We are six months into the calendar year and investors have enjoyed resilient markets in the first half of 2021; a continuation of the strong recovery from the immediate Covid-19 impacted crisis. Andrew Bascand, our Managing Director, has penned the below letter to clients framing the current environment, thanking our stakeholders for their support, and providing some thinking about the period ahead of us.
As the global economic recovery moves forward into an expansion phase, we think now is an extremely good time to check on longer term investment objectives, risk tolerance and whether portfolios would benefit from strategic rebalancing. The subsidiary questions you may wish to explore are whether your portfolio is set for fresh risks from climate change, a more general embedding of sustainable practices, the potential threat of more persistent inflation as we move further into expansion, and maybe rising interest rates. Additionally, across many industries we see the threats and opportunities from continued digital disruption and remain relatively optimistic about the potential for innovation to drive positive investment returns.
I want to thank all our investors and clients for their support over the past year. At Harbour we continue to invest in new solutions and funds. We have also been employing new people in our investment, operations and client teams. In the last year, we lowered our fees on several key funds, and engaged deeply with companies on sustainable issues. This has resulted in our Harbour Australasian Equity Fund receiving certification from the Responsible Investment Association of Australasia (RIAA) and our recent award from Mindful Money as the Best Ethical Retail Investment Provider. We have made multiple submissions on a range of Climate Change issues, published the carbon intensity of our equity portfolios, and Harbour has received Toitū certification for our carbon zero journey. We were also recently a primary investor in Australasia’s first sustainability-linked bond, and we are continuing to examine deeper ways of engaging with companies on sustainable disclosures.
In the next six months we are exploring several new fund options in response to our listening to the needs of our clients. We now act as investment guardians for more than $6bn of assets under management and are very grateful for the support also of many financial advisers and direct clients who chose to use Harbour’s funds on a no-advice basis.
Market considerations – into the Expansion
Market volatility is a normal part of investing. Corrections, or over-reactions to unexpected news, are also common. However, markets often price in most of the news that lies ahead. Some people believe markets over-discount tail risks, however well-diversified portfolios have continued to provide reasonable real returns for investors over many decades, despite the global financial and Covid-19 crises. Our return forecasts for most asset classes are more circumspect for the next 5 to 10 years. This reflects the starting point for both bond and equity valuations.
As we enter a broader global expansion, further positive earnings revisions can drive equity returns even in the face of a modest rise in interest rates. For investors with a long-term investment horizon, diversified growth-oriented portfolios seem to be a better way of handling the most likely market environment ahead. For investors with a greater focus on income, or a more medium-term horizon, we still favour a strong allocation to high quality, dividend-yielding companies, within a broader mix of credit, cash, and shorter duration bonds.
Today we know that the global and local economic expansion is on solid ground and that some central banks are contemplating a marginal tightening in monetary conditions. A cessation of extraordinary stimulus seems warranted; in part because inflation has trended back to targets (and seems destined to over-shoot for a time), and also because labour markets are increasingly tightening, and many sectors are operating at full capacity. These pressures can be seen in the prices of commodities and asset prices more generally.
Interest rates seem likely to rise, and some increase is already foreshadowed in yield curves and forward interest rate expectations. For instance, we currently project a rise in the New Zealand 10-year bond yield of about 25-50 basis points in the next 6 months, which is a little higher than what is currently priced into the yield curve.
The trade-off for equity investors is assessing the extent to which corporate earnings may still positively surprise, and therefore offset the relative valuation impact from potentially higher-than-expected inflation, and higher interest rates and bond yields. We stand in the camp that the world economic recovery has moved from recovery to early expansion, and until either inflation becomes persistent, or central banks signal that they want to get in front of inflation, staying invested in a diversified portfolio of growth and cyclically growth-oriented companies seems to provide the best option for absolute returns. In the near term, we suspect the next quarter’s earnings surprises will still be tilted to have a positive bias.
However, we may see a reversal in the relaxed attitude the market is taking on inflation.
Right now, markets seem to have turned to believing that inflation will prove temporary, allowing central banks to gradually lift interest rates over the next few years. For instance, the financial markets price-in the first interest rates rises in New Zealand in early-2022, and the first rises are expected in the US in early-2023. Before then, we will likely see a reduction in surplus liquidity, through a further tapering of bond-buying in New Zealand, but more importantly, by the US Federal Reserve starting to taper their bond-buying programme. The market seems to be relatively sanguine about those prospects, perhaps because of the sheer stock of liquidity available today, but also because fiscal stimulus is ongoing, and households have built up such a huge surplus of savings. We think that this is a fair perspective for a central scenario, but on many counts the risk for markets is that inflation outcomes continue to provide upside surprises.
What is less certain is the outlook for Covid-19; however financial markets reaction to Covid-19 news has been dampening. Perhaps this is because vaccines are proving highly effective against Covid-19 and all variants known today. And vaccination programmes are ramping up. The world is vaccinating almost 45mn people a day. At that rate we may achieve 80% global vaccination by November 2021.
In the UK, where vaccinations are close to 80%, confirmed Covid-19 cases have picked up sharply, reflecting the more infectious Delta variant. However, Public Health England reported this week that the Pfizer-BioNTech vaccine is 96% effective against Delta hospitalisation after 2 doses, and the Oxford-AstraZeneca vaccine is 92% effective against Delta hospitalisation after 2 doses. Johnson and Johnson also said that its single-shot Covid-19 vaccine was effective against the delta variant over the course of at least eight months and remained confident there is no need for a booster.
What does this Covid-19 evidence mean? There is a potential that we begin to normalise Covid-19 news, and that, overseas, the reopening of economies gathers pace. People return to restaurants and movie theatres. They travel more, initially in their own region. As further evidence on the effectiveness of vaccines emerges, countries may continue to open up. On the other hand, there is still a possibility, that new variants continue to occur, and markets become worried about the effectiveness of vaccines. Our advice is to follow the science carefully. Consider the capacity of mRNA technology, follow longer term trials, and watch the evidence of the effectiveness of Covid-19 vaccines on severe disease and mortality.
More generally, high vaccination rates in the US, UK, China and Europe are allowing reopening. This means that the global services economy will pick up. For instance, in the US restaurant bookings reached a new cycle high in early June, back to pre-pandemic levels. As a result, the US job market is tightening; new job postings are more than 30% above the pre-pandemic baseline.
This is good news. However, it is news that the markets have possibly largely priced in. A recovery in global GDP and earnings is certainly priced into equity markets. And hence a lot of the good news – effective vaccines, extraordinary stimulus and policy responses, and much better economic data – seems unlikely to repeat and propel equity markets significantly higher in the near term. What may not be priced in is that we are at the beginning of an expansion phase. And, initially, equity markets generally perform well early in expansion phases of an economic cycle and can perform better than bond markets. But additionally, history suggests that equity markets can become more volatile in expansion phases as the tension between higher interest rates and better earnings see-saws. Often market narratives take over, then rotation between bonds, equities, sectors and stocks become thematic, hanging on little real news.
At these times, predicting either a correction, short term direction or rotation can prove to be a stroke of luck rather than skill. For that reason, after a spell of excellent returns, our advice is not to predict a correction, but focus on how longer term trends that may drive earnings through the cycle.
We may not see any market stress in the next two to three years. It is possible that growth continues through innovation, stimulus, more labour being employed, higher real wages, and households freeing up their purse as they become more confident about the exit from Covid-19 dominating our decision making. This is as plausible a narrative as considering the tail-risk from an inflation shock. We tend to be open-minded about contending with both an ongoing expansion and higher than expected inflation.
In a recent newsletter to both staff and clients, a research-focused US financial institution talked about the challenges they face as investment guardians. They identified embedding sustainable investment practices and being collegial and engaging with companies being key skills to employ in developing portfolios. Additionally, knowing when we just don’t have conviction about the future, and how we might mitigate unforeseen risks through diversification are important to investment management in the expansion phase.
Concepts of partnership, being humble in our ability to forecast, and being extremely vigilant to disruption and surprise, seem to be factors to bring even more deeply into our investment practice and discussions.
A period of strong investment returns, both absolute and relative, can falsely build excessive confidence. Looking forward the next challenges may still be Covid-19, or may be the nature of how central banks exit from zero or low interest rates and bond-buying.
More likely however, the new challenges will be considering the winners and losers from decarbonisation, from awareness about innovation in digital platforms, artificial intelligence, mRNA technology, and new immunotherapies to tackle endemic diseases.
In most businesses, change has accelerated. More new businesses have started in the US, France, the UK, Australia and New Zealand than in any other 12-month period highlighting the potential for innovation and fresh employment opportunities.
Having a diversified portfolio in the period ahead and being alert to opportunities in equal measure as risks is likely to continue to be an appropriate strategy.
All the best for the second half of 2021
Andrew and the team at Harbour
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