06 Apr 2021
The two primary trades in markets since 9 November – ‘vaccine day’ – have been Covid recovery and reflation. The Covid recovery trade is to buy anything hit hardest during the height of the pandemic, including retail, airlines, pubs, cinemas, certain types of property and pretty much anything else that operated in the physical and face-to-face world we all abandoned at pace last year. It also involves selling anything that benefited from going online and digital last year; the ‘stay at home’ trade. The reflation trade is to buy commodities and financials, both of which benefit from inflation, and to sell growth stocks, which as long-duration assets are most impacted by rising bond yields, themselves a consequence of higher levels of inflation. Together, these two trades have resulted in a rapid and significant rotation in equity markets of a size rarely seen in recent times. Since the start of the year, for the US S&P 500, the energy sector is up 35% and financials 16.3%; whereas IT is only up 2.3%, healthcare 0.8% and consumer staples down 2.5%.
Of these two trades, we are more confident that the Covid recovery trade is coming toward its end. Good quality companies that were impacted by Covid last year have recovered in share price terms to somewhere near where they were before Covid (Greggs in the UK would be an example of this). This is a clear indication that we have to a large extent discounted the return to something like a normal existence in the coming months. The inflation trade is however more perplexing.
The history of inflation, over say the last 100 years, is one of disinflation, or declining levels of inflation, punctuated by events that have created multi-year counter-trend rallies. These events are typically associated with oil price shocks and wars, which have enough scale to offset what has otherwise been a long-term downward trend for inflation. This trend is a function of technology, which is very deflationary, demographics and a much more stable geopolitical environment than in the past. The important point here is that the long-term trend is one of disinflation.
The question then is whether Covid is another event significant enough to create a prolonged period of counter-trend inflation, and of a length that should change our investment views? There is no doubt in the short term that the answer to that is ‘yes’. Supply chains, and the supply side of the economy more generally, can be shut down rapidly, as they were last year, but they cannot be restarted so quickly. Airline pilots who have been delivering parcels not passengers in recent months cannot simply park their vans and get back into the cockpit. Car manufacturing is already being slowed by a lack of key components such as semiconductors. This combined with the consumer savings rate being at record
highs in the last year will in the short term create a supply/demand mismatch that will clearly be inflationary.
In the long term, the outlook for inflation (and indeed everything) is much less clear. Our view is it is likely that the pandemic, post the effect of stimulus packages and central bank liquidity, is more likely to be a long-lasting deflationary force, rather than inflationary. When we think about what we will be doing less of in the future, commuting for example, we think that will be deflationary for a whole range of industries. Whereas when we think about what we will be doing more of, using increasing amounts of technology for example, that will also be deflationary. It seems to us the use of the inherently inflationary physical world (there is finite ‘stuff’ for money to chase) will fall, and the use of the deflationary digital world (there are unlimited digits) will rise. This at some point should return us to the disinflationary trend of the past; the question is more when, not if. Were this to happen we would see the return to a more normal market, where industry and business trends define investment outcomes, not ‘value’ vs. ‘growth’ as it is now.
If there is one number that will rule the markets for the foreseeable future, it will be the US 10-year treasury yield. This has moved up rapidly in recent weeks as inflation concerns have mounted, and the economic recovery gained traction. The US Federal Reserve is of the view, like us, that inflation will be transitory. The bond market disagrees. This week the Fed committed to not raising interest rates until 2024. Yields still went up as bond investors bet interest rate increases would be sooner. Until we find some stability in yields the current trends in markets will continue. Should the current level of yields, currently 1.71% as measured by the 10-year treasury, stay below 2% we don’t think this will be an impediment to overall equity market levels. Should it move materially above 2%, the extent to which valuations will need to be adjusted to reflect the higher cost of debt will start to impact equity valuations.
We have said recently that markets in 2020 reminded us of 2008, when huge government and central bank stimulus followed a market panic, and a V-shaped market recovery occurred. We have also said that 2021 could be like 2009, which was a cyclical/value market as economies normalised after the financial crisis. 2009 was also a year of inflation concerns, as quantitative easing and an economic recovery kicked in. This of course proved to be incorrect and 10 years of subdued inflation followed. There are of course critical differences between 2021 and 2009: in 2009 stimulus was used to prop up the banking sector, whereas today it is being used to feed consumption. Equally, back in 2009 central banks wanted to keep inflation down, now they want to see higher inflation. Still, the point stands. Markets obsess about one thing at once (who remembers trade wars?). The current obsession with inflation should not be confused with the probability of it occurring, which is not zero but distinctly less than 100%.
We continue to underperform and have done since 9 November. Looking at the year-to-date sector performance noted above, you can see why. Healthcare and technology-orientated funds like ours have underperformed those funds with exposure to energy and financials. These are not ideal conditions for sustainable investing. Alongside this, the companies that we own have performed reasonably well operationally, with perhaps the most notable trend from them being the need to invest more in their businesses. Sage, GlaxoSmithKline, London Stock Exchange Group and Unilever have all come to us with this narrative. Markets do not generally like investment, even if it leads to a more valuable business in the long run, as it usually requires the short-term downgrading of profit forecasts. We take the opposite view, but time will tell if these investments will pay off.
If 2021 turns out to be like 2009, we may have some headwinds in the funds for a little while longer. That said, in recent meetings with the companies we invest in one thing is clear: sustainability is becoming a significant business opportunity for them that didn’t exist even last year. Whether this be providing sustainable chemicals, auditing supply chains for environmental performance or providing ESG data to fund managers, sustainability is alive and well in the corporate world and this will only benefit our funds over time.
We try to see the opportunity in every situation we face when running our funds. Last year, when the Covid panic was at its peak, the price for those stocks that today are performing the strongest had no floor to them. Good quality businesses working in the face-to-face and physical economy fell in share price every day and it was a great time to buy them. We managed to get attractive entry points into several companies at favourable prices. Today the price of good quality growth stocks is challenged, not to the extent perhaps of a year ago with the aforementioned areas, but we still have the opportunity to buy more of the companies we know to be of high quality with bright prospects at share prices often 20% and more below recent highs. It seems sensible to us to take advantage of this.
One example would be Taiwan Semiconductor (TSMC). TSMC is the leading manufacturer of semiconductors in the world. In fact, along with Samsung and Intel, it is the only manufacturer of size and is the biggest. Semiconductor manufacturing is highly technical with huge barriers to entry. It is also an area where we expect demand to increase significantly in an increasingly digital world. We have held TSMC for some time and have used recent weakness, which is nothing to do with the health of the business, to buy more stock at lower prices.
Beyond this, activity has been limited. We think the window of opportunity for buying Covid recovery stocks has closed, and we are not (yet) convinced on the arguments for inflation returning in the long term. As a result, buying more of what we own at lower prices makes more sense to us than chasing market trends.
Mike Tyson has often been quoted (some say incorrectly) as saying that everyone had a plan to beat him until he punched them in the face. This is quite applicable to investing. Everyone has a plan for delivering long-term outperformance that, in a quiet and thoughtful moment, can be articulated with precision and conviction: until markets punch you in the face.
This is what it feels like to have an investment strategy that isn’t giving short-term results. Clarity of thought can be lost, and plans can go out of the window. With Mike Tyson in his prime, as soon as he knocked the plan out of the head of his opponents, they stopped doing what they were good at (and most likely to work) and became much easier for him to beat.
Our opponent for the last 18 years (since the current management team took over the RLAM sustainable funds) has always been ‘the market’. It is an intelligent and vindictive creature, wanting to beat us. Our strategy has been to back sustainable (as measured by ESG standards and products and services), value-creating companies with strong long-term growth prospects. We think this is not only logical, but also demonstrably effective over the long term. Our opponent has come flying out of its corner this year and is acting in a way that is testing our conviction in what we do and in our clarity of thought, in the hope that we change our behaviours. It is a very effective strategy, but one we must resist. We will stick to our plan in the belief it has the best chance of success and when ‘the market’ (aka ‘Iron Mike’) punches itself out, we should be in a good place to take advantage.
Please note that this is a fast-moving environment and markets and impacts on portfolios are changing. Opinions contained in this document represent views of our fund managers at the time of writing, and performance numbers are estimates and not audited.
Reported yields reflect RLAM's current perception of market conventions around timing of bond cash flows. Heightened uncertainty due to the Covid-19 crisis may impact these timings for bonds with callable features.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. This does not constitute an investment recommendation. For information purposes only. The views expressed are the author’s own and do not constitute investment advice.
For more information on the fund or the risks of investing, please refer to the fund factsheet, Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Price page on www.rlam.co.uk.
Issued March 2021 by Royal London Asset Management Limited, Firm Registration Number: 141665, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, Firm Registration Number: 144037, registered in England and Wales number 2372439; RLUM Limited, Firm Registration Number: 144032, registered in England and Wales number 2369965. All of these companies are authorised and regulated by the Financial Conduct Authority. Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number 364259. Registered office: 70 Sir John Rogerson’s Quay, Dublin 2, Ireland. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office: 55 Gracechurch Street, London EC3V 0RL. The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The Royal London Mutual Insurance Society Limited is on the Financial Services Register, registration number 117672. Registered in England and Wales number 99064. Ref: O RLAM EM 0016