Article 21 October, 2021

Macro update: October 2021

Welcome to our monthly macro update. Here we provide an overview of our current market views, and our recommendations for strategic portfolio positioning.

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Snapshot of views

While equities have been our highest conviction allocation this year, credit markets are a more useful indicator of economic health. As we move into a period of falling policy support, we will continue to watch our credit conditions indicators closely. Sovereign bond yields have risen in similar fashion to Q1 2021 ahead of policy withdrawal. In line with our upgrade of sovereign bonds last month, we think they are now more fairly valued. So how might lower policy support impact markets in the future? Typically, the withdrawal of stimulus coincides with below average equity market performance, however, it doesn’t inevitably follow that equity returns are negative. Our base case is that equity returns will be positive over the coming months, albeit more muted than we have seen of late. But with minimal compensation from credit, we still expect equity returns to outperform both defensives and other return seeking assets.

What can we learn from credit conditions?

We have discussed our equity views at length throughout the year, given our high conviction allocation. However, this does not mean credit has played an inferior role in our research. In fact, during periods of equity weakness, credit spreads (the additional yield that investors receive over a risk-free bond) have an important influence on returns. The corporate profitability owned by shareholders through equities is inherently linked to the health of credit markets.

So, what have credit conditions shown us over the past month, during a period of weaker equity performance? While credit spreads have increased, they remain close to their long-term lows, supporting cheap capital expenditure for companies. In part, this is a by-product of explicit central bank support, but it is also evidence of the confidence investors have in the ability of companies to remain profitable and meet interest payments. . Reduced central bank support may hurt credit markets in the future, and we are closely watching our credit conditions indicators for signs of this.

The tightness of spreads also has implications for buy and maintain credit and we remain underweight in our asset class views. In general, this supports delaying investment, in favour of allocating at higher spreads in the future. However, this approach requires careful consideration of client-specific cash flow needs. By delaying investment yield is foregone, potentially outweighing the benefit of waiting it out for higher spreads in the future.

Credit conditions remain healthy

Source: R&M proprietary indicator, 14/10/21

Are sovereign bond yields set to rise further?

Sovereign bond yields have soared in the past month as inflation expectations rose and we edge closer to the withdrawal of policy support. But with yields now close to pre-pandemic levels, where do we expect them to go next? As central banks purchase fewer sovereign bonds, in theory there will be less demand thereby increasing bond yields (all else being equal). But this view omits that sovereign borrowing will also fall as governments reign in fiscal support, reducing supply. We expect this reduction in supply to at least match the fall in demand. The pace of the rise in yields has been akin to Q1 2021, where yields rose too much, and a period of consolidation followed. Although still low by long-term standards, current yields present an opportunity for clients who are looking to reduce an underweight underhedged position. We upgraded our sovereign bond asset class view last month to neutral, reflecting our view that sovereigns appear more fairly valued and portfolios no longer need to reflect a specific underweight.

UK yields have risen back to pre-pandemic levels

Source: Bloomberg, 14/10/21

“Our base case is that equity returns will be positive over the coming months, albeit more muted than we have seen of late.”

What could be the impact of central banks withdrawing stimulus?

The Federal Reserve has indicated their plans to reduce bond purchases in the coming months, so how could this impact asset returns? Historically, reducing policy support has coincided with below average equity market performance, and this would come as no surprise given extremely strong equity returns over the last 18 months. However, it doesn’t necessarily follow that equity returns will be negative. Our base case is that equity returns will be positive over the coming months, albeit more muted than we have seen of late.

Does this information prompt a change in asset allocation? More limited upside may warrant a slightly lower equity allocation, or increased downside protection, but with minimal compensation from credit, we still expect lower equity returns to outperform both defensive and other risk assets. As a result, our view is that equities continue to represent the best use of the available on risk allocation.

Negative central bank stimulus doesn't necessarily result in negative equity returns

Source: Bloomberg, 14/10/21

 

 

 

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. 

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