Posted 5 July 2021
Overview: transition uncertainties ahead
The great British summer may have struggled to materialise so far, but the end of the first half of the year always brings an element of sunny optimism. And, after what proved a quite decent 2020 for investors, the first half of 2021 has again left investors with plenty to be positive about. However, those with a higher allocation to equities than bonds will have fared much better than last year. On the back of calmer bond markets – and a significant rebound of the global economy – the second quarter saw many equity markets close at all-time highs. Meanwhile, despite a notable recovery rally in the second quarter, bond investors have not had it quite so good. This poses an important question against historical observations. Can equities continue their rise despite a lack of upside for bonds?
Of course, this period of stock market positivity has been driven by the expectation that the pandemic and its restrictions is gradually ebbing away, opening the path for an outsized economic catch-up rebound all the while central banks keep bond yields stable. However, the ebbing away of the pandemic also means the inevitable phasing out of the government and central bank support that bridged the past year’s economic void. This introduces a significant – and potentially unnerving – period of transition when the global economy will have to stand on its own feet again. For markets, the main fear is that this positivity could lead to a premature tapering from central banks. On this, we note that the current transition period does create an air of uncertainty – which might make markets more sensitive to ‘central bank speak’. We believe policymakers will ultimately want to lift their economies onto a sustainable growth path, but any signs of tweaks of policy have to be digested by the market. So, market reactions could be a bit choppy during this transition period.
As we go forward and into next year, historically low bond yields will be difficult to maintain while the global economy is going strong – and an uptick in bond yields has the potential to make things difficult from a valuation standpoint as discussed at the beginning. But we are comforted by the fact that the real thing that would worry investors – faltering growth expectations – looks wholly unlikely. To be clear, while we believe the pandemic peak is now well behind us, and economic growth lies ahead, we also expect to see bumps and humps on the way. For one, it has to be recognised that only the UK’s public health has so far successfully weathered the onslaught of a far more infectious variant against a widely vaccinated population, while the rest of the world is still where the UK was only six weeks ago – reopening as the rate of infection has declined to very low numbers. This is just one example of the uncertainties that lie ahead as we transition to the post-pandemic environment, and it will make it very difficult for politicians and central bankers to calibrate the pace of withdrawing support. All the while, capital markets will fret over whether the remaining support level are too much – stoking inflation and yields – or too little, undermining the economic outlook and corporate earnings.
Why central bankers have played a good first half
In normal times, a bout of growth (and subsequent inflation) would result in central banks tightening monetary policy. And yet, central bankers around the world have been at pains to reassure that rates will be kept low – and liquidity flowing – for the foreseeable future. Last week’s Mansion House speech was an opportunity for Bank of England Governor Andrew Bailey to hit back at claims (most loudly from ex-chief economist Andy Haldane) that policy would need to tighten. Bailey’s confidently dovish tones are matched by those of his global peers and – perhaps more importantly – capital markets fully believe it. This dovishness is not because central bankers are privately worried about the health of the recovery. Rather, it seems that monetary policymakers want to keep interest rates below the rate of inflation well into 2022, which should allow the global economy to get the full benefit of the recovery, without sapping away growth into increased savings. This is important for equities, as it decreases the discount factor that gets applied to future earnings. It leaves markets in a good position in the short to medium term; company earnings are expected to trend strongly upward into next year and beyond.
What’s more, as the latest business and consumer confidence surveys suggest, the recovery is no longer a long-term promise but a near-term reality. For Europe, much of this has been driven by an easing of restrictions, with very positive consumer sentiment a particular highlight. Even those sectors relatively less affected by lockdowns are feeling upbeat. In the US, consumer confidence has yet to return to pre-pandemic levels, but indicators suggest it is well on the way, albeit still with room for consumers to grow more confident. Though unemployment has fallen drastically from its pandemic peak, there is still some way to go before we reach the full employment target set by the US Federal Reserve (Fed) – despite many reports of difficulties securing workers. Confidence levels are anticipating a strong job market and rising wages, and that is in our opinion likely to be the case.
So, while central bankers can congratulate themselves on a job well done through the first six months of the year, they won’t need any reminding that they – and us – are not out of the woods just yet. Fiscal support is already beginning to fade as the economy opens up, and many commentators have feared we may be approaching a ‘fiscal cliff’ in the US if emergency measures are withdrawn too quickly or in a haphazard way. What this tells us is that labour market dynamics will be key to the next phase of the global recovery. If things continue to improve, it could well motivate consumers to use their ample savings – greatly increasing demand. If things stall, they could become more fearful.
Green Bonds: accountability and fears of ‘greenwashing’ remain a concern
Green bonds – bonds whose proceeds are earmarked for environmental projects – have grown exponentially in size and popularity. In 2020, total issuance of green-labelled bonds was the highest it has ever been, and that record looks set to be broken again this year, after Q1 delivered the highest quarterly issuance on record. Funds devoted to green bonds have also gained traction, with $4.7 billion flowing into green bond funds in 2019, followed by $10 billion in 2020. Like many other ESG investments, the push to clean up capital markets’ environmental footprint is making green bonds increasingly mainstream.
The “Green Bond Principles” established in 2014 by a consortium of investment banks emphasise transparency as a key part of the green bond market, imploring issuers to provide accurate information about how funds are used and the impact of projects. However, the two biggest drawbacks are that (1) they are voluntary and (2) the exact meaning of ‘green’ is left to issuers to decide. This calls into question the eco credentials of the green bond market – especially considering recent concerns over ‘greenwashing’ by companies. There is no requirement to stick to the guidelines, and even if issuers do comply, disputes continue over how green their standards really are (the current debate around the EU’s classifying biomass as ‘renewable’ being a good example).
Another issue for investors to contend with is that although green bonds are sold on the same credit profile as conventional bonds, there are extra transaction costs involved. These come from the fact that issuers have to track, monitor and submit reporting on how the bond proceeds are being used – all of which is expensive. This boils down to a problem common to any kind of ESG investment: Oversight is always needed to ensure promises are actually being honoured. This is especially pressing when you consider reports that around 20% of green bonds do not fulfil the environmental obligations they are supposed to. This is a potential area for active management to be a differentiator, particularly in terms of the underlying green credentials of a portfolio of these bonds.
But oversight can eat into investment returns. In 2020, 89% of green bonds came with external reviews to check environmental standards, up from 82% the year before – but these reviews incur costs. For issuers of green bonds, the money spent on reviewing might well be outweighed by the benefits that come with the green label – from marketing opportunities to a wider investment base – all of which can add returns. Investors do not have those same return benefits, however. To be clear, this is not to say that green bonds are not worth it – far from it – but only to point out that, where ethical or environmental concerns come into investment, they can interfere with straightforward returns. For those who want their capital to do more than just generate returns, this is often a price worth paying, but it is nonetheless something green investors need to recognise.