Macro update: November 2021
Welcome to our monthly macro update. Here we provide an overview of our current market views, and our recommendations for strategic portfolio positioning.
Snapshot of views
US equity markets bounced back from a weak September 2021 to reach all-time highs, however, the risk of higher inflation remains present. Our primary concern is to what extent inflation causes policymakers to withdraw support prematurely, but recent assurances from the US Federal Reserve are supportive of our ongoing preference for equities. We expect equities to be supported by above-trend economic growth and low real borrowing costs. Equities should outperform other return-seeking asset classes over the next 12-18 months (albeit more muted than the last 12-18 months in absolute terms). As policymakers withdraw stimulus, we expect bouts of volatility to be sharper, which warrants a greater use of ‘structured equity’ for downside protection. Not that we think equities will fall. Rather, we acknowledge equities may not uniformly rise in a similar fashion to the past 18 months, calling for a more risk-managed allocation. We continue to prefer equity over credit. Real yields for lower-quality bonds took the unprecedented step in moving negative. This means that if inflation were to remain at these levels and adjusting the yield accordingly, a broad index approach would lead to investors receiving a minimal compensation for lending to higher-risk companies.
Equities reach new heights
US equity markets bounced back from a weak September to reach all-time highs, driven by strong corporate earnings and central banks stoically standing by their policy frameworks. We have long said that corporate earnings would be the driver of equity returns in 2021. Companies are benefitting from strong demand and the ability to pass on increased costs of business to consumers. However, we have also been aware of the risk higher inflation presents, specifically if it causes premature withdrawal of support from policymakers (for example, by unwinding stimulus or raising interest rates). The US Federal Reserve’s commitment to a slow withdrawal of stimulus expected to complete by Q3 2022, (rather than a knee-jerk reaction to inflation) supports our ongoing preference for equities.
Whilst we advocate a modestly lower equity allocation relative to earlier this year, we maintain our strong preference for equities over credit. Despite economic growth moderating, it is declining from all-time highs, and we expect it to remain above pre-pandemic trend levels over the near term. As shown below, GDP growth continues to supersede pre-pandemic levels. With real interest rates (interest rates adjusted for inflation) negative and corporate borrowing costs close to record lows, it incentivises companies to undertake growth projects. Both factors are beneficial for shareholders and increase the attractiveness of equities, particularly compared to the compensation on offer from credit assets (more on this below)...
Figure 1. US GDP has recovered back to trendSource: Bloomberg, 10 November
Fading stimulus warrants downside protection
While our base case is that equity returns will be positive over the next 12-18 months, we expect more muted returns than over the last year. Monetary and fiscal stimulus has been effective in providing a backstop to equity markets throughout the pandemic and limiting market corrections. But as policymakers withdraw stimulus, albeit gradually, we expect bouts of volatility to be sharper in the future. Historic analysis illustrates this pattern, with 5 of the last 7 equity drawdowns over 10% coinciding with the bottom quartile stimulus (shown in the table below). This calls for the greater use of risk management tools, such as structured equity. Structured equity provides exposure to equity markets up to a certain level of gains, with explicit downside protection against equity market falls. Given we expect more modest equity returns over the next year, sacrificing high gains (which are unlikely to materialise) in favour of downside protection is a prudent, risk-managed way of maintaining a meaningful equity allocation. Not that we think equities will fall, rather, it is an acknowledgement that equities may not rise as uniformly or rapidly as in the past 18 months.
Source: River and Mercantile, Bloomberg, Index is S&P, 10 November. Market drawdown is the percentage change in market index price from peak to trough.
Lower quality bond yields unprecedentedly move negative
As credit spreads (compensation for a risky bond above a risk-free bond) progressively tightened over the past 18 months, we took steps to reduce our exposure to credit for mandates where we have discretion. Driven by explicit policy support for corporate bond markets, lower-quality bond yields have now taken the unprecedented step in moving negative in real terms. This means that if inflation were to remain at these levels and adjusting the yield accordingly, a broad index approach would lead to investors receiving a minimal compensation for lending to higher-risk companies.. While monetary and fiscal policies have been effective in minimising economic scarring from the pandemic, it is realistic to think defaults may rise as policymakers withdraw stimulus. This further justifies the use of opportunistic credit mandates which can select more attractive individual credits without benchmark constraints, thus can rotate away from segments of the market, which are looking increasingly overvalued or susceptible to default.
Figure 3. US GDP has recovered back to trendSource: Bloomberg, 10 November 2021
This article has been issued and approved by River and Mercantile Solutions, a division of River and Mercantile Investments Limited which is authorised and regulated in the United Kingdom by the Financial Conduct Authority (Firm Reference No. 195028; registered in England and Wales No. 3359127) and is a subsidiary of River and Mercantile Group Plc (registered in England and Wales No. 04035248), with its registered office at 30 Coleman Street, London EC2R 5AL. Please note that all material produced by River and Mercantile Investments Limited is directed at, and intended for, the consideration of professional clients only within the meaning of the Financial Services and Markets Act 2000 (“FSMA”). Retail clients must not place any reliance upon the contents .The information expressed has been provided in good faith and has been prepared using sources considered to be reasonable and appropriate. While this information from third parties is believed to be reliable, no representations, guarantees or warranties are made as to the accuracy of information presented, and no responsibility or liability can be accepted for any error, omission or inaccuracy in respect of this. This article may also include our views and expectations, which cannot be taken as fact. The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a reliable guide to future results. Changes in exchange rates may have an adverse effect on the value, price or income of investments.
Macro update: December 2021 – Pandemic, Policy and Prices: 2021 in review
Macro update: December 2021 – ...
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