A remarkable recovery, but are we out of the woods yet?

A remarkable recovery, but are we out of the woods yet?

Even the most seasoned investor will admit that the  recovery in equity and fixed income markets over recent weeks has been surprisingly fast. But with market volatility still at large, how confident should investors really be feeling?It remains to be seen if this is enough to placate investors, who must realise that such stimulus can take six months to work its magic. In the meantime, as companies report their half-year results, we should get a better idea of the real state of play.

Given the continued uncertainty surrounding Covid-19, it would have been wrong to assume a sharp recovery in equity markets after such a deep shock back in March. Yet, here we are. With equity returns now higher than they were for most of 2019, the recovery has been extraordinary.

This is largely due to the vast amount of government stimulus being pumped into the economy – particularly in the US – and signs that the real economy is re-opening for business. However, as Beijing was forced back into lockdown in mid-June, markets wobbled, and this was a stark reminder that nothing can be taken for granted.

An improving but tentative outlook
While the level of volatility has subsided over recent weeks, it remains elevated, and we should expect further jitters until there is more certainty over a vaccine. Forward looking economic indicators, such as the Purchasing Managers’ Index (PMI) are improving, but they are still predicting an economic contraction. Indeed, the global economy is unlikely to recover for two years or more, and there will be a significant impact on certain sectors of the job market. So, while there is plenty to feel optimistic about, we must continue to remind ourselves that we’re in the middle of one of the most significant economic events in recent history, and times are likely to be tough.

The Sanlam approach
For that reason, we have returned to a largely neutral stance on equities, meaning we don’t see many buying opportunities for now. Back in March, the dramatic correction meant we were comfortable taking slightly more risk since prices were low. As valuations have continued to recover, we have sold some of those opportunistic stocks to realise their value and lessen some of the risk we were taking. We are now focusing on companies that offer good long term returns and have a stable cash flow, and those that can protect portfolios from the threat of inflation. We look at why inflation is a threat in more detail in the ‘Investment View’ section.

Investment view: Why should we be worried about inflation?

With inflation figures falling, and interest rates at an all-time low, it might seem strange to be talking about inflation as a risk. So why do we continue to worry about it? The reason is simple: very low interest rates, a swathe of quantitative easing, and large amounts of government spending – paid for by printed money.

But we’ve been here before, haven’t we? This has all the hallmarks of the handling of the credit crisis, and we didn’t experience rising inflation back then. There are, however, two significant differences between the credit crisis and the current Covid-19 situation:

  1. The sheer scale of today’s quantitative easing programme dwarfs that of 2008.
  2. In 2008, the banking system absorbed the money created through quantitative easing and withdrew lending to other parts of the economy. In today’s crisis, banks have increased their lending, which will give people and businesses purchasing power they have not created themselves. A balanced economy relies on people being able to buy goods and services when they have contributed to the economy in the first place. Expanding the money supply enables some people to take from the economy without contributing to it, which forces prices up.

How to protect against rising inflation

It has been several years since we’ve experienced a high inflation environment, and many investors could be caught out as a result. The reality is that market conditions could become extremely tough, and it will almost certainly give rise to increased volatility in equity markets. That said, there are ways to protect against inflation, and the good news is that these ‘insurances’ are still relatively cheap given the risks at large:

In a high inflationary environment, it’s important to choose stocks accordingly. Focus on goods and services that everyone needs and wants, regardless of the prevailing market conditions. These companies can usually increase their prices along with inflation, and consumers will still be prepared to pay for them.

Inflation-linked bonds are a good way of hedging against inflation because they increase in value during inflationary periods. These bonds are relatively well-priced at the moment, which makes them attractive.

Gold is also a good hedge against inflation as it holds its value while paper currencies depreciate and lose purchasing power.

The Sanlam approach
We believe it’s prudent to have a balance of good inflation- proof investments right now, and we have been able to position portfolios to defend against the risk of inflation without having to pay over the odds for those insurances. It won’t happen overnight, if indeed it does manifest at all. But as we see it, to be forewarned is to be forearmed.