It is six months since the World Health Organization declared the coronavirus outbreak a pandemic. Investors should take stock. Rather than simply looking at the world in binary terms — tech and the rest, or Wall Street versus the world — they should consider the lessons learned from the opening chapter of the Covid-19 era.
One clear takeaway: there is no point trying to fight central banks and their gushers of liquidity. Advocates of momentum trading, or simply buying assets that keep appreciating, have duly prospered. That strategy has been particularly rewarding when it comes to companies with strong growth prospects and solid balance sheets, and long-dated bonds. Such an asset mix is not bullish, as it reflects a gloomy prognosis on economic recovery and not much inflationary pressure.
In contrast, the Covid-19 market has not been kind to investors who have shunned bonds with long maturities, or who have been drawn to some of the cheap valuations that abound in US and global equity markets — in areas such as financials, leisure, transport, energy and industrials.
Investors hoping for a recovery in growth and inflation that could boost assets like these, could be waiting a while yet. The latest outlook from the Federal Reserve projected rock-bottom interest rates until at least the end of 2023. It is also worth noting that the US central bank does not expect core inflation to rise to 2 per cent and unemployment to fall to 4 per cent until that time. That raises the bar considerably for any return of higher rates.
One bright spot is that consumers and companies continue to save cash as a buffer — money that at some point will be spent. Residential home markets are also gaining a boost from the pandemic, which has accentuated a desire among many homeowners for greater space. Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, notes that the US has not seen such a “robust” housing market for 15 years.
Another important consideration for investors is whether the potency of central bankers will wane. Given that interest rates are bumping up against the zero lower bound, there is limited scope for further stimulus if the economy falters again. It may be up to fiscal policy, rather than monetary policy, to nurture expectations of a more reflationary future.
But Ms Shalett makes an important distinction when looking back at the lack of inflationary pressure over the past decade. That reflected “aggressive deleveraging by banks and households — two factors that are not present today”.
US bond-market expectations for inflation over the coming three decades are sitting around 1.75 per cent. But even a modest shift beyond 2 per cent could really reverberate across financial markets, rattling holders of richly-valued tech stocks and long-dated bonds.
A market clamour of “inflation is back” would intensify, and would prompt a sharp response from plenty of investors. Already, there is some measure of trepidation.
Ian Harnett, co-founder of Absolute Strategy Research, says a lot of clients have been asking what could upset portfolios that are heavily weighted towards growth stocks. He adds that many are looking at ways to shield themselves from a significant rise in economic growth and inflation, such as by increasing exposure to emerging markets or commodity producers.
The good news is that there are solid opportunities available, if global economic output does indeed pick up faster than expected in 2021 and beyond.
The gap between valuations of technology stocks and financial stocks, for example, sits at its widest point for almost 20 years. The banks face plenty of problems, of course, including a rise in bad loans, but the sector is far stronger in capital terms than it was in 2008. Mr Harnett says that cheaply-priced banks have historically provided “significant protection for equity managers when inflation risks have risen in the past”.
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Calling a turn is a guessing game, of course: investors of all stripes can never profess complete confidence in the economic and financial outlook, let alone during a global health crisis. As economies, companies and households adjust to living with Covid-19 and await news on vaccinations, so must investors.
For now the important assets to watch — long-dated bonds for a rise in yields, and equities for a broader recovery beyond the current narrow group of winners — are parked on the runway. But they are ready to take flight, creating opportunities for investors with time on their side to adjust portfolios.
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