Global equity markets continued to move higher in the 1st Quarter of the year, with Continental Europe, UK and US all higher by around 5% in sterling terms, with Japan being one of the few major markets failing to progress. Bond markets, however, continued to decline as the prospects of recovery and with it the potential for higher inflation and interest rates brought to an end, at least temporarily, to the long bull market.
As the world continues to grapple with the impact of Covid, the hesitant vaccine rollout of Continental Europe is in stark contrast to that of the UK and US. However, investors are still optimistic that as the year progresses, the benefits will flow through into a much improved economic outlook and with it, a healthier recovery in share prices. This can be seen in the make-up of sectoral performances over the past few months, with many of the cyclical and ‘value’ stocks and sectors, which were heavy fallers during the height of the pandemic, continuing to progress, while staples and technology shares saw continued profit taking. In addition, many governments are continuing to provide huge financial support for their economies, not only through immediate income assistance, but also infrastructure projects to maintain longer term economic help and momentum.
The overwhelming financial support being provided also has some negative implications. The major downside to these financial incentives is the impairment of government balance sheets and the sudden rapid fiscal ‘shock’ given to kick start the economic system. In the UK, government debt is now estimated at £2 trillion, with the size of the economy at £2.6t and in the US, debt stands at $21t and the economy at $27t. These eye watering debt numbers are unlikely to get better any time soon but with current low levels of interest rates, they are easily manageable. In fact, there is still around $14t of debt which is attracting negative rates of interest, so investors are still paying the German government, for example, to hold its bonds. However, the avalanche of financial support is raising concerns over the inflationary impact and with it, the effect on interest rates and bond yields. In the US, government bond yields have been rising, having almost doubled to 1.7% for 10 year bonds in the past 6 months. This is providing a nervous backdrop in bond markets, with sporadic spill over into equities: however, governments are likely to be supportive of markets, at least in the shorter and medium term and any modest uptick in inflation is likely to be accommodated. While this may be the case, it is difficult to see a positive outlook for bonds given the long bull market for this class and the very meagre yields which they, even now, offer.
In equities, many financial commentators will point to already high valuations as lofty compared to historical standards and a hindrance to further progress; however, while this is the case at the headline level many cyclical stocks have seen their profits heavily impacted by events and provided the economic recovery is not hampered then a healthy profit rebound should ensue leading to a swift recovery in estimates. Of course, financial markets are always attempting to predict what will happen 12 or 18 months ahead so some of the recovery is already being factored into share prices. While this is certainly true, it is likely that cyclical and value stocks have further to go yet although there will be a point over coming months when a rotation into more staple sectors will occur, probably and perversely at a time when the world and investors are at their most optimistic. That said, a balanced equity portfolio should continue to offer benefits over the coming year with healthy yields, improving profitability underpinned by proactive government support and recovering economic activity.
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