The Investment Committee
1st April, 2021
Quarter 1 2021 Investment Review
The economic environment looked set to improve in 2021. We entered the year on the back of successful vaccine news, with a roadmap for the future, one where in theory we had a great chance to turn the tide on the pandemic. The Brexit story was now in the past and although the picture at the borders was still murky, at least the political posturing was over.
Approaching the end of Q1, and from a UK perspective at least, we have made good progress. At the time of writing, we have given more than 30m people their first vaccine dose. Early data suggesting vaccines also reduce transmission of the virus is hugely encouraging, though we won’t understand to what extent until later in the year.
Vaccine progress globally has been inconsistent, however. Putting Israel to one side, the UK and US are leading the vaccine charge. The European programme has struggled to gain traction comparatively, with to date only 13% of their population having had a jab compared to the UK at 45%. Asia and other emergency markets are even further behind. At this point it is worth remembering that whilst in the short-term single country vaccine progress can be liberating, in the long-term it’s a global battle.
Nonetheless, it would seem sensible to think that in anticipation of economies reopening, and growth rebounding, investment markets would have had a strong quarter. There have been challenges however, as a better economic future also leads to the possibility of interest rate rises, or more widely a change from the ultra-accommodative stance that policymakers have held through the recession. Once we emerge from our homes, pent up demand may cause a spike in inflation. Again, taking the UK as an example, with supply chains from Europe still very much disrupted post-Brexit, if everything opened up tomorrow and people started spending, too much money would be chasing too few goods. Rising prices can be good for certain business’, but bad for others, so again we have seen large divergences in performance between different areas.
Government bond yields have increased in anticipation of future interest rate rises and inflation, causing their capital values to fall. Certain equity sectors, such as the technology driven areas of the market, that performed so well only a few months ago, prefer lower bond yields, so they have had a volatile and more challenging start to the year. The FTSE 100, which we often use as a benchmark for equity returns here at home, has gyrated all quarter, being 6% up inside the first 8 days before losing it all in the same period. It repeated this behaviour in February, and again in March, though as I write today it looks to be closing at the positive end of that range. It feels a little as if conviction in its journey is lacking, and it is still below the level it was 3 years ago.
So, quarter one has felt very hit and miss, with certain areas doing well one week, before struggling the next. That is probably reflective of the uncertainties and the challenges that markets see ahead in 2021, sparring with different outcomes and variables, waiting for a clearer view. Will the re-opening go as planned? Will that lead to a wave of spending, higher inflation and then interest rate increases? Or will further Covid-19 challenges delay things? These routes have hugely different investment implications, requiring an active and disciplined approach to our asset allocation.
Our positive portfolio returns last year were built on a broad exposure to a diversified range of quality assets, many of which will remain central to our longer-term strategy.
However, we have always been of the view that there would be some profit taking as the world starts to emerge from Covid-19, and that we would need to reduce exposure to some of these assets and buy into other areas that will recover strongly on the other side. Of all the challenges with investing for the longer term, market timing is always the hardest to get right. Ideally, we would like to move with conviction, though there is little about the present environment that can offer that either way. How the world emerges post Covid, and how quickly it happens remain very unknown, even now.
Whilst we certainly feel optimistic about the economic recovery, it is important not to get carried away and ignore the risks. Populations are still walking a very fine tightrope that requires ongoing suppression of virus cases whilst immunity is rolled out. Even if we achieve that in the desired timeframe in the UK, progress elsewhere could be slower, or delayed due to mutations for example.
Nonetheless, our central case has been that vaccine rollout will be progressive globally, albeit at different speeds. This will cause a rotation into sectors that have been severely challenged via Covid (travel and leisure) from areas that have prospered (technology and healthcare). We have been adding to the former across the first quarter, but not with as much conviction as we’d like due to the risks noted earlier.
In addition, some of the areas that have benefited from the pandemic will continue to do so for many more years to come. The acceleration of trends such as e-commerce, the technology required to work from home, and the electrification of travel, are with us to stay. These are themes we have reduced in favour of the more Covid-challenged sectors, but that we continue to hold in the portfolios, both for their long-term potential, but also to hedge the risk things don’t go as smoothly as we all expect.
As discussed earlier, markets have been very stop start this quarter. One minute they appear comforted by Covid progress, almost to the extent that they then become overly concerned about inflation gathering pace too quickly. The next they become concerned about the effectiveness of the vaccine rollout, mutant Covid strains and further lockdowns. In short, Q1 saw certain areas within the portfolios perform well, with others struggling. Then, a flip the other way, effectively countering the progress made.
The low-risk portfolios in particular had an additional headwind, as fixed income (a core, low risk asset class) values fell as markets started to anticipate interest rate increases in response to higher inflation. To be clear, we do expect inflation to rise, but not sustainably, and therefore we continue to expect interest rates to remain low for some time yet. Nonetheless, in January a 10-year UK government bond offered a meagre income stream of 0.15%, compared to 0.83% at the time of writing, with the capital value down more than 5% across that period. This has made Low risk investing more challenging in Q1, though looking ahead, the selloff means there’s greater opportunity for returns from here on in.
As is often the case in life, where there is a negative, there is a positive. On reflection we feel we are in a transitionary period, where we continue to see lots of opportunity ahead, though the path to it and the timing of it remains unclear. For sure, 2021 will not be an easy year to navigate, though we remain focussed on continuing to build on the strong results over the last few years, and in this respect, it is a marathon, not a sprint.
At the current time, our base case is that by the end of 2021, the Covid-19 risk will have moderated considerably through vaccination, leading to economies recovering into 2022. Inflation has the potential to burst through for a few months, though will calm back down again, and policymakers will remain accommodative given the scaring from the crisis, and the need to sustain a good recovery. This should be a positive world for risk assets, and one which is supportive for continued portfolio growth.
However, the risks to our main scenario remain large in our opinion. There is a significant chance that our base case does not play out as we think. To this extent we have to stay balanced and diversified. We are well known for our defensive qualities, and we do not want to leave the back door open. We are therefore considering several other potential scenarios in case we need to change course.
If we do emerge from Covid-19 restrictions as we all hope, we are likely to see a large recovery in economic activity, and a quick burst of spending. Inflation will temporarily increase, and it is likely investment markets continue to favour ‘old economy’ stocks such as banks, retail, and leisure business’, over the new economy.
That environment would likely be short short-lived however, as society will no doubt want a small blow-out, but where possible they are also likely to want to have a greater level of savings than they would have had before, to protect against any such challenges in the future. Business’ that have been basically shut for 12 months or more, need to recover. And whilst domestically we are likely to have restrictions eased, internationally it will be slightly trickier, given the progress of countries are happening at very different rates.
In accordance, our baseline assumption is a quick boost in economic activity, followed by a slow recovery over a number of years. The risks to that are virus trends that cause setbacks, and further restrictions. That would cause markets to revert back to the new economy technology stocks that support our socially distanced lives. At the other end of the spectrum, if the economy is performing so well and spending increases do sustain beyond a number of months, a key risk is Central banks react and signal interest rate increases to come. Markets would certainly wobble in that scenario, and we could see bonds and equities fall together.
Balance is the word for the coming quarter. One thing that is very clear, is that active management, such as the ability to pick the airline business that will come out of the crisis in the best position, or the technology platform that can sustain its competitive advantage, is likely to play a bigger role than it has in past years. As long-standing clients will know, we have the ability to implement ideas both through buying an index, which keeps costs low and gives you a set exposure, or through an active fund, which try to determine the winners and losers. The ability for the latter to make a difference in a period of significant change is usually more marked, so we have very little passive exposure at the current time.
So the task at hand is to adjust slowly, and hope that Covid journey finds calmer water. If that plays out we must watch for sustainable inflation in the form of above average wage rises. If instead the waters remain choppy, then lower risk assets such as fixed income bucket now offer better value, so we can take comfort from some contribution there. Either way, it feels a lot like sparing at the moment, waiting for the right time to commit, though very aware of the need to keep our guard up.