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.
This article first appeared in the Telegraph
GOLDILOCKS famously liked her porridge neither hot nor cold. As such, she’s lent her name to market conditions that are not too weak for growth nor so strong that central banks feel compelled to douse the economic fire.
That’s pretty much what we are enjoying today. The combination of yet another buoyant corporate earnings season together with persistently accommodative monetary policy is about as clear a definition of a Goldilocks investment backdrop as we are likely to see. No wonder the stock market has just enjoyed a record-breaking series of new highs.
This week, shares completed their longest run of all-time highs for nearly 25 years. The key US benchmark, the S&P 500, has closed at a record level more than 60 times this year. It is up 25% since January, a third higher than it stood 12 months ago. Shares have doubled in price since the low point of the pandemic in March 2020.
And the records are not solely down to a handful of high-flying shares, as has been the case at times during this remarkable Covid rally. Three quarters of America’s biggest shares are trading above their average for the past 50 days, a common measure of positive momentum. Bull markets are often narrowly based when approaching a peak. This one is moving forward on a broad front.
Earnings are the key driver of share prices, so September’s market wobble in part reflected tempered hopes for the third quarter results season. The first two quarters of 2021 had brought high expectations that were easily bettered. The 28% rise in profits year on year that analysts predicted for the July to September period was lower than in the prior quarters but it, too, has been easily beaten. With only a handful of companies yet to report, it looks like 40% will be closer to the mark.
With numbers now in from about 460 of the leading 500 companies, 80% have exceeded forecasts by an average of 10% or so. Businesses have complained about mounting cost pressures, but the evidence is that they have been able to pass on the pain to consumers. Profit margins, which fell to 10% during the pandemic are back at 13%, struck from significantly higher sales. And it’s not just a US story. Europe is bouncing back too.
Despite all of this, monetary policy remains supportive. Last week, the Federal Reserve delivered what it had promised - a steady tapering of bond purchases from $120bn a month to zero by next summer and a cautious return to rising interest rates thereafter. Here, the Bank of England’s communication was less assured, but the surprise was positive as far as investors are concerned. The Bank left rates at 0.1% when everyone had priced in a first rise to 0.25%.
This continuing easy policy on either side of the Atlantic comes despite growing evidence, confirmed yesterday by still accelerating US prices, that inflation is anything but ‘transitory’. Consumer prices in America are rising at their fastest rate since 1990. The gap between inflation expectations and the nominal level of interest rates means that in real terms, adjusted for prices, central banks are as accommodative as they were in the wake of the financial crisis.
Strong earnings are not the only reason why the Fed might start to think about tightening policy. The jobs market picked up the pace in October after a couple of quieter months; encouraging results for Pfizer’s new Covid pill bring the end of the pandemic in sight; and the successful passage through Congress of Joe Biden’s infrastructure bill provides another reason why it might move sooner rather than later.
But it is holding fire. And that suggests two possible outcomes. One is that in due course the Fed will realise it has made a mistake and tighten harder and faster than the economy can bear. Obviously, that would be bad news for investors. The second possibility is that the central bank knows what it is doing and has decided that an over-indebted economy means it simply has to accept higher inflation and lower interest rates than might otherwise seem prudent. It has form here, albeit a long time ago. In the 1940s, financial repression with a similar tolerance of above-target inflation provided a positive backdrop for shares.
It caused problems further down the track, of course, but not for many years. It wasn’t until the 1960s that inflation started to stir and not for another ten years did it become a serious problem. Faced with the alternative scenario of choking off the recovery, not just from the pandemic but from the financial crisis before it, the Fed is probably right to take the gamble.
For investors, however, it does suggest the need to think differently about their investments. Bonds have had a good week thanks in large part to the Bank of England’s dovish surprise. But, longer term, the picture painted here is not a friendly one for fixed income investments. Even if rates do stay lower for longer, rising inflation will erode the purchasing power of investments that lack the ability to grow in line with prices.
If the market is misreading the inflation shock ahead then real yields (adjusted for the change in prices) will stay negative for the foreseeable future. That is a positive environment for gold and silver, for shares and for real assets like commodities. With luck, Goldilocks can stay one step ahead of the bears.
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. 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. 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 a Fidelity adviser or an authorised financial adviser of your choice.
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