deVere Group: Global Market Review

• Directionless markets, but a belief in a Goldilocks scenario remain valid
• Inflation – how different asset classes might respond
• Sterling – appreciating on an improved U.K growth outlook

Market sentiment: Global stock and bond markets appear directionless. Investors are delighted by the ever-improving pace of economic recovery in the U.S and the U.K (less so in the euro zone), but nervous of the inflation that has begun to emerge across much of the world. A jump in China factory output prices yesterday triggered a global stock market mini correction – but from cyclical highs.

There remains confidence in the ‘Goldilocks’ scenario, which describes an almost ideal situation for stock market investors in which economic growth drives corporate profits higher, while central banks keep interest rates unchanged. It is notable that bond markets have been more measured in their response to rising inflation over the last few weeks, with Treasury and gilt 10 year yields just back to where they were at the start of May. Bond investors appear to be taking the Fed, the ECB, and other major central banks at their word when they say they are in no hurry to raise interest rates. Because they see current inflation pressures as temporary, and not a structural problem.

Worried about inflation? Different asset classes will respond differently to worries over inflation. An investor who believes current price rises are temporary, and the temporary side-effect of a strong global recovery, may prefer to sit through a period of rising prices in equities. If, however, one believes that a prolonged period of structural inflation is about to hit the global economy -especially if wages start to rise- then real assets, gold, cryptocurrencies and inflation-linked bonds might be a better approach. A multi-asset fund manager will be constantly weighing up the pros and cons of various assets as regards inflation. The following is a brief description of how different assets might respond:

• Real assets. The traditional hedge against inflation is to use assets that are grounded in the ‘real world’, such as property and commodities. Within commodities, gold is perhaps the best known inflation hedge, but many professional investors are also eyeing copper at present because so much green energy requires copper cabling and components. These are physical assets that you can touch, that actually exist, and for which man has always had a need for. They do not represent someone else’s liability (a ‘financial asset’).
• Crypto. Privately issued cryptocurrencies are not physical, and not generally held by multi-asset fund managers, but they may also be an option for some investors. They offer independence from the risk of central banks’ creating too much money, while some actually guarantee a diminishing fresh supply over the long time (eg, Bitcoin).
• Bonds. The classic ‘financial asset’. Since bonds are based on someone’s promise to repay a fixed sum -in interest payments as well as capital- they have not stood well against inflation. Rising prices shrink the inflation-adjusted real return of the payments. But interestingly the riskiest parts of the bond market, high yield and emerging market debt, can benefit from inflation if credit rating agencies re-rate the debt because it is cheaper for the borrower to service. This is most apparent to an investor that sees a high yield bond jump a notch into the investment grade category. 
• Inflation-linked bonds. A more reliable way for a fixed income investor to protect themselves from inflation is through using inflation-linked bonds. However, these are much sought after at present and do not offer real value, as judged by the so-called breakeven rate. This is calculated by subtracting the yield on a government bond by the yield on an inflation-linked bond of the same maturity. For example, the 10 year Treasury breakeven rate is currently 2.53%, which means investors believe this will be the average inflation rate over the next decade. This seems unrealistic, given the structural deflationary forces (eg, demographics and automation) at play. But of course, for an investor who thinks a major structural inflation problem is around the corner, a breakeven rate of 2.53% may appear a bargain. 
• Equities. Equities are a diluted form of real asset: a company can raise its prices in a period of inflation, and so maintain the real value of the dividends and the worth of the company. Indeed, financial history shows that equities perform relatively well in periods of low to moderate inflation. But there is an element of promise in an equity, such as the promise of the company to share its profits through a dividend, and profit margins are at risk if input costs also rise faster than selling prices can be raised.

In addition there are many ‘alternative’ funds available to the fund manager, with which to protect a portfolio from inflation. 

Sterling. Sterling’s recent rise against the dollar, to $1.41, reflects the improvement in the UK growth potential. The Bank of England last week upgraded its estimate for GDP growth this year, from 5% to 7.25%, and it now believes that unemployment will peak in the current cycle at just 5.5%. This confidence is widely shared by other economists, and it has led to increased inflation expectations. The prospect of negative interest rates this year is now remote. Economic growth upgrades, and a reduced prospect of further monetary easing, are both positives for sterling. In addition, some FX analysts believe a second (and this time successful) Scottish referendum on independence is less likely after last week’s Scottish parliament elections.

Of course, a stronger currency exerts a deflationary force on an economy by making exports more expensive, and imports cheaper. The Bank of England will probably be keen to manage sterling’s appreciation in order to maintain momentum in the economic recovery, whether or not this is an explicit policy. 

Remain diversified. As always, investors should be as diversified as possible in order to maximise returns relative to risk (ie, volatility). This means geographical, sector and asset class diversification. 

By Tom Elliot