What’s happened in the first quarter of 2021?
The first quarter has flown by and it seems investors are confident that economies are on the road to recovery. This assumes the global vaccine roll-out is effective and that we all get back to something approaching normal as the year progresses. This sentiment is having a positive effect on some asset classes within our investment portfolios, particularly equity assets (shares in companies), where demand has been strong.
This demand has been fuelled by the expectation of significant fiscal support in the US and Europe with this stimulus resulting in improved economic growth expectations. This support is good news for equity investors, but a consequence of this has not been so good for investors in fixed interest securities (frequently referred to as ‘Bonds’).
Let’s look at the bonds in your portfolio
It is often said that investment markets have already ‘priced in’ future events. This sometimes turns out to be true, sometimes it isn’t. At the moment investment markets are weighted towards the expectation of very strong economic growth but the concern is this could see some economies overheating! A classic case of where demand outstrips supply. This would lead to a rise in inflation and the possibility that central banks may decide to increase interest rates sooner than expected to control this. These potential outcomes will have consequences for fixed interest securities, as they generally have fixed annual coupons (regular interest payments) and a pre-determined maturity date when the capital invested is returned. The structure of bond assets means an increase in inflation would erode the value of the regular interest payments, as well as the capital value at maturity. If interest rates were increased it would further lower bond prices, which is unhelpful for bondholders, but potentially attractive to new investors.
Fixed interest securities feature in most investment portfolios as they generally offer a lower risk alternative to equity assets, they are structured differently, and they usually react differently to economic conditions. This diversity helps manage some of the investment risk, although we are currently seeing bond values being affected by these inflationary and interest rate concerns. This resulted in a rotation out of bond investments during the quarter with this drop in demand seeing bond prices falling. Equity assets were the benefactor with the reflationary environment good for these assets.
Breaking down bonds even further
The bar chart below provides a general overview of the performance of the main asset classes during January, February, and March. It shows the discrete performance for each month (from the start to the end of the month) and reports the total return, which assumes any interest or dividends are reinvested in pounds sterling. The blue bars are the fixed interest assets (bonds) both UK and International with the red bars showing UK and International equites. The cash bar at the start of each month is flat and virtually indistinguishable with property represented by the green bar.
The chart shows how fixed interest assets have fared in comparison to other assets, particularly equities. Although this is a relatively short period it also highlights the generally uncorrelated relationship between equities and bonds and the benefits of combining these in investment portfolios.
How will a rise in inflation affect my investments?
Looking ahead central banks will want to maintain interest rates at low levels in order to be able to service the significant amount of debt within their economies. This is going to be a key issue assuming the global vaccine roll out delivers the outcome we are all hoping for and governments successfully navigate their way out of lockdown. If this happens, it is anticipated that pent up demand for goods and services will result in a temporary uplift in inflation. The conundrum for central banks may occur if economies were to grow too quickly and use up all the available supply, they may have to look at increasing interest rates to cool demand.
This situation has been rumbling on for a few months with speculation about the potential outcome swaying investor sentiment. Bond assets are an essential part of risk managed long term investment strategies. They have strong defensive qualities and play a pivotal role in maintaining a balance of diverse asset holdings within investment portfolios. At the moment it is the asset class that is most under scrutiny and to put it into context, it was just over a year ago that bonds assets helped support portfolio values as equities plummeted in the first wave of the pandemic.
Think about the long game.
It is sometimes difficult to shut out the short term ‘noise’ surrounding investments and this recent issue is one of many that will be encountered during the investment journey. This will have affected the reporting value of some portfolios, although all the speculation driving this may not materialise and it is why we remain focused on long term objectives.
As a valued client of Lloyd & Whyte we are here to discuss any queries about your investments. Our Independent Financial Advisers are happy to chat about your current or future investment plans.
Call our specialist team on 01823 250750
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