The headline market trends that characterised the second quarter of 2020 extended through July. Equity markets continued to accrue gains, with longer duration growth stocks to the fore.
Along with COVID, the main topics of debate remain the outlook for both inflation and monetary policy, which are, naturally, very closely related. Although headline inflation indices continue to surpass expectations and to make new highs for this cycle, the majority opinion is that this is a fleeting phenomenon and the result of low comparative numbers from 2020 combining with temporary COVID-induced disruptions to supply chains and labour markets. Central bank chiefs are in broad agreement, describing such inflationary pressures as “transitory”.
As for central bank policy, it is an open secret that monetary conditions will be tightened at some point, although the exact pace and timing remain something of a mystery. It is fairly clear that, in most cases, the sequence will begin with a reduction (and eventual cessation) of asset purchases. If markets can bear that, then gradual interest rate rises will be the next stage. The process of raising rates is expected to be extremely gradual, with the very high levels of government debts accrued during the pandemic imposing a much lower ceiling on rates than might have been the case historically.
Indeed, it remains difficult to see interest rates surpassing inflation rates for the foreseeable future. This form of “financial repression” might be helpful in reducing the overall debt burden relative to the size of the economy, but will continue to leave savers needing to take some investment risk in order to generate income and to preserve their wealth in real terms, as has been the case for much of the period following the financial crisis.
A strong current source of support for equity markets is corporate profitability, with results for the second quarter of 2021 handily beating expectations. Overall earnings growth for the constituents of the MSCI All-Countries World Index is forecast to be around 40% for the year as a whole. It is worth pointing out that this will leave earnings some 25% higher than the previous peak at the end of 2019, following a double-digit fall in 2020. This surge in aggregate profitability goes a long way towards justifying the strong performance of equity markets that we have witnessed in the past year or so, and is, surprisingly, not widely reported.
The timeline for a return to post-COVID normality has undoubtedly been extended, but the good news, in many respects, is that will also have been reflected in share prices. Much now depends upon the next twists in the COVID narrative – and the virus still has the capacity to surprise us. For example, in the UK it appeared in mid-July that case numbers were set to soar to new highs, but, instead, they have fallen back dramatically.
That sounds like good news, but the fear persists that a fuller return to work after the summer holidays combined with schools and universities resuming normal service could trigger yet another new wave of infections. Meanwhile, in other parts of the world that are not so well vaccinated, the Delta variant is of greater concern, with more restrictions being imposed.
The uncertainties of COVID developments combined with the planned exit from extreme monetary policies continue to make this an investment environment in which it would be imprudent to make heroic bets on market direction.
While we cannot rule out a more meaningful correction at some point – indeed, by some measures, one is already overdue – a more enduring market fall appears improbable in the face of such strong corporate earnings growth. Even if interest rates and bond yields move higher, they will remain very low by historical standards, and we continue to believe that policymakers are more fearful of a loss of economic momentum than a period of higher inflation.
Having said that, there is widespread talk of “peak growth”, which is hard to deny. But the bounce from the COVID trough has been unprecedented in its speed and scale, and it would be unreasonable to expect the recovery in activity and profits to continue at the same pace. However, it does mean that, in all probability, market returns will be shallower from here, and investors will have to display more patience.
If you have any questions regarding this update or your own financial planning needs, please do not hesitate to get in touch on 0117 450 1300.