Against a backdrop of economic optimism and ebullient stock markets, it is no surprise that corporate bonds again provided better returns than government bonds in the second quarter.
In the US, credit spreads on high yield bonds have fallen to their lowest levels since before the financial crisis.
In a financial world in which investors remain starved of income-generating investments, we certainly understand the attraction of a high yield bond which yields 3% more than a government bond but the question is whether this is sufficient compensation for the risk of default.
Equity markets in Q2 2021
It was another barnstorming quarter for stock markets. The UK stock market made more than 5%, taking its year-to-date advance to just over 11%.
However, this performance was eclipsed yet again by US equities, the main benchmark rising by over 8% to take its year-to-date return to more than 15% including dividends.
The only notable laggard in Q2 was Japan, which was broadly unchanged. Japan’s vaccine rollout has been much slower than many other developed countries, with only just over 10% of its population fully vaccinated compared to figures of approximately 50% in both the UK and the US. As a result, restrictions have lingered for longer, causing the Japanese economy to contract by almost 4% in the first three months of the year.
The last few years have witnessed an extraordinary divergence between the performance of usually high-priced and often technology-related ‘growth’ stocks and cheaper, more economically sensitive ‘value’ stocks in sectors such as commodities and financials. The former has trounced the latter. However, in the first three months of 2021, value stocks at last had their day, outperforming growth stocks by almost 10% as economic growth surged.
The recovery accelerated in the second quarter so it would be rational to expect value stocks to continue to have done better than growth stocks but the opposite happened with growth stocks outperforming value stocks by about 6%.
The explanation probably lies in the bond markets where yields unexpectedly declined in the second quarter, making the future cash flows and valuations of growth stocks more attractive to investors.
Actively managing the tilt between growth and value in a portfolio might seem like a perfectly valid investment strategy but the experience of just the last two quarters shows just how easy it is to be wrong-footed and a more balanced approach seems prudent.
Stock markets are revelling in a Goldilocks set of circumstances. Economic growth is buoyant and corporate profits will benefit accordingly. Inflation is going up but is not out of control (according to central banks).
In any case, stock markets have historically taken modest, say low to mid-single digit, inflation in their stride as it allows companies to increase their revenues. Similarly, bond yields have risen but not by too much.
Despite this, risks remain. Central banks could be wrong about inflation and are forced to increase interest rates considerably. In addition, share valuations are expensive even allowing for the anticipated bounce in corporate profits. There is therefore little or no margin of safety if, for example, profit margins begin to be squeezed by higher labour or other costs.
One other area of concern is the degree of speculation evident in stock market an example of which has been the recent investor mania for Special Purpose Acquisition Companies (“SPACs”). SPACs have enabled a string of private companies to become publicly listed, some on the basis of heroic assumptions about future prospects. One such company was Nikola, an electric truck maker, which was valued at US$12bn when it listed on the US stock market via a SPAC in March 2020. Some months later it was exposed that the movement of a prototype vehicle in a promotional video was not self-powered but was because it was rolling downhill!
Currencies
In currency markets year-to-date sterling remains the strongest, up by a little over 1% against the dollar, by 4% against the euro and by nearly 9% against the Japanese yen. The strength of the pound in the first quarter and therefore year-to-date reflects expectations of an earlier and stronger economic recovery following the world-beating rollout of coronavirus vaccines and also the removal of uncertainty about the UK’s trading relationship with the EU following Brexit.
