic and there was no sign of inflation increasing.”
The jobless rate in February of last year, before 24 million jobs were lost to the pandemic, stood at a half-century low of 3.5% with inflation running well below the Fed’s 2% target.
She said if inflation does become a problem “there are tools to address that” and policymakers will be monitoring the situation closely and will be prepared to act.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.