In last month’s note we remarked that we would like to see a 5-10% correction for equity markets, in order to cool sentiment and lay the foundation for a more sustainable rate of appreciation.
Well, sometimes you do get what you want. Whilst the world equity market is little changed since our last note, it did experience a c.5% correction during this period, before recovering. However, simply looking at the broad market does not quite reveal the whole picture. Over the past few weeks, we have seen the Nasdaq 100 index correct by c.11% and we have seen 20-40% corrections across some of the high-flying technology winners of 2020.
This is exactly what we wanted to see. Whilst we believe investors need to think deeply about the evolving nature of the economy and how to position for the technological disruption we see ahead, we were also growing a little concerned by the pace of gains in certain ‘disruptive’ technology leaders. A narrow bull market driven solely by gains in the technology sector is not what we want to see.
Over the past month we have seen a very clear broadening of the global bull market. We have seen indices with higher weights to more cyclical companies, like the German Dax or the Dow Industrials, make new highs, while the leaders of 2020 have taken a back seat.
So why do we believe this is happening? Quite simply the world economy is healing, and investors are starting to anticipate a strong economic recovery ahead. This is also leading to higher inflation expectations and rising bond yields, which presents something of a relative valuation challenge to higher valued businesses.
This brings me on to what will likely be a growing concern as the year progresses: inflation. It is clear that inflation expectations are moving higher, and we are pretty much guaranteed to see higher year over year inflation, given last year’s deflationary shock. The key question we must address is not whether inflation will be higher this year, it is whether it will be higher in the years ahead – and what are the implications?
Bluntly nobody knows the answer to this question, and we are sceptical of dogmatic views on this topic. It would seem logical that with more money chasing fewer goods that inflation will increase in the coming years. However, we must also recognise the disinflationary forces of disruptive technologies and ageing populations with technological disruption, in particular, likely to accelerate in the coming years.
Over the last decade whenever we have been asked about inflation, we have responded that we do not know what it will be, but we are pretty sure it will be higher than interest rates. This remains our answer today.
There is a good chance inflation will trend higher but after an initial ‘burst’ higher it may revert lower.
However, what seems almost certain to us is that it will be very difficult to earn an interest rate that matches, let alone exceeds, the erosion of value by inflation for as long as we can presume to predict.
History tells us that, in many cases, this has been the most politically acceptable way of dealing with high public debt levels and this seems like a pretty ‘easy’ prediction to make today.
This, of course, has significant ramifications for long term investors and almost compels us to invest our capital. If we are ‘certain’ that cash and government bonds will lose purchasing power, the logical conclusion is to invest in higher returning assets. This dynamic is clearly supportive for the equity market, although this view should be nuanced when considering different potential growth and inflation scenarios.
I should also add that low or negative after-inflation interest rates are supportive for a myriad of other strategies promising to deliver higher returns. So, whilst we are positive on equity markets and we are card-carrying members of the equity investing club, we also wish to sound a word of caution.
We have no doubt that capital will be raised in this environment for lower quality assets, as investors stretch for yield. Indeed, we can see this today and whilst we believe investors should invest their capital to preserve the after-inflation value of their assets, we would like to re-iterate the need for proper due diligence when investing your irreplaceable capital. It is likely that lower quality assets or strategies will only be revealed in the next downturn or as Warren Buffett said many years ago ‘only when the tide goes out do you discover who’s been swimming naked’.
Returning to the equity market, we believe we are in the midst of an ongoing bull market that has seen a slight ‘changing of the guard’ in recent weeks, with more cyclical assets outperforming leading technology businesses. This may continue for a little while. Indeed it probably will, as growth expectations shift higher.
We are not especially concerned by these short-term relative moves, as we always seek to build longer term portfolios for clients and if our technology related holdings or strategies take a back seat for a while that is perfectly fine with us. Indeed, it is welcome.
Overall, our message remains unchanged. The evidence points to a broadening bull market, with attractive relative equity valuations and supportive monetary and fiscal policy. There will, of course, be further bumps along the road but these are all simply part of the investment journey.
As always, please do not hesitate to contact us to discuss our views further.
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