Markets are forward-looking, so medium and long-term themes can help you future-proof your diversified portfolio. The global economy has gone through a major disruption very different to the last crisis, and as we enter a new cycle there will be some surprises along the way.
Inflation is likely to be the primary focus for the rest of this year. Short-term inflation is likely to remain high as prices of goods and services recover. Disruption to supply chains may also cause temporary spikes. The commonly accepted view is the current inflation spike is temporary, but experts are split on the longer-term outlook.
Inflation matters because it affects interest rates – and they’re likely to rise sooner and faster if inflation is higher than expected. This, in turn, affects investments. Government bonds are affected, and to a lesser extent so are corporate bonds. The value of bonds tends to tend to fall so the interest offered by them can rise. Real assets, such as infrastructure, tend to have some inflation protection built into them and benefit from expectations of higher inflation. Equities are more mixed, with value stocks typically benefiting more than growth stocks.
For information, growth stocks are companies that are considered to have the potential to outperform the overall market over time because of their future potential. Value stocks are classified as companies that are currently trading below what they are really worth and therefore provide a superior return.
Is the value rally over?
The value recovery, which began when effective vaccines were first announced in November 2020, dominated markets until this summer. This value rally has been strong reflecting lower valuations, expectations of a strong recovery and the position in the economic cycle. The initial phase tends to be the strongest and most profitable as the economic data looked most positive. It is no surprise that the data has softened leading to speculation the value rally is over.
It is far too easy to think the value trade is done. Many ‘value’ stocks are still trading below levels before the pandemic as the outlook remains unclear. However, once the pandemic is truly behind us their earnings and share price should recover, although in some cases it may take years. Value stocks should also benefit if inflation is more persistent. The disruption caused by the pandemic should also help the better-quality stocks as good management have adapted and restructured their business, whilst their competitors fall further behind.
The initial shock of the pandemic hit financial markets hardest. But as companies adapted and governments put in place policies to support the worst affected sectors, the impact of further lockdowns has been less severe. But there are likely to be aftershocks – potentially as new variants appear or the recovery disappoints.
As things slowly return to normal there are also likely to be bankruptcies as some businesses struggle to survive and as government support is removed. Listed companies, which have been able to access finance throughout the crisis, may well be less affected.
Dividends to make a comeback
The latest Link UK Dividend Monitor report for the three months up to June, showed that UK dividends rose by 51%. This was mainly because many companies were either over cautious (understandably) or forced to suspend their dividends in 2020. As the economy recovers companies are raising their dividends once more, with many businesses in a stronger position having used the crisis to reset dividend policy to more affordable levels.
I believe 2020 was a reset for dividends, particularly for UK-listed companies. While it will take a while for overall dividends to get back to 2019 levels, income stocks are attractively valued in a low interest-rate environment and with the current high inflation.
Look to smaller companies for growth
After such a strong 2020, it is hardly surprising growth stocks have lagged in 2021 as the focus shifted to the recovery play. The pandemic has accelerated some long-term trends including digitalisation, e-commerce and remote working. This benefited tech giants’ share prices. As economies reopen, there is less to get excited about in the mega-cap tech space, but there are plenty of areas that have been overlooked as the focus in 2020 was very narrow. Smaller and mid-cap technology companies offer exposure to high growth industries, digital innovation and Greentech. Valuations and earnings growth look attractive compared to their larger peers.
2021 marks a new cycle for investors and it’s important to remember that the best performers of the last cycle are rarely the best performers of the next. Themes are useful to provide expectations for the future, but will change especially as we exit the crisis and that’s why diversification is important. Having a well-diversified portfolio means you are prepared for all eventualities and don’t have to accurately predict where inflation might be in two years’ time.