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Global Markets to 2 July 2021

More good news for global investors?

We are now a whisker over midway through the year, and the extraordinarily strong global economic recovery we have seen means that – on the face of it, at least – there is plenty of good news for global investors to be positive about.

They have enjoyed unprecedented investment returns over the past 18 months or so. Inflationary concerns, fears over emerging new variants of Covid-19 and a series of mixed messages from governments and central banks have admittedly all affected day-to-day movements in financial markets. Nevertheless, the underlying direction for risk assets (equities) still seems relatively positive.

Over the second quarter of the year, vaccination programmes, a disregard for any inflationary issues and continuing dovish central bank policies led to the benchmark 10-year Treasury bond yield falling back to 1.45%. This supported growth stocks, leading to them outperforming value stocks over the quarter – the reverse of what happened in the first quarter of 2021.

Strong corporate earnings ahead

The likelihood of further government spending, the unleashing of pent-up consumer demand (as lockdown rules are relaxed) and adjustments to the working environments of businesses are all likely to drive a strong corporate earnings recovery for 2021-2022.

Central bank policy has been to keep interest rates lower for longer – regardless of inflationary pressures. This is likely to make professional investors want to keep owning global equities – the expectation is that these will deliver better investment returns than bonds or cash.

Economic data over the past three months has been strong – particularly in the US, which saw an annualised growth rate of 6.4% in the first quarter. However, this did not hold true globally: the eurozone economy contracted by 0.6% over the same time horizon.

How transitory is the current inflationary increase?

The speed of the vaccine rollouts – particularly in the western world – has enabled numerous economies to reopen. The resulting rebound in economic activity has subsequently fuelled inflation in some countries. In May, the US consumer price index increased by 5% year-on-year. However, a number of underlying elements suggest that this might be temporary, which is why the Federal Reserve Bank sees the current inflationary increase as transitory. More hawkish policymakers are already arguing for a tapering of the bond-buying programme, while the median Federal Open Market Committee members are now expecting two interest rate hikes at some point in 2023. This is a departure from their thinking some three months ago.

Interest rates left unchanged in the UK – again

In the UK, the Bank of England expects the strength of the UK’s economic recovery to push inflation above 3% by the end of the year. However, members of the central bank’s monetary policy committee (MPC) have confirmed that the bank’s base rate will remain at 0.1% until the economic outlook is more certain. Interest rates were therefore left unchanged at their recent meeting.

The inflationary debate will most likely continue until the rest of the year, while certain domestic economies are allowed to “run hot” for a while. In the main, western central banks are quite happy to see an average inflation rate of around 2%. They see this as a “sweet spot”– the level of inflation that they have been trying to manufacture since the end of the Global Financial Crisis.

Little prospect of monetary policy changes

Prospects for the global equity markets remain positive for the second half of this year. The central banks are unlikely to make any changes to their monetary policy over that time horizon, and the corporate earnings outlook is favourable for most companies (they should benefit from the unleashing of post-Covid demand and the unlocking of the global economy).

What road doesn’t have bumps?

There are, however, some potential bumps in the road ahead that could affect the current positivity regarding the global economic recovery. Firstly, there is a risk of inflation spiking up further and remaining high – that is a risk that the authorities are very aware of, and which would end up being far more serious for central banks. Secondly, the US central bank might taper its bond-buying programme too quickly, creating repercussions that could affect financial assets. And thirdly, there may be some additional corporate damage to the companies that were hardest hit by Covid and the ensuing lockdowns and disruption.

In short, the equity markets have been incredibly generous over the past 15 months. There are now arguments for being somewhat more cautious over the coming weeks. The summer months can be highly unpredictable. And with so many companies’ share prices now priced to perfection, their valuations and forward guidance for corporate profitability become even more important.

Indeed, the corporate earnings season gets under way soon and will play a key role in investment outcomes. Any disappointments are likely to be harshly punished by the market. Nevertheless, as the global economic recovery gains momentum, risk assets – such as quality equities – should continue to benefit.

Growth should remain strong

We therefore believe that overall global growth will remain strong, and that equity markets will continue to do well, maintaining their upward trajectory. The rotational tilt into value stocks from growth still has further to go – particularly if bond yields rise. However, we would endorse a strategy that involves having exposure to both.

Finally, as we expect more volatility in both global equity and bond markets over the coming months, we also endorse having an asset allocation tilted towards innovative themes. These will benefit from disruptive technologies and the fast-changing world.

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