Neil Birrell, Premier Miton’s Chief Investment Officer and manager of the Premier Miton Diversified Growth Fund, considers what might be in store for the world economy and financial markets over the next few months and years.
I don’t know about you, but I have had just about enough of looking back over what has happened in the recent past and more than enough of writing about it. So, for this piece I will try to make it forward looking, more of a preview than a review. After all, what the future holds is more important for financial markets than the past.
Deflation is bad; falling prices of goods and services lead to lower spending, reduced production, lower wages and unemployment, which is an unpleasant cocktail for the economy. A modest level of inflation is good as it has the opposite effect of deflation. However, too much inflation, particularly if it is rising quickly, is bad as it can reduce the real value of assets. Stagflation is the worst environment; it is a combination of a stagnant economy and rising inflation, thankfully this is unusual as it requires an unlikely combination of economic conditions to occur.
There are a number of factors that are leading to higher inflation at present which can be seen in many developed countries. The trigger is the ultra-loose monetary conditions that prevail; interest rates at very low levels and asset purchasing programmes from central banks to provide support to economies and financial markets. The strong recovery we are going through allows for price increases in goods and services which is inflationary as well. These two factors are predictable. Other features of what we are seeing in the economy have been less predictable and are clearly associated with the fall-out from COVID. These include supply chain induced shortages in everything from electronic components in cars, to building materials, to milkshakes in McDonald’s. These are being exacerbated by labour shortages as government support schemes remain in place and labour is proving to be less mobile.
It is likely that inflation will continue to rise for a period. The Bank of England has predicted that inflation will peak at over 4% this winter and stay there until the second half of next year. Should we worry about this? If that is the outcome, then, no, I don’t think it is a concern. It would become concerning if inflation rose much above that as interest rates would need to rise and economic growth would be at risk.
I doubt it. Central banks have done a good job of managing their economies and remain vigilant and supportive, but we have an extraordinary range of factors facing us in a combination that has not been experienced previously and that is before we try to factor in the unknowns, that we can’t, well, factor in. There is little doubt that the COVID hangover will provide more surprises for us in the months and years to come.
Economic recovery is well underway, sufficiently so that the pace of growth is already slowing and forward looking indicators are suggesting that this trend will continue. So, how concerned should we be? If I were to simply list the factors that, in aggregate, could cause growth to stall, it would be a long one, but here are a few of the main ones. Any pick-up in COVID cases and lockdown measures are top of the list although it is getting easier to put those behind us. The shortages of goods and labour do not just lead to rising prices, they also reduce economic activity. Government job support measures unwinding (at home and in the US) are likely to lead to more companies failing. Commodity prices rising reduce profits and disposable income.
The issues in China are real as well. Government intervention in a number of industries from education to computer gaming to technology are having an impact on their domestic economy and have global ramifications. Perhaps of greatest concern however, is the property sector. The government has always tried to control the huge levels of debt which have fuelled massive expansion and price rises. The future of property company, Evergrande is in considerable doubt, it is very highly indebted and has run out of money. To put that into context, it is the largest company in the largest sector in the second largest economy in the world. The ramifications could be significant, for the Chinese banking sector and many others, HSBC for one!
That’s all a bit sobering, but let me be clear; the world economy is growing fast, in fact at a pace that cannot be maintained, it is on a rapid recovery from a deep recession. It is healthy that it slows, the key is dealing with the issues that are coming out of left field in such an extraordinary period.
When thinking about financial markets and what might lie ahead, it can scramble the brain. One way or another, the prices of different asset classes are interlinked and there are many asset classes to consider; government bonds, corporate bonds, money markets, company shares (equities), commodities, foreign exchange and real estate are the main ones and they all have many sub asset classes within them and that’s before we get on to derivatives, private equity, cryptocurrencies and the like.
For this purpose, I will stick to some thoughts on the outlook for bonds and equities, which are the markets on which most of the funds that we manage focus. Although, there is one common denominator that drives all asset prices; risk. If conditions are such that there is an appetite for risk, then riskier asset classes will do well and within asset classes the riskier elements will outperform. Investors want to make money in the good times and not lose it in more difficult market conditions.
The outlook is always uncertain; we do not know what is going to happen, but we need to form a view, decide upon our appetite for risk and invest accordingly. The problem at the moment is there are more variables to consider than usual, partly due to COVID.
Rising inflation, strong economic growth and rising interest rates are not normally a good backdrop for bond prices; that is where we are at the moment. If you were to choose only one asset class to invest in today, it probably wouldn’t be bonds, unless you are very risk averse. Maybe you are very concerned about new COVID variants taking hold over the winter or the Chinese property market resulting in a Lehman Brothers style induced financial crisis; if so bonds are for you, particularly government bonds as they are seen as less risky or “safe haven” assets. However, it is difficult to call bonds cheap at present and on a risk / reward basis they do not look that attractive to me. But the bond market is broad and deep; there are parts of it that are attractive and active managers, as we are, can find them. We can also mitigate and manage risks within our bond portfolios through diversification and other methods.
Again, it is difficult to call them cheap by historical comparison, indeed, some parts of the equity market look expensive. Most commentators will tell you that the share prices of the large US technology and communications companies such as Apple, Netflix, Facebook, Google, Amazon are on dangerously high valuations and are riding for a fall. This may be the case, but there are many industries, sectors and companies to choose from and plenty of good quality companies at attractive valuations all around the world, with which we can build diversified, long term portfolios.
Equities are also sensitive to the economic environment. At the very basic level, strong economic conditions lead to stronger company profits, which is good for share prices. But, not all companies are the same; some are sensitive to the economic backdrop such as those in the construction, retail or hospitality industries, often characterised as “value” companies. Others are less so, including household goods and technology sectors, grouped together as “growth” companies, such as the ones named above. It could be expected that “value” companies will do better if the economic recovery remains strong, including through a period of higher inflation and rising interest rates. The opposite can be said of “growth” companies; they will do better when there is a scarcity of profits growth as investors will be willing to pay more for it and that growth will not be eroded by inflation.
I hope that this gives a feel for what might be in store for us over the coming months, but, I don’t, and indeed, no one, knows exactly what we will experience. As you can see, the economic outlook is uncertain and as such how central banks will react is the same. In my view, we will see the economic recovery continue, with the rate of growth moderating through the rest of this year and next. Inflation will rise, but fall away as growth moderates. Central banks will start reducing their gigantic asset purchasing programmes towards the end of this year, starting with the US, and interest rates will start to be increased (very modestly) next year, but not until the second half.
But, I repeat, we do not know, so being active in our selection of which parts of the bond and equity markets and which individual bonds and companies to invest in is crucial. But for us that is always the case, we fundamentally believe it is the best way to provide good returns, with the appropriate level of risk. We manage risk and we want to have the flexibility to reduce risk and increase risk in different economic and market conditions, without taking too little or too much. That means being active in our approach.
The value of investments may fluctuate which will cause fund prices to fall as well as rise and investors may not get back the original amount invested.
The performance information presented in this document relates to the past. Past performance is not a reliable indicator of future returns.
Government and corporate bonds generally offer a fixed level of interest to investors, so their value can be affected by changes in interest rates. When central bank interest rates fall, investors may be prepared to pay more for bonds and bond prices tend to rise. If interest rates rise, bonds may be less valuable to investors and their prices can fall.
Future forecasts are not reliable indictors of future returns.
About the author
Neil Birrell is chief investment officer for Premier Asset Management and is fund manager of the Premier Diversified fund. He joined Premier in 2013 from Elcot Capital, where he was part of the team responsible for managing multi strategy investments. Neil was previously chief investment officer of Framlington Investment Management and a senior fund manager at Prolific Asset Management.
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