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Q2 2021 Update

22 July 2021

Inflation replaced Covid-19 as the markets’ main preoccupation in Q2 2021. The market over-reacted to short term inflationary fears and has, for now, settled on the “transitory” inflation narrative. However, risks remain that the market under-estimates the impact of central bank balance sheet expansion on financial market stability and central bank credibility over the longer term.

In admitting that a few of its FOMC members were thinking about an upward movement in interest rates by Q3 2023, the Federal Reserve played an astute hand. The USD rose, the gold price fell, and the Fed killed the reflation trade in one move. This slightest hint of a tap on the brakes, two years, hence, was sufficient to pivot the yield curve around the 10-year rate, with short rates rising and 30-year rates falling.

As highlighted in our May 11th blog post, The Case Against Inflation, if inflation is transitory, then so too is the move to value from growth in equity markets. Scottish Mortgage Investment Trust, the flagship growth trust in the UK market, was at £10.80p on that day. It ended the quarter 27% higher at £13.80p. Temple Bar, a flagship value investment trust, fell modestly over the same period. The recent rotation to value has run its course.

Overall, equities remain in demand. As Bank of America strategists have highlighted, flows into equity funds are currently running at a rate such that the full year 2021 outcome could exceed the total of the last 20 years combined. Another reminder, if we need it, that we are living in a world of unprecedented liquidity. In short, the investment case for equities remains TINA (There Is No Alternative). Indeed, some commentators suggest that the outlook for bonds looks so poor that a 60:40 growth/value equity only allocation should replace the traditional 60:40 equity bond split. This view suggests we should consider long-duration equities such as Alphabet, Amazon and Facebook as having bond-like (risk-off) characteristics capable of balancing out the more economically sensitive (risk-on) value stocks.

However, markets need something to worry about, and the return to the Goldilocks environment for equities has risks. Mohamed El-Erian pointed out three current core equity market drivers: durable high global growth, transitory inflation, and friendly central banks. In his words: The result is a comforting equilibrium with underpinnings that become increasingly unstable. The issue he is referencing is government debt rising to levels not seen since World War Two. With credit spreads narrowing to levels last seen in 2007, it is hard to argue that markets are pricing for longer-term structural issues.

The ability of governments to reduce their debt burdens requires sustained economic growth. But they are increasingly constrained. The renewed dominance of fiscal policy needs acquiescent central bankers to keep a firm lid on interest rates while allowing inflation to “run hot”. The “not too hot and not too cold” balance needs to be sufficient to help their political masters but insufficient to undermine their credibility. Interestingly, the gap between the rate of USD inflation to Eurozone inflation is now running at the widest in living memory. However, the USD has strengthened, reflecting higher levels of GDP growth and vaccinations.

The UK equity market continued to grind upwards over the quarter, with large-cap, mid-cap and small-cap indices showing an approximate +5% return. By the half-year mark, the UK IPO market had raised £8.6bn, already surpassing the full-year tallies of 2018 and 2019. In this century, the year with the most significant IPO volume was 2011. So far, in 2021, we are only slightly short of that year’s tally. While there is some evidence of investor fatigue from so many deals, there is no current end in sight. With record flows into equity funds playing the music, the banks and brokers are on the dance floor doing their deals. It is hard to see this trend ending until it does, we understand that these things are cyclical.

We wrote about our approach to IPOs on June 25th when we highlighted the attractions to The Artisanal Spirits Company – a tasty wee dram. We remain selective in our policy towards IPO deals. However, we also believe that there will be some attractive additions to our favoured investment universe of quality mid-cap companies during this period. As always, it will take time to determine which are the longer-term winners. To this end, we continue to meet company management teams. In Q2, we held 185 company meetings.

We continue to believe that the UK mid-market is an attractive place to source longer-term investment opportunities.

Written by Jeremy McKeown