Investment Outlook - Market Update
Global equity markets were unsurprisingly relatively flat during the third quarter. After a very strong first half of the year, a battle played out between the pessimists and optimists on various topics from growth slowdown and inflation to the resurgence of the Covid pandemic. From the micro perspective a further dynamic unfolded with uncertainties emanating from company-specific and industry-specific comments pertaining to supply chain bottlenecks, labour shortages and raw material price increases.
Looking forward, we believe that after a decade of central banks flooding the global system with liquidity to counter deflationary forces, a ‘regime change’ lies ahead and we should expect and plan for a reversal in those forces and for a period of central banks increasing short term interest rates and ‘tapering’ their bond purchases. It has already begun, with several countries already raising short term interest rates during the final quarter of 2021. We can expect that the US Federal Reserve will commence a material reduction in its bond purchase programme while the UK may also be forced to raise interest rates. Our central scenario looking into 2022 is for both economic growth and inflation to remain above trend.
For equity markets such a transition period or regime change poses a real time to think and consider how we should invest. A decade of central banks driving asset class returns (that were in our view well beyond those merited by fundamentals) is most likely behind us. Bond markets and stocks and industries particularly benefitted from this regime, along with growth & momentum style investing and ‘growth’ sectors such as technology and the famed FAANG names.
Looking ahead investment terms that have been almost forgotten about or overlooked such as lower beta, equity income and dividend growth, and downside protection could well be beneficiaries from the new regime.
As ever, we continue to live in uncertain times including the path of the Covid epidemic, which is not yet over. While remaining ever-vigilant we do see equities as the preferred asset class but expect more rotation within markets as well as more modest and volatile return patterns.
Asset class outlook:
At an aggregate valuation level, equity markets remain expensive compared to history, but not aggressively so. For the first nine months of 2021, while we have seen strong equity market returns, they have slowed down of late and we can also note strong style rotation from value to growth and back again more recently towards value again.
We do expect that the Q3 2021 earnings reporting season will be important to market direction and will be closely watched. Company narratives will be important and most importantly in areas such as input cost increases and the outlook for any supply chain-related problems. Finally, and most importantly, a focus on any labour shortages or cost pressures will be closely monitored.
We believe that the rotation towards cyclical and value sectors is far from complete and that the expected transition towards higher rates and steepening bond yield curves will further drive this. While absolute market returns may be more muted, we do believe an environment that will reward stock-picking lies ahead. M&A activity has been a positive
Of late we have once again seen upward pressure on bond yields but none-the-less they remain extremely overvalued and close to historically low yield levels. As has been the case for years, bond markets remain ‘artificially’ supported by central bank intervention and are not reflective, I believe, of their true fundamental value. Over the coming months, the Fed will have a more challenging period as it begin to ‘taper’ bond purchases and move ever-closer to interest rate increases, most probably during H2 2022. In a world where we forecast above-trend growth and inflation, expect bond markets to struggle against such a fundamentally healthy growth backdrop.