As we approach the start of spring, we’ve seen a significant rotation in markets over the past few weeks. This has caused portfolios to go through a drawdown (peak-to-valley loss), since mid-January.
The chart below shows historic drawdowns of the Best Ideas balanced portfolio, going back to 2014. Markets don’t go up and down in straight lines, so there will always be some drawdown, but typically these have been limited to around 2.5% – 3%.
There are some occasions when losses exceed this level but it’s usually during significant global macro challenges. In 2015/16 we were dealing with the slowing growth of China; in 2018/19 it was the US-China trade tariffs and rising US interest rates; and of course, in 2020 it was Covid-19. In 2021, the drawdown is being caused by rising US bond yields, themselves driven by rising inflation expectations.
Reopening trade in full swing
With vaccine roll-outs picking up pace, talk has turned to lifting social distancing restrictions. And getting life back to normal – whatever that looks like now…
Economic activity is rising, in some cases from near zero levels. Compared to a standstill, any activity is inflationary. So, the key question is whether these increases in inflation are more structural or if it will just be a short-term blip as economies get back up to speed.
We can tell what the market currently thinks about this by looking at what level of inflation is forecast in the inflation linked bond market. In the chart below, the dark blue line shows expectations in January last year before the pandemic took hold, with inflation expected to be around 1.5-1.8% over all time horizons. In the depths of the Covid-19 crisis less than three months later (in the light blue line), the market was seeing deflation in the short term and barely a hint of inflation over longer time frames.
Currently, the expectations curve is inverted. The market expects inflation in the short term to be higher than in the long term. In other words, a blip. Keen-eyed readers will note the curve today is still higher than it was pre-pandemic. Given greater coordination between central bank monetary policy and government spending, we think this is fair. But it’s too soon to say whether expectations will (or should) rise further or whether we are at around peak levels already. There are compelling arguments on both sides of the inflation/ disinflation divide and currently we have sympathy with both.
Capturing pro-cyclical sectors
We are managing your portfolios actively – decreasing exposure to defensive sectors and adding to more pro-cyclical parts of the market. We have refrained from chasing beaten up sectors, like airlines and hotels & leisure. We still believe there are risks of longer-term economic scarring.
Instead, we have opted to increase exposure to smaller companies that perform well in economic recoveries. We also increased exposure to long term growth themes. Decreasing defensives served us well, but our second move has been buffeted.
Smaller and higher growth companies always trade at valuation premiums but as bond yields and inflation expectations have risen, these growth premiums have been eroded. Or more simplistically, investors have been rotating out of more expensive long-term structural growth in search of shorter term, cheaper cyclical growth.
There is absolutely nothing that changes our long-term view of the structural themes. The question is whether lower prices of these themes today are an attractive buying opportunity or whether there is more volatility ahead if interest rates and/ or inflation expectations continue to rise. We are comfortable with portfolios for now, but we are preparing ideas in case evidence points more firmly to a structurally higher inflation environment in the future.