Quarterly Investment Review – Q1 2021

by James Macpherson

“And bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at yearend – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.”

Warren Buffett, Berkshire Hathaway Annual Report 1/3/2021

Stock markets were strong in the first six weeks of the first quarter of 2021 before falling back. More dramatically bond markets sold off sharply. For example the US 10-year bond yield rose from 0.91% to 1.74%, while the German 10-year bond rose from -0.57% to -0.29%. These are massive moves in what are enormous markets. In addition industrial commodities were strong, particularly those related to expanding renewable energy infrastructure. The investment debate was dominated by countries’ efficiency in rolling out the various vaccines, and by concerns about inflation as economies start to reopen and respond to the tremendous stimulus that Governments and Central Banks have put in place. Bond markets will be closely watched for how they react to inflation. If the reopening of economies only leads to transitory inflation then the sectors that flourished prior to the pandemic should continue to thrive. However if inflation surges higher than expected and shows signs of being persistent then many asset classes will be reconsidered. Bond markets will continue to fall, as will those assets that are priced off bonds. On the other hand it could be a further boost for sectors that have languished in the past decade, such as commodities and financials.

It has been estimated that over $20 trillion dollars of debt was added to the global system in 2020 in response to the Covid crisis. Total global debt now stands at $281 trillion or 355% of global GDP. The scale of the intervention is extraordinary. Debt expenditure per capita in the US was $12,600 last year, which compares to an estimate of $5,200 spent over eight years in Roosevelt’s New Deal in the 1930’s. This is before the latest package by President Biden of $1.9 trillion, and a further recent announcement proposing one of $3 billion. The $1.9tn package includes sending a cheque for $1400 to almost everyone in the country. The proposed package focuses on huge infrastructure spending. Meanwhile the lockdown has driven the saving rate higher and it is reasonable to assume that this will decline when people are allowed out to spend again. If the savings rate returns to the pre-Covid level in the US that would free up one trillion dollars, or 4.7% of GDP. This level of stimulus raises the risk of inflation. The situation is different to the post 2008 crisis when banks were de-risking their balance sheets and being required to increase their weightings in Government issued paper. The enormous QE programs saw trillions of dollars issued by Central Banks, which were absorbed by the commercial banks which sterilised the inflationary impact. The money sat idly in excess reserves, trapping the inflation in asset markets. But today the excess money resides in household accounts and Government balance sheets and is earmarked for spending. This money is destined for the real economy and its impact is much more likely to be inflationary. In addition to this the events of the past year mean that companies have avoided unnecessary capital expenditure or running inventories at high levels, so the demand impact will be immediate. In addition to all this the trade tensions between the US and China have created extra pressure as supply chains are moved for reasons other than cost. Half the world’s semi-conductor chips are made in Taiwan, and at the end of the quarter the accidental blocking of the Suez Canal by a container ship show how fragile supply lines can be. This has occurred when the market has squeezed all the defensive qualities out of fixed income by driving rates to extreme low levels. Buffett’s quote at the head of this report should be considered in light of the fact that most people’s savings are linked to the bond market directly, or indirectly through equities or real estate, whose price is strongly influenced by the direction of interest rates. Despite these concerns companies have continued to enjoy benign conditions. At the beginning of March the European airline easyjet was able to raise €1.2 billion of debt at just 1.875%, at a time when it is operating at just 10% of normal capacity.

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