In the depths of the COVID sell off in 2020 the market narrative was pretty depressing. The economy was never going to recover, inflation was dead and interest rates would be permanently lower. The Austrian Government famously raised a 100-year maturity bond at a paltry 0.9% pa. While the economic reality evolves slowly, the market's mood and narratives underpinning it can flip with break-neck speed.
The narrative well and truly flipped in February, with investors now firmly focussed on the consequences of coming out of a COVID ravaged world. The prevailing concern at the start of the month was a lack of economic activity, which has flipped to worry about the longer term consequences of the massive monetary and fiscal policy support programs put in place in the middle of last year.
That worry has a name, inflation. According to Google Trends, searches for the word “inflation” have doubled in the last year. And its not hard to see why. Economic activity as we come out of global lockdown will lift, and lifts in economic activity can impact inflation.
The risk that worries investors most is that this will be no ordinary return to form for the global economy. We could be about to “enjoy” a mini boom in activity. There are a number of trends supporting this theory. The most obvious are the massive stimulatory policies put in the place to protect the global economy during COVID which continue to be rolled out. US president Joe Biden’s 1.9 trillion-dollar package being the latest.
But it’s more than just that. Consumers have been saving during the crisis - it’s hard to shop when you are stuck at home - and there is the distinct chance of an explosion in consumption as the northern hemisphere summer dawns and vaccines begin to take effect. This can be most easily seen in the U.S personal savings rate which has averaged 6.5% of income this century and has blowen out to 16% in 2020. That is a lot of pent-up spending power.
Fears of higher inflation feed directly through to higher interest rates, as do expectations of more economic activity. Interest rates have risen from lows and risen strongly. In New Zealand the ten-year rate bottomed out at 0.5% in September and hit 1.9% this month.
Rising interest rates reduce the value of fixed income investments and have a material impact on conservative fund returns in particular. As an example the broad New Zealand fixed income market index, the Bloomberg NZBond Composite Index, fell in value by 3.2% this month. That’s a big move.
Higher interest rates and prosects of increased economic activity impact more than just fixed income markets. They affect not only the overall level of the share market, but who the winners and losers within the market are.
For the New Zealand share market higher rates are a definite headwind. The New Zealand market is dominated by safe, economically insensitive high dividend yield companies. These are not the kind of shares to own as interest rates rise. That meant a very challenging month for the market with NZSE50 index falling 6.9% led lower by the gentailers and listed property companies.
It was more mixed in offshore markets, although they did sell off towards month end. There has been a real change in market leadership in February with the growth companies that had lead the market during the pandemic and early stages of the recovery underperforming and smaller companies and companies more exposed to the level of economic activity doing significantly better.
Like most narratives in financial markets there is truth in its core that is sometimes then taken too far. There is no doubt, in our view, that the global economy is recovering and that this recovery will be strong. There is little doubt, in our view, that this will put some upward pressure on inflation. But there is significant doubt, as we see it, that the inflation genie has been let out of the bottle and that inflation will spiral out of control.
At current interest rates markets feel like that they have appropriately adjusted to the economic realities of 2021. We wouldn’t expect rates to head decisively higher.
Within portfolios we have been cognisant that one day the world would return to normality and ensured we had investments well suited to perform in a recovering world. Positions in banks like Signature Bank (+32%) and recovery plays like Hilton, Vista in New Zealand and in Australia have all proven to be valuable members of the team in the past month.
The good news is that the world is recovering, the challenge for investors is that this change necessitates careful management of your wealth. To paraphrase Bowie time may change markets, as investors we need to be prepared.
That’s exactly why we have all weather portfolios designed to be robust in different market environments. That approach has been an important protection in February and a core element in how we manage your money.