THE three Rs of the pandemic. Last year brought the Re-rating - the V-shaped market rally as investors bought into the post-pandemic bounce back. 2021 has seen the Recovery, as economies re-opened and company profits were restored. Next year it will all be about the Return to normal - the journey back to neutral policy and the speed and extent to which it can - or can’t - be implemented.
The road to policy normalisation will be a long one. The latest dot plots from the Federal Reserve point to peak interest rates for this cycle of 2.5% in five years’ time. The markets think even that slow and steady return to normal is too ambitious. The shape of the Federal Funds curve suggests an interest rate of less than 2% by the end of 2026. 13 years on from the financial crisis, with rates still on the floor, lower for longer continues to look like the right call.
Investors think either that the Fed won’t have to raise rates because growth and inflation stall or that it will do so only to reverse course after it all proves too much for a fragile economy. The bond market shares this scepticism. Who would have thought that the yield on the 10-year Treasury bond would be 1.4% with inflation of 7% and employment at an all-time high?
The Fed may have given up on the word ‘transitory’ to describe the current spike in inflation but plenty of others think the deflationary impulses from debt, demographics, disruption and digitization will regain the upper hand in due course. It was interesting that inflation expectations fell back just as soon as the Fed unveiled its new hawkish stance.
Why does this matter? Because easy monetary policy has been the rocket fuel of the post-financial crisis bull market. Just as it underpinned the other major stock market runs in the post-war era. In particular, the real, inflation-adjusted interest rate matters because there is no better way to keep a bull market bubbling than by keeping interest rates below the rate of inflation. If the Fed really does manage to push interest rates higher just as the post-pandemic inflation runs out of steam, as looks likely in the middle of next year, it could be a tricky cocktail for investors to swallow.
History suggests that negative real rates are an anomaly. All the sustained economic growth cycles have been accompanied by stable and positive real interest rates. The one exception to this rule is the financial repression during and after the second world war when interest rates were pegged below inflation for a decade or so and fuelled a long bull market.
You could argue that the war on Covid, and its enormous economic cost, justifies the 1940s parallel. But things also look quite a bit like the late 1960s with that era’s speculation in technology stocks, social unrest and incipient inflation. Back then a long bull market hit the buffers on the back of a three-year interest rate tightening cycle. So, there are credible precedents for good and bad outcomes.
The good news, in the short term, is that the early stages of interest rate tightening cycles are often accompanied by ongoing bull markets. That makes sense because the reason for raising interest rates is often that things are going just a bit too well. Low but rising inflation may be a worry for central bankers, but it can feel pretty good for the rest of us.
As we head into 2022, things could indeed be a lot worse. Company profits look like rising by another 8% next year. That’s obviously a lot less than last year’s unsustainable recovery but it’s still healthy, and it has kept a lid on the stock market’s valuation. Rising profits have also fuelled a record level of share buybacks, which have underpinned the markets.
A year ago, when the S&P 500 stood at 3,750 a simple model that factors in earnings growth, the level of government bond yields, dividend payments and the long run premium for taking the risk of investing in shares, suggested fair value at the end of 2021 would be just under 4,500. That’s pretty much exactly where the index stands today. The same model points to 4,900 this time next year.
Looking a little further into the future, growth forecasts become less reliable and the best guide is valuation. Broadly speaking the higher today’s valuation, the lower the expected medium and long-term returns should be. Where we stand on that measure depends how you frame the question. Consider only company earnings and the market looks expensive, offering unexciting returns in the future. Measure the market against combined cash returns to shareholders (dividends and buybacks) and we’re somewhere in the middle of the historical range.
So, putting it all together, the outlook for inflation, interest rates, earnings and valuations, says to me that the next few years remain a reasonable time to be invested in shares, a less good time to be in bonds and the right moment to protect your portfolio with some diversifiers like gold and other commodities.
That’s the background to my annual fund picks, which I said a few weeks ago I’d share before Christmas. The Ninety One Global Gold Fund provides the diversification, the Fidelity Global Special Situations Fund plays the expected returns from shares, while the Artemis UK Select Fund and the Baillie Gifford Japanese Fund reduce the valuation risk by weighting the picks towards two of the markets which have, unfairly I think, lagged during the past two years’ rally. Rest assured, I eat my own cooking when it comes to my fund picks. Happy Christmas.
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. The Fidelity Global Special Situations Fund, Ninety One Global Gold and Baillie Gifford Japanese Fund invests in overseas markets and so the value of investments can be affected by changes in currency exchange rates. The Fidelity Global Special Situations Fund also invests in emerging markets which can be more volatile than other more developed markets. The Artemis UK Select Fund invests in a relatively small number of companies so may carry more risk than funds that are more diversified. The Fidelity Global Special Situations Fund and Artemis UK Select Fund use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The Ninety One Global Gold Fund invests in a relatively small number of companies, so may carry more risk than funds that are more diversified. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.
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