Quarterly Market Update

Summary

It is too early to judge if inflation is transitory or entrenched but this is the economic measure with the greatest power to determine the course of financial markets over the next year.

Return expectations for government and high-quality corporate bonds are modest at best. Lower quality bonds are richly priced and, in our judgement, offer inadequate compensation for the risk of default. We favour bond funds with flexible mandates which can cherry-pick the best opportunities across the wide spectrum of bond markets.

Equities remain our most favoured asset class. However, our enthusiasm is tempered by lofty valuations, the squeeze on corporate profit margins from higher wage, energy and raw material costs and higher tax rates. It would require a significant fall in stock markets for us to consider increasing exposure.

Macro Highlights

Rising inflation has dominated financial headlines and been at the forefront of investors’ concerns over the last few months. Although dipping slightly in August, the annual inflation rate in the US has been above 5% for the last four months, a far cry from the 1.4% at which it began the year. In the UK, the Consumer Prices.

Index surged from 2.0% in July to 3.2% in the twelve months to August, its biggest monthly jump since records began in 1979. The Bank of England now expects the rate to top 4% by the end of the year. Meanwhile, the Retail Prices Index (remember that?) which includes mortgage interest payments and is still used as the basis, inter alia, for final salary pension payments, train tickets and interest on student loans, jumped from 3.8% in July to 4.8% in the twelve months to August.

The burning question is whether the rise in inflation is ‘transitory’, as central banks largely continue to insist and reassure, or is becoming more entrenched and structural. The truth is that it remains too early to judge. The distortions wrought by the pandemic are still working their way through year-on-year statistics and will continue to do so for some months to come. In the UK, for example, the jump in August 2021’s inflation rate was partly due to August 2020’s 50% discount on restaurant food under the government’s Eat Out to Help Out scheme which has now dropped out of the calculation. The deflationary forces of technology, ageing populations (who spend less) and indebtedness remain and we would also expect the supply bottlenecks, which have been a feature and problem of the economic bounce-back, to ease. However, the vast sums now being spent on infrastructure (including decarbonisation), as well as social programmes such as President Biden’s US$2trn American Families Plan and the UK government’s ‘levelling up’ schemes, are contributing to upward pressure on both wages and raw materials. In the UK, the situation is being exacerbated by the withdrawal of European workers as a result of both the pandemic and Brexit. Incidentally, the well-publicised challenges being presented by skyrocketing gas prices and the shortage of lorry drivers are not peculiar to the UK but are global and a consequence of perfect storms of supply, demand, Covid, climate and politics. Taking all these factors into account, our best guess is that inflation will fall from today’s elevated levels but, in the US and particularly in the UK, could easily settle higher than the 2% level that central bankers are targeting.

The last three months have seen some reductions to forecasts of still very strong economic growth in 2021. This is most likely because the pent-up demand which was suddenly released as pandemic restrictions were relaxed earlier in the year has peaked. It may also be because of the prospect of higher taxes, both corporate and personal. In the UK, national insurance rates and taxes on dividends are increasing by 1.25% from next April to provide funding for the NHS and social care. In the US, the Federal Reserve has revised down its forecast of economic growth in 2021 from 7% to 5.9%, citing the impact on businesses of the new delta variant of the coronavirus. Unsurprisingly, unemployment rates have also continued to fall, albeit not fast enough to prevent wages from rising due to skillset shortages. In the US, the unemployment rate fell to 5.2% in August, which compares with a figure of just 3.5% immediately before the pandemic took hold. Similarly, the unemployment rate in the UK has continued to drift lower (the latest figure for the three months to the end of July is 4.6%) but it is expected to rise by about 1% over the next few months following the ending of the government’s furlough scheme.

As much as the statistics measuring growth and unemployment corroborate the continuing recovery from the pandemic, it is the inflation numbers that we will continue to monitor most closely and which are likely to have the greatest influence on the actions of central banks and hence the future course of financial markets.

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