Square Mile: Q3 market review

The macro view:

Inflation is likely to be the most significant factor influencing the direction of markets over the coming year
It is too early to say with confidence whether higher levels of inflation are entrenched or transitory.
The Bank of England expects CPI to top 4% by the year end, while RPI jumped from 3.8% in July to 4.8% in the 12 months to August.
In the deflation camp sit factors such as technology, ageing populations (who spend less) and indebtedness, while supply bottlenecks which held back the economic bounce-back should ease.
Inflationary pressures include significant infrastructure spend (including decarbonisation), and social programmes (the US$2trn American Families Plan in the US and ‘levelling up’ schemes in the UK) which are increasing wage and raw materials costs.
At a best guess, inflation should fall from current levels but in the US, and particularly in the UK, it may well settle higher than central banks’ 2% target.
Economic growth forecasts for 2021, though still very strong, have been revised downwards over the last quarter. A combination of factors is likely to be at play:
- Pent-up demand, which was suddenly released as pandemic restrictions were relaxed, has peaked.
- The prospect of higher corporate and personal taxes: in the UK, NI rates and taxes on dividends are increasing by 1.25% from April.
- In the US, the delta variant and its potential impact on business led the Fed to revise its 2021 economic growth forecast downwards from 7% to 5.9%.

Bonds

Despite rising inflation, bond yields fell sharply in July reflecting investor acceptance of central banks’ reassurances that inflation will be transitory.
Between the end of June and early August, the 10-year gilt yield fell from 0.72% to 0.51% and US Treasury 10-year bond yields declined from 1.47% to 1.17%.
However, central bankers are cognisant of the threat of inflation and interest rates rises and the end to QE may be brought forward.
The prospect of monetary policy being tightened earlier than previously expected caused bond yields to rise sharply in September. In the US, 10-year Treasury bond yields finished the quarter close to where they began.
In the UK, the gains that investors enjoyed in July were overwhelmed by losses in August and September.
Return expectations for government and high-quality bonds are modest at best.
Lower quality debt looks expensive and offers inadequate compensation for the risk of default.

Equities

Equities remain the best option for investors seeking to maintain or grow their capital in real terms, albeit with greater risk to that capital.
In the near-term, stock markets should continue to be supported by strong economic growth and the impressive bounce-back in corporate profits. Additionally, stock markets have historically weathered moderate inflation and gently rising bond yields.
However, challenges remain, namely:
- Higher wages and rising costs for raw materials increasing pressure on corporate profit margins;
- Higher rates of corporation tax;
- Year-on-year growth in corporate profits will be harder to achieve and will slow markedly as the worst ravages of the pandemic retreat into the past;
- The risk that inflation remains stubbornly high, forcing central banks to raise interest rates faster and by more than investors currently expect. This would undermine valuations which are lofty and in which there is little or no margin of safety.

Alternative Investments:

The price of gold tends to rise when bond yields are falling or inflation is rising: at the beginning of Q3, the gold price rose as bond yields fell, but this was almost entirely reversed in September.
After gains of 19% in 2019 and 24% in 2020, gold is down by 7% in dollar terms and 6% in sterling terms so far in 2021. Its future direction is dependent largely on inflation expectations with the narrow range in which it has traded recently being symptomatic of uncertainty.
The volatility in the price of bitcoin reflects polarised views surrounding cryptocurrencies: PayPal now allows customers to trade in bitcoin whilst it was effectively banned by the Chinese central bank.
In dollar terms, bitcoin appreciated by 27% over Q3 but its performance ranged from a loss of 13% to a gain of 49%. Year-to-date bitcoin has appreciated 49% but at the end of September its price was still more than 30% below the peak recorded in April.
In real estate, the outlook for office and retail space has almost certainly been boosted as employees return to the workplace. Nonetheless, the long-term scarring caused by a shift to flexible working and online shopping will be difficult to quantify for some time.

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