Posted 24 May 2021
Overview: markets display admirable stoicism
Beyond the directly virus-related stories, the week’s news has been dominated by cryptocurrency shenanigans and the return of outright war in the Middle East. For markets, the week’s economic news cycle was far more upbeat. The “flash” purchasing manager business sentiment survey results published on Friday showed that optimism is growing in Europe. Meanwhile, the US may have passed its peak of optimism. Weekly jobs data is still indicating an improving employment market, but the pace of improvement has slowed. Many will take comfort from this, given employers have recently found it challenging to find employees amid the scramble to reopen. A more considered moderate environment is probably healthy. As a consequence, the recent inflation narrative has perhaps also passed its peak.
The minutes of the US Federal Reserve Open Market Committee (FOMC) meeting told us that the pressure is mounting from some members that the time is coming for the Fed to discuss whether it needs to alter its stance and begin to pare back bond purchases. Such discussions seem like healthy debate rather than a sign of growing hawkishness, which is probably why markets mostly glossed over the mostly speculative headlines. Bond yields wobbled a bit, but long yields ended up lower, not higher by the end of week.
In contrast to riding the wave the of the crypto-crash, the relative steadiness of capital markets offered much comfort. However, it would be naïve to assume that this relative levelheadedness after an extended period of absolutely unprecedented levels of monetary and fiscal stimulus means we are already on safe ground. The risk that markets overinterpret future central bank communications as the beginnings of a policy error, or declare a temporary fall in the upwards trajectory of the economy as a looming downturn, will be with us for the foreseeable future. In other words, last week showed that, while we should always guard against complacency, perhaps we should not be too concerned about the risk of over-extended market valuations just yet.
Europe’s beacon of hope shines light on old problems
Europe is capturing investor interest once again, with the green shoots of a recovery coming through. Despite the horrible slow start, vaccination programmes on the continent have stepped up greatly, with ever more jabs set to be delivered in the coming weeks. That, combined with warmer weather and a slowing spread of the virus, is thawing the freeze on economic activity as businesses reopen. Indeed, signs suggest the recovery is already underway – high-frequency data from the Eurozone is showing a sizable uptick in travel, business activity and job postings – even while growth data suggests the Eurozone economy fared better than feared in the early parts of the year. Barring another turn for the worse, it looks like Europe is headed out of its punishing double-dip recession.
That prospect is making capital markets excited. For most of the year, a dreary economic outlook (and drearier virus crisis) meant investors held some scepticism on European equities, even if this year they have traded level with their US counterparts. Bonds are being pushed by rising inflation expectations, with Eurozone five-year forward inflation swaps (a measure of long-term price expectations) at their highest levels since late 2018. Crucially, rising yields do not seem to be overly worrying the ECB. This marks a big change from just a couple of months ago, when a move up in Eurozone yields led it into damage control. That the ECB seems rather nonchalant this time round is significant. It suggests officials think the recovery is real, and the Eurozone economy is strong enough to withstand a move higher in bond yields. This is understandable, given where the market moves are coming from. In February, soaring US growth expectations pushed bond yields up all around the world – even though regions including the EU were still languishing. This time, expansion hopes fanning inflation expectations are coming from Europe itself.
As ever with Europe, there are political headwinds swirling. Italy, the EU’s third-largest economy, has a host of longstanding problems that have been brushed under the rug by the pandemic. Its banking sector has struggled under a raft of non-performing loans since the financial crisis (even if some progress has been made), while its old fashioned and complex legal system has long been a barrier for investment. These structural problems are one of the main factors behind Italy experiencing more than a decade of low growth and disinflation – something that only compounds its debt issues.
Markets were happy earlier in the year when technocrat and former ECB governor Mario Draghi assumed Italy’s premiership after the fall of a fractious government featuring the far-right Lega Nord party. Draghi commands financial expertise and significant respect in Brussels, so markets hoped his technocratic unity government could find a way out of trouble. But Draghi has failed to win over the electorate, specifically because he was not elected to office. Even if he manages to continue in office until Italy’s next scheduled election in 2023, it would be a tall order to solve the country’s structural problems by then. Any political uncertainty would certainly be a headache for capital markets – potentially dampening the outlook for the wider Eurozone as it dampens hopes for structural reform. For now, we can at least take comfort that these problems are coming from a place of strength.
Don’t blame property fund woes on bricks and mortar
News last week that Aviva was shutting its UK Property Fund, as well as its two feeder funds, gave investors another timely reminder that the value of investments can go down as well as up. Like many other investment firms, Aviva suspended trading in its open-ended property fund last March – just as the pandemic began and capital markets were in nosedive. Equity markets have long since recovered, generating impressive returns over the rest of 2020, but the gates never opened on Aviva’s property investments. Now they never will. The fund manager cited an internal review that admitted generating positive returns while maintaining a suitable cash level for redemptions was not viable amid the fallout of the pandemic.
This sounds much less reasonable when you consider the global real estate market has been doing quite well. Like everything in the early pandemic, both commercial and residential property prices looked in trouble last March. But more recently, prices, trading volumes and interest have fared fairly well in almost all areas. Our point is that the travails of open-ended property funds cannot be put down to economic or market factors alone. The problem is the way these funds are structured.
Open-ended property funds promise investors the best of both worlds: exposure to the returns of the highly illiquid property market, but with the benefit of daily-traded liquidity. Investments that sound too good to be true usually are, and these funds are no different (which is incidentally also why we do not consider holding such property funds in our investment portfolios). As investors in these funds have found out, liquidity turns out into a mirage as soon as the going gets tough. Several such funds are only just re-opening, and those that are open have had to sacrifice huge chunks of their property portfolios – the bit that generates the return – to do so.
In truth, the stability offered by open-ended property funds is really just an inadequate form of risk-pricing. We can see this when comparing their performance against REITs (real estate investment trusts), the structure of which we would consider much more suitable for portfolio inclusion. Unlike open-ended funds, the value of REITs fluctuate day-to-day as the market moves. Investors may be put off by the volatility REITs experience – especially given the perception of property as a non-volatile asset. But again, this is actually just an accurate pricing of the underlying risk, which can move around even when underlying property valuations might not. As the recovery gathers momentum, property prices should benefit. That gives it a solid investment profile, but investors should as always be aware of the risks they are taking. If the investment is clearly labelled as volatile, this is still better than papering over the risks with false promises.