Monthly macro update: April 2021
Snapshot of views
At the turn of the year, we discussed how record stimulus and low borrowing costs presented a great environment for equities. We’re pleased to see our view playing out, with equities having another good quarter. But the dominant story over the last few months has undoubtedly been the pace of the rebound in government bond yields. While we expected upwards pressure on bond yields, a return to pre-pandemic levels by the end of March 2021 was certainly faster than we and most other investors expected.
With equities continuing to rise and government bond yields sharply higher, it begs the question, how much longer can this equity rally continue? But we expect equity markets to remain supported for some time yet, as rates are rising for the right reasons (i.e. improving economics). To be sure, rising yields have weighed on parts of the market, in particular technology companies, but improving economic expectations should support broad equity markets in the near term.
Longer-term, we need to be mindful of the risk that higher rates pose to equity markets, as well as the impact of the “stimulus effect“ fading. While stimulus has provided a backstop to equity markets over the past year, we expect markets to reconnect with fundamentals as it gets withdrawn. We expect a reversion back to high-quality companies, with ESG continuing to be important. Looking further out, as higher rates start weighing on economic activity, dynamism will be crucial in managing the rotation away from equities when the time comes.
Equities set to keep climbing in the near term, with reflationary stocks catching up
As we take stock after a busy quarter, we find ourselves assessing another period of rising equities. Four consecutive quarters of positive equity performance is not unusual, in the past decade 75% of quarterly periods in have been positive for US equities. But the scale of the rally since markets bottomed a year ago has been extraordinary. Stock markets in the US, Germany and Japan have each risen over 50%¹ since this time last year.
Looking under the hood of headline equity indices also paints an interesting picture – we can see the effect rising yields have had. Unsurprisingly high growth technology companies have lagged, with the MSCI World Technology Index broadly flat year to date. Meanwhile, energy companies and financials, two of the worst worst-performing sectors in 2020, appreciated approximately 24% and approximately 14% over the same period. This rotation into cyclical sectors is a healthy sign of the equity rally broadening, and one we think will continue in the near term.
Admittedly valuations are not supporting this theme to the extent they were earlier this year. Bond yields have risen rapidly, while economic expectations have also picked up. Given cyclical assets have been the major beneficiaries, the opportunity is not quite as appealing as it was, albeit still preferable to defensive sectors in the short term.
Source: Bloomberg 03/30/2021
Bond yields have been the dominant story and will continue to be important
What probably surprised investors most over Q1 2021 was the pace of the rebound in government bond yields. While we expected upwards pressure on bond yields this year the return close to pre-pandemic levels by the end of March 2021 was fairly remarkable. Government bonds suffered losses (yields move inversely to prices), while corporate bonds also struggled as a result. While corporate credit spreads were generally steady, higher government bond yields weighed on interest rate-sensitive assets, such an investment grade bonds.
With government bond yields having risen sharply, the obvious question now is whether this affects our high conviction view favouring equities over other asset classes. In the near term, we don’t think so. Bond yields at these levels are not an immediate headwind for equities, as yields are rising for the ‘right’ reasons (i.e. improving growth expectations, as we detailed last month). Equity markets generally absorb rate rises well in these circumstances; the risk comes as higher rates start weighing on future economic activity. Historically PMIs (a key economic indicator which is highly correlated to equity market moves) trail government bond yields by around 18 months, so we expect equities to remain supported in the near term. The chart below illustrates this, with PMIs forecast to stay healthy (above 50) until at least the second quarter of 2022.
Looking further ahead, we recognize that higher rates may weigh on growth expectations, and consequently equity markets; hence a dynamic approach will be important in managing potential weakness next year.
Source: Bloomberg 03/30/2021
Where do we go from here? From reflation back to innovation.
Stimulus has dominated the last year. Governments are running deficits not seen since wartime and central banks have increased balance sheets by orders of magnitude higher than in previous crises.
Source: BCA Research 03/30/2021
But with economies now reopening, the rate of change of new stimulus is going to slow. It’s likely that as this happens, we will see markets reconnecting with fundamentals (rather than being driven by the “stimulus effect”).
The question then becomes which parts of the market will be winners in a more conventional economic environment. While ‘value’-style companies have had their best period of performance in years recently, we find it hard to see that trend continuing over the medium term. Bond yields are still very low by historic standards and we struggle to see structurally higher inflation driving up interest rates over the medium to long term, – both are headwinds for value stocks Furthermore, green transition requirements will weigh on key ‘value’ sectors such as energy and automobiles. With this in mind, we expect a rotation back to companies able to grow and innovate; factors such as ESG, quality and growth will probably take over again, and dynamism within equities will be needed to capture this rotation.
While on the face of it this looks much like our pre-pandemic outlook, we expect nuanced differences from previous economic cycles. The US dominated other regions post the financial crisis, whereas we now expect economic growth to be broad-based; we are seeing a global economic recovery, with stimulus reigniting previously stagnant economies such as Japan. As such, we believe there is merit in broad regional exposure.
Investment advisory services are provided by River and Mercantile LLC, an investment advisor registered with the US Securities and Exchange Commission. It is a subsidiary of River and Mercantile Group PLC, a U.K. corporation.
The information and opinions contained in this document do not constitute investment advice and is provided for background purposes only. References to specific securities are provided solely as illustrative examples of the River and Mercantile LLC analytical methods, and are not a recommendation to buy or sell such securities. This information is subject to updating and verification. Portions of this presentation are based on data provided by third parties whom River and Mercantile LLC deems to be reliable; however, River and Mercantile LLC cannot guarantee the accuracy and completeness of the information.
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS.
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