Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
Market activity over recent days has certainly borne some of the hallmarks of a turning point. Technology stocks have become increasingly volatile, suggesting they are now caught between the clutches of investors shifting into old economy, economically sensitive shares and the technology bulls, who see short term price dips as opportunities to snap up bargains.
February was certainly a positive month for shares in companies expected to do well in improving economic conditions. The Dow Jones Industrials Average – relatively skewed to traditional industries – comfortably outperformed the technology biased NASDAQ Index¹. Please remember past performance is not a reliable indicator of future returns.
A similar pattern emerged in the UK, with the MSCI UK Enhanced Value Index – which is a good proxy for very large companies with modest valuations and attractive dividend yields – returning around double the market average².
Such an expression of economic confidence certainly seems justified, given what has gone before. The passing this week of a US$1.9 trillion stimulus bill in the US, the further rollout of vaccines and the release of pent-up business and consumer demand once social distancing restrictions end could prove powerful economic drivers as the rest of the year unfolds.
This explanation, however, only partly holds water. Stock markets have a tendency to look out into the future and last year’s strong rally in global markets after March was widely attributed to growing confidence that the world economy would mount a broad-based recovery directly post-Covid.
The big winners of 2020 though were not economically sensitive stocks. They were, in fact, those companies seeing an increase in demand for their products and services as a direct result of pandemic lockdowns.
Shares in companies such as Amazon, Alphabet (Google) and Facebook rose steadily during the first half of the year and broadly held onto their gains thereafter³. Gains on America’s S&P 500 Index became increasingly narrow, concentrated on a handful of mega-cap tech names.
Value stocks are still nursing losses in the wake of big falls last March⁴. If stock markets were, indeed, anticipating a broad cyclical upturn in 2021, they were being slow to reflect it in terms of a wholesale switch to stocks likely to prosper in that environment.
A missing ingredient was a real belief in a return of inflation, which stayed low and fairly stable throughout the year. This reflected depressed consumer demand and what central bankers like to call “economic slack”, since commodity prices – notably the prices of industrial metals and oil – staged good recoveries.
As far as inflation expectations are concerned, government bonds represent something of a litmus test, as the present-day value of their future interest and capital repayments are calculably influenced by inflation.
The yield on benchmark 10-year US Treasury bonds ended 2020 at a depressed 0.9% – a meagre annual return for investors prepared to lend their money to the US government for a decade⁵. This was an indication that bond investors considered the risk of excess inflationary pressures eroding bond returns over the next 10 years to be minimal.
However, inflation expectations have clearly moved up a gear since then. US 10-year Treasury yields moved through the psychologically important barrier of 1.5% just over a week ago⁶. While this is still a low yield compared with history, it’s also more than half as much again as end-of-2020 levels.
Importantly, the yield on 10-year Treasuries is now about 2.3% higher than the yield on 10-year Treasury Inflation-Protected Securities, or “TIPS”, compared with a gap of just under 2.0% at the end of last year⁷.
Investors are demanding a higher yield today from conventional government bonds compared with those protected against inflation, because they believe inflation risks have increased. A widening gap between the yields of these two types of bonds indicates bond investors are prepared to give up an increasing amount of yield in the present day in exchange for a yield that is automatically protected against future inflation.
A message like this from the world’s largest government bond market is important to equity markets. That’s because the transition to a world where inflationary pressures are no longer minimal is a better world for money lenders (banks), miners, energy producers and a raft of other “old economy” stocks that, coincidentally, rank highly in terms of financial metrics such as dividend yield, price-to-earnings ratios and price-to-book value.
The truth is, no one knows for sure which kind of stocks will eventually gain the upper hand during the economic recovery to come. Growth or value – there is a good case to be made for both. The real risk – as value investors will know to their cost over recent years – is of being overly skewed in favour of one type of company or another.
Conventional thinking supports the idea traditional value stocks will benefit from an upward re-rating as economies move back closer to normal and trillions of dollars of savings seek a new home that doesn’t involve bonds, cash or highly rated growth companies that have served investors so well in the past.
However, it may still be wrong to abandon growth stocks. Businesses able to generate growth on a regular basis whatever the economic weather – sometimes called “secular” growth – should have little to fear from improving economic conditions and moderately higher inflation.
Their innovative products and services may suffer stiffer competition as the economy reverts closer to normal, but the mantra of growth investors might be that innovation never goes out of fashion and that it deserves to command a premium price in stock markets.
For most investors, an exposure to both growth and value companies makes sense. This is a factor worth bearing in mind particularly if you were planning to use up the remainder of your ISA or SIPP (personal pension) allowances this tax year on rebalancing your investment portfolio.
Fidelity’s Select 50 list of favourite funds offers ideas for gaining an exposure to both growth and value stocks across a number of markets. In the UK, the Fidelity Special Situations Fund focuses on businesses undergoing positive change yet to be recognised by the wider market, and has a strongly value-oriented style that stands to do well if the recent focus on economically sensitive businesses persists. Legal & General and Serco are among its largest investments.
The Fidelity UK Select Fund offers a counterpoint to this, in that it favours businesses with strong brands and robust balance sheets – “quality growth” companies, in other words. Unilever and the plumbing products group Ferguson are among the UK Select Fund’s largest investments.
Both funds feature in Tom Stevenson’s five fund picks for 2021
Growth investing: Growth investors seek the shares of companies where the principal attraction is earnings growth.
Value investing: Value investors actively seek the shares of companies that they believe the market has undervalued.
¹ Bloomberg, 28.02.21
²ʼ ⁴ MSCI, 28.02.21
³ Bloomberg, 10.03.21
⁵ʼ ⁶ʼ ⁷ US Department of the Treasury, 11.03.21
Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Overseas investments will be affected by movements in currency exchange rates. Select 50 is not a personal recommendation to buy or sell a fund. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55. 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 an authorised financial adviser.
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