In this week’s market update: shares enjoy their best 12 months since the 1930s; but bonds are hit hard by inflation fears.
Well it’s shaping up to be a quiet week on the corporate and economic front as we head towards Easter. A good time then to look back at the past 12 months. The past year has been a remarkable period in the markets. Shares have risen strongly everywhere in the face of the worst health crisis for 100 years. 12 months ago, you would have had to be quite a contrarian to have forecast the best returns since the 1930s. But that is what we have experienced.
A year ago, we were coming to terms with the worst pandemic since the Spanish flu in the wake of the first world war. Our understanding of the coronavirus was sketchy. There was no cure or vaccine. What we did know was that it was a highly virulent, highly transmissible disease that was spreading very fast. It was not an obvious moment to be very bullish as an investor.
But if you had bought into the market in the last week of March last year and held on you would have enjoyed the best one-year performance by shares since 1936, according to Deutsche Bank. The 75% rise in the S&P 500 index since March 23rd 2020 has been better even than the remarkable rallies from the financial crisis low in 2009 or the bounce backs in 2003, 1982, or 1974 or the late 1940s - all the legendary bear market bottoms of the past 90 or so years.
You have to go right back to the Great Depression to have experienced anything like it. We really have been living through market history in the making.
March 23rd last year was the day that Britain finally went into lockdown after dithering fatally for weeks. More importantly, however, from a market perspective it was the day when the US Federal Reserve pledged to buy unlimited amounts of Treasury bonds and to buy company bonds for the first time in the US central bank’s history.
It was America’s ‘whatever it takes’ moment. And it had a galvanising impact on markets. It stopped the rot that had seen the stock market fall by a third in just over a month, one of the fastest bear markets ever. It was a remarkable demonstration of the almost unlimited power of the financial authorities in a country with the freedom to print its own money.
With the benefit of hindsight, it has been an entirely rational market response. Two things drive markets, money flows and earnings. The determination of governments and central banks to print as much money as it takes to solve the crisis has provided the liquidity to drive the market higher. Meanwhile the earnings outlook has turned out better than anyone could have hoped for a year ago. According to S&P, the average earnings of the companies in its benchmark index are forecast to rise by 40% between 2020 and 2021, from $122.37 last year to $172.44 this time.
That has kept valuations within reasonable bounds. Even the high-flying information technology sector which has driven the market higher over the past year trades on a far from excessive price-earnings multiple of 25, which compares with an average of 19 over the past 20 years. With IT sector earnings forecast to grow by 45% the market can hold onto today’s level even if there is something of a de-rating back to historical norms.
The bullish argument a year ago for anyone willing to hear it was that any shutdown in the global economy would be temporary with things getting back to normal in due course. That looks to have been the case. Indeed, the latest data have actually exceeded expectations. In part that is because economies have proved surprisingly adaptable to the changing environment.
Most of the economic data since the latest lockdown began here in the UK in January has been better than forecast and much better than in the first lockdown. In February, it was expected that the UK economy would shrink by 4.2% in the first quarter. That would have been massively better than the downturn a year ago but even that now looks too pessimistic. Economists are now looking at a fall of just 2-2.5%. The unemployment rate, too, is much lower than had been predicted only a few months ago. The public finances too have held up better than expected, with tax revenues providing more resilient than forecast.
In part this is because businesses and consumers have learned to live with a changed world. Online sales, home delivery and streaming services have allowed life to go on, albeit differently. And with vaccines being rolled out faster here than in the rest of Europe, and on a par with the rollout in the US, the outlook for an economic bounce this summer is significant. Perhaps especially if people are not able to travel as they hoped. The domestic economy could be a big beneficiary.
The Office for Budget Responsibility now forecasts that the UK economy will regain its pre-pandemic size in the third quarter of 2022, six months earlier than it had forecast in November. Some view that as too pessimistic.
So, that is the good news. Economic recovery is good news for companies, particularly those more cyclical businesses which need a strong economic backdrop to flourish. It is less good for fixed income investors if recovery comes hand in hand with rising inflation, which is increasingly the fear. Longer-maturity Treasury bonds have fallen by around 13% so far this year. It is shaping up to be the worst quarter for the asset class in more than 30 years.
Some high-profile voices in the industry are sounding the alarm. Ray Dalio, a hedge fund investor, said recently that ‘the economics of owning bonds has become stupid’. He says that ‘ridiculously low’ fixed income yields mean that bond investors are almost bound to lose money in inflation adjusted terms and makes the point that with interest rates so low bonds no longer have the ability to offset falls in stock markets, one of their principal functions in a balanced portfolio.
Bill Gross, another well-known bond investor, is also betting against Treasury bonds on the grounds that inflation will rise to 3-4% this year, putting pressure on the US central bank to reverse its super-easy policy approach. The bond market is already anticipating that the next moves are upwards. 10-year Treasury bond yields have risen from around 0.3% a year ago to more than 1.7% today.
For a generation of investors that has never really experienced significant inflation, it is reasonable to worry that spiralling prices might be poised for a return. But it is not guaranteed. While in the short term the simple arithmetic of year on year comparisons with last year’s shutdowns will lift inflation, it is far from certain that the effect will be anything other than temporary.
Labour markets are not pointing to high levels of wage growth. It’s worth remembering that the inflation of the 1970s was a consequence of a powerful cocktail of influences: post-war rebuilding, the collapse of the Bretton Woods currency system, the growth of trade union power, an oil crisis, war in Vietnam. Even then it took decades for inflation to emerge as a major problem.
And investors are still in many cases obliged by various rules and regulations to put pension funds and other insurance-related money into so-called safe assets like bonds, even if they offer pretty paltry returns on the face of it.
Bond yields have risen sharply in the past few months but if central banks hold their nerve and cap short-term interest rates, buyers may well soon re-emerge.
So, it is too early to write off bonds but it does seem likely that shares will continue to be the favoured asset class as long as the combination of stimulus and recovery remains in place. And within the market, the rotation from growth to value does finally look to have legs.