12-Month Review

Over the last year the investment team have delivered strong risk-adjusted returns during a period of considerable uncertainty and market volatility. Relative to the peer group, all but one of the ACUMEN Portfolios significantly outperformed their respective IA sector, with some of the funds making the top ten and ACUMEN Portfolio 7 ranked first out of 173 competitor funds. This strong performance also bolstered our inception-to-date rankings where four of the funds now appear in the first quartile.

Key Themes

2020 was a year of extremes. We witnessed a global pandemic, an ailing economy and yet generous capital markets with bumper returns across equity and bond markets. Because Covid-19 represented an external shock to the system, for all the uncertainty, there was, perhaps paradoxically, a strength of conviction in the economic recovery to come. Markets moved quickly to price in that road map and never looked back.

Today, with valuations at all-time highs, and economic recovery peaking, that sense of clarity is now behind us. Markets once again find themselves at a critical juncture. This is evident from the wide range of views clogging my inbox every day. If there is one thing market strategists can agree on… it is that they do not agree.

Uncertainty creates opportunity, and with that in mind, let’s turn to our outlook for the next 12-months. The good news is the global economy looks strong. Economic growth going forward will be driven by consumption, given excess savings, a pick-up in corporate capital expenditure and fiscal policy which continues to work its way through the system. Monetary policy is also likely to remain supportive. Whilst some of the smaller central banks are turning hawkish, and there is rising concern the Fed may tighten earlier than expected, our view is the Fed’s clear focus on full employment and social policy objectives means it will not tighten policy any time soon. Therefore, we think the global economy is poised at the start of a new multi-year cycle, with slim chance of imminent recession. Historically, such periods are conducive to strong equity market performance.

Our bullish outlook rests on the assumption that, ultimately, we will overcome the virus. Whilst that might be true over the next few years, it’s almost impossible to say what will happen over the next few months. The current litmus test for that is England’s ‘Freedom Day’, which saw the Government lift most remaining Covid restrictions across the country. As the test case for a global stage, it is reassuring, therefore, to see mortality rates remain low, even as new cases pick-up, in what is now the third wave of the virus. We hope to see these low mortality rates persist, and this pattern replicated in the US and elsewhere, where Delta has become the dominant variant only recently.

The combination of strong growth, and constrained supply, has led to a jump in inflation. There is ongoing debate about whether this inflation is transitory, as central banks would have us believe, or something longer lasting. In my view, we are now approaching an important potential inflection point with this inflation story. To see why, consider the following analogy… if you look back over the last 10 or so years, low levels of inflation have been a permission slip, or a driver’s licence for central bankers to do as they please. Now, we have central banks, particularly the Fed, driving 200mph on a 70mph motor way, thinking they still have that get-out-of-jail-free card of low inflation. However, if price levels, at a wholesale and a consumer level continue to rise as they are, then central bankers could get ‘pulled-over’ by the market. To provide some numbers, most recently we’ve had month-on-month US CPI at 0.9%, the highest level since 2008 and more than double what was expected at 0.4%, and the lesser-watched producer price inflation at 1%, versus 0.5% expected. These are aggressive price increases and they do not include the so-called base effect from one year prior. The concern is inflation is only just starting to pass-through to the consumer economy and if these price rises get baked-into expectations, they can become self-fulfilling. To provide some anecdotal examples from earnings season, earlier this month Jamie Dimon, CEO of JP Morgan Chase, said inflation would likely prove worse than the Fed thinks and Hugh Johnston, PepsiCo CFO, went one step further by categorically stating the food and beverage company would be increasing prices to offset rising costs.

At present, the market believes everything the Fed tells it, but if we do get another month or two of elevated CPI readings, we think that ability to control the narrative, and accompanying timeline, gets taken away. If the market does choose to call the Fed’s bluff, then we could see a repeat of the first quarter when bond market rates adjusted rapidly higher. Based on the historical relationship with the ISM Manufacturing PMI index, below, we think the 10-year Treasury yield could rise back towards 2% by the end of the year.

Turning to the ACUMEN Portfolios, we remain overweight risk-assets. Strong economic growth, rising yields and moderately high inflation point to a resumption of the reflation trade, which unwound during the second quarter but should re-instate moving forward. Admittedly, US equity market prices are already very high, particularly this early in an economic recovery. With markets driven by the second derivative, we could see a period of consolidation as earnings growth rolls-over later this year, but we would view this as a healthy correction within a structural bull market. As such, we remain bullish equities overall, albeit less so than at the start of the year. Whilst we continue to like cyclical and value names, particularly the S&P 500 industrials and financials sectors, we have balanced this against new allocations to healthcare as well as global ‘quality’ stocks, which we define as those highly profitable companies that tend to exhibit strong fundamental characteristics including stable earnings, solid profit margins and strong balance sheets. There is some overlap here with ESG, which should continue to benefit from significant AUM inflows. Regionally, we remain underweight the US, in favour of alternative regions, like the UK, which is historically and relatively cheap and well placed to benefit from the reopening theme.

Asset Allocation Outlook

Fixed Income

Inflation rhetoric has dominated financial markets since the beginning of the pandemic. During the most recent quarter these concerns have come to fruition. With only one US year-on-year CPI data point higher since the turn of the millennium, and yields as suppressed as they are, it is no surprise there is very little consensus as to how one should be positioned in fixed income.

Our view is that current yields on the majority of developed market government debt do not compensate investors in real terms. Looking at breakeven rates in the US, and the yield provided on longer maturity government debt, we believe that it is in largely uncharted, and in our opinion, unsustainable territory. Hence, we favour inflation protected securities in the US at the front end while underweighting longer maturity government bonds altogether.

The recent flattening of the US yield curve, with longer maturity yields falling on the back of weaker market expectations of economic growth, does not seem to be supported by the credit market. Economic growth concerns caused rallies in long-dated government bonds in 2007, 2015 and last year and in each instance credit markets supported this with corporate spreads rising. This has not yet happened with the recent rally in long dated government bonds. In fact, both investment grade and high yield spreads remain supressed at record lows. Hence duration remains our primary concern in investment grade debt while we favour higher-quality high yield exposures.

Within emerging markets, we have adopted a barbell approach with exposure to both hard currency debt and local currency Chinese government bonds. This allows us to participate in the pick-up in yield whilst also insulating the portfolios from risks posed to less stable emerging economies.  

Physicals

In the Q2 Quarterly Perspectives, we described an environment for higher commodity prices, with a focus on oil. Physical demand continues to outstrip supply across the commodity curve. Inflation expectations marched higher through most of the preceding 3 months, with oil prices setting successive new highs. Prices reached $77 per barrel in July, and we now find ourselves at key support around $75. The taps of global demand are on, and supply remains curtailed; until recently, both OPEC vigilance and a reduction in corporate capex spending, especially by distressed shale producers, has tightened inventories. Whilst this recent rally may be over-extended, we believe this could entail an environment of higher-for-longer oil prices. We retain our exposure to energy-dominated Russian equities.

We believe that recent retracements in copper prices represent long-term buying opportunities. This is underpinned by higher-than-expected recent inflation readings, increasing structural demand from China and elsewhere, supported by our long-term conviction in a weaker US dollar. Copper has been under pressure from Chinese intervention in the form of promises against higher prices, but we believe this represents an undeniable tightness in markets and that intervention is a short-term solution. Copper continues to outperform in the portfolios. Gold has found support from a recent decline in real yields, as inflation has picked-up. With high volatility in equity and bond markets, it continues to provide a solid source of portfolio level diversification.

Property markets have continued to exhibit signs of a modest recovery, however growing disparities between physical assets and homebuilder equities represent continued volatility in the space. Further increases in house prices will feed through to inflation, further spurring on our current exposure to commodities.

Foreign Exchange

The contentious talking point of Q2 was the shift in the Fed’s tone regarding when they will pump the brakes on their stimulative spree. Monetary stimulation had been justified on the basis that inflation would prove “transitory” and nothing more, which helped ease the US dollar lower for most of the quarter in anticipation of the ongoing low-rate environment. However, a then hawkish twist took the market by surprise at the Federal Open Market Committee meeting on the 16th of June. This contributed to a revival in US dollar strength, as investors searched for attractive growth prospects. The scramble for growth led to the recent bond surge, suppressing yields below the key support level of 1.40% on the 10-year US Treasury yield. It is worth noting this aggressive bond move has suppressed US real yields significantly, particularly versus other developed market counterparts such as the UK. As shown in the chart below, this has contributed to our longer-term bearish view on the dollar, which faces ongoing pressure from a number of not insignificant headwinds including the expanding twin deficits and longer-term fiscal outlook. On a short-term horizon, the Covid-19 delta variant continues to dictate moves, alongside relative vaccination and mobility rates and diverging growth trajectories. We see some scope for short-term US dollar strength as uncertainty remains high and investors seek safe-have assets. Within emerging markets, we have been extremely selective with our unhedged currency exposure; allocating to the Brazilian real, Russian rouble and Taiwanese dollar, regions whose central banks are set to lead the charge in raising their interest rates relative to their wider EM counterparts.

Final Thoughts

In the key themes section, we mentioned one of the reasons for tumbling bond yields was growing concern over slowing Chinese economic growth. This is something we are watching very closely, not least because China will contribute the greatest amount, more than one-fifth, to global economic growth over the next five years, according to the IMF. With that in mind, it is interesting to note that China’s broad credit and money growth has slowed noticeably. This is concerning given China’s credit impulse tends to lead the business cycle and can be a reliable indicator of future market returns. Given the lag time, the effect of this slowdown could impact the third and fourth quarters of 2021. Further, this is happening at a time when the Chinese Communist Party seems hell bent on reigning in some of the capitalist excesses within its economy, specifically internet technology companies which have grown dramatically over the last decade, spawning a host of billionaire household names in the process. Whilst this is a key risk to our outlook, we remain hopeful. It is unlikely Beijing wants to engage in full-on deleveraging and the surprise cut to bank reserve requirements, effective July 15th, suggests policy may be less hawkish than expected.

China’s credit impulse has historically proven a reliable leading indicator for the business cycle, and market returns.