Super 60 fund and trust managers name their biggest fear for the second half of 2021.
The coronavirus may continue to defy all efforts to suppress it, but - for the world’s financial markets at least - it is starting to lose its potency. While a resurgence still has the potential to disrupt, investor attention has started to look for risks elsewhere, asking where the next significant shock could emerge.
When considering risk, former US defense secretary Donald Rumsfeld’s concept of known knowns and unknown unknowns is useful. The Covid-19 outbreak fell squarely into the ‘unknown unknowns’ segment – few had predicted it and, initially, even fewer understood its potential significance. While these events can be disruptive, fund managers cannot plan for them except through the usual good practices of diversification and portfolio construction.
For the most part, fund managers need to deal in known knowns, the risks that they can understand and manage. Here, there is one clear risk that dominates investor thinking: inflation. It is perhaps not difficult to see why this is exercising fund managers. In June, the US reported its highest inflation print since 2008 and inflation has been picking up across the globe. A confluence of government stimulus packages, supply bottlenecks, economic recovery and pent-up spending has created the perfect conditions for rising prices.
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Anthony Cross, co-manager of the Liontrust Special Situations fund, says inflation is the greatest non-Covid risk for markets in the year ahead. “Concerns about inflation have become increasingly prominent over the last few months following inflation readings in the UK and elsewhere which have come in ahead of market expectation,” he says.
“As the world economy continues to emerge from the coronavirus pandemic, the prospect of unleashing the pent-up demand that has built up since early 2020 could potentially drive a sustained move higher in prices.”
Inflation has a number of knock-on risks. In the early stages, higher prices leave the consumer with less money in their pocket to support economic growth. Further ahead, there is the risk that central banks are forced to raise interest rates, which raises the cost of borrowing and depresses economic growth. This is often a catalyst for recession. Often, just the anticipation of higher rates is enough to derail markets.
Will inflation be cyclical or structural?
The key question is whether the current inflationary pressures prove to be cyclical or structural. If they are cyclical and tail off towards the end of the year, then there will be little need to raise interest rates. This scenario is largely priced into markets today. However, if it persists for longer than expected, central bankers may come under pressure to raise rates and there could be consequences for financial markets.
Eric Burns, chief analyst at Sanford DeLand, which manages the CFP SDL UK Buffettology fund, says inflation can be good for markets as long as it doesn’t get out of control: “Unless we are in for a return to the 1970s, then a bit more inflation can actually be healthy for equities; as long as you hold the right ones...if there’s a bit more inflation coming down the pipe then those companies with the ability to pass on increased costs to customers should be the ones to own.”
Cross agrees: “Companies with these high and sustainable barriers to competition should be better able to weather exogenous shocks such as increasing inflationary pressures. We would emphasise that a company with true pricing power can pass on some or all cost inflation rather than having to absorb it through a reduction in profit margins.”
The risk is that inflation becomes structural and hard to control, raising input prices for companies and forcing a rise in interest rates. Burns says that there could be disruption in bond markets that spills over into the stock market: “Rather than inflation itself, our view is that the bigger risk is a disorderly repricing of the yield curve as investors realise interest rates of 0.1% aren’t compatible with inflation of 2-3% in the long run.” There is precedent for this: in 2013, the ‘taper tantrum’ – the market response to the Federal Reserve paring back quantitative easing – proved disruptive for markets.
‘I’d take the other side of the bet...economic growth will disappoint’
Inflation is far more of a concern for bond managers. It eats away at their returns at a time when bond yields are already at historic lows. The 10-year UK gilt yield of 0.7% looks unattractive when inflation is at 2%. If it rises to 4-5%, the drag is significant. However, Ariel Bezalel, manager of the Jupiter Strategic Bond fund, believes the greater risk is that growth disappoints.
He says: “As the global economy reopens, inflation pressures should start to subside. If anything, I’d take the other side of the bet, that economic growth will disappoint again in late 2021, early 2022. We have a highly levered world, there are still structural pressures, such as ageing demographics. The fiscal stimulus is now in the rear-view mirror in the US.
“We are now entering a period of fiscal tightening. There are signs that the Chinese economy is beginning to experience some kind of slowdown. The credit impulse is slowing – reducing the flow of credit round the economy. This hits the global recovery because China is the marginal driver of economic growth.”
What would this mean for markets? It could see the long-standing preference for growth areas such as technology revive, while ‘value’ stocks that have performed well since November last year could slip back. Bezalel adds: “Rates will be lower for longer and the hunt for yield will still be there.”
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Other risks fund managers are worrying about
Debt could be another problem. It constrains growth and leaves governments with little flexibility to support their economies. For Richard Hallett, manager of the Marlborough Multi-Cap Growth fund, this needs to be a consideration. He says: “In terms of additional risks, high levels of global debt remain a concern. In the final quarter of 2020, global debt rose to 365% of global GDP, compared with 269% in 2007. Clearly there is the potential for this to have a negative impact on economic growth, if, for example, heavily indebted governments are forced to increase taxes as interest rates rise.”
This also pushes governments to a pro-inflation stance. Paul Niven, manager of the F&C Investment Trust (LSE:FCIT) says: “How do you pay for this fiscal expenditure? A bit of inflation and negative real yields really helps to reduce the stock of debt.”
He believes that investors should also look at the potential for higher taxation. He adds: “This is a 2022 issue, but it will have an impact in terms of US earnings. It could be reasonably significant and I’m not certain it’s been given due attention by investors yet.”
Debt and inflation are largely developed market problems. Most emerging markets haven’t built up the same debt levels and, with the exception of China, their recovery has been slower. For emerging markets, the risks are the usual blend of geopolitics and governance. With Biden in the White House, geopolitical tensions have ebbed somewhat, but China is unlikely to enjoy unfettered access to US markets from here and China/Taiwan relations have come under scrutiny.
Austin Forey, manager of the JPMorgan Emerging Markets Trust (LSE:JMG), admits that political risk and governance problems are undoubtedly a factor in some countries and in some industries. They seek to sidestep it by investing in companies that are outward-facing rather than majority state-owned. “The more a company is exposed to market forces and market discipline, the more that industry is shaped by customer choices, the better their standards have to be. It is no accident that many of our investments are in export-oriented companies, selling into global markets.
“Companies will be audited as part of a supply chain and you have to move towards the higher standards that their customers impose on them. We are heavily invested in industries that are driven by customer choices and customer outcomes and less by government policy, less by contractual or concession arrangements.”
History suggests that the biggest risks to financial market stability are not the ones that have been forecast, but investors can only deal in known knowns. Inflation continues to dominate investor thinking and, for investors in developed markets, this is the key risk to mitigate today.
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