A familiar buzz has been returning to the Schroders office in the past month. As Covid rules relaxed, we were able to welcome clients back to the office and even hosted a couple of conferences. Meanwhile, the staff canteen is bustling and the investment floors are getting reassuringly noisier.
Even amid this returning semblance of normality, however, it still feels like we are living through a profound period of change.
Once-in-a-generation crises like the pandemic force us to fundamentally alter the way we live. They inevitably lead us to question the previous status quo, particularly when we are confined at home by infection.
I know this because I caught Covid-19 (in spite of being double vaccinated, I hasten to add) during the summer.
Government intervention not going away
Confinement resulted in me re-watching all of Downton Abbey, the historical TV drama series. In between the vagaries of the love story between Lady Mary and Matthew Crawley, the programme reminded me that World War One saw thousands of women entering the workplace to do jobs usually done by men. It was a first, irreversible, step towards greater equality for women.
The pandemic’s impact may prove just as profound in the way it has accelerated many disruptive forces that already existed in the realms of technology, the environment and politics.
In particular, the need to manage the medical crisis has led to a far more interventionist stance from governments worldwide. I’m not sure we can put that genie back in the bottle, particularly given the challenges of climate change and income inequality.
Regarding the latter, there has been a lot of talk around the slew of Chinese regulations over the summer driven by the government’s emphasis on “common prosperity”.
Leaving aside the decision to control online gaming (a policy which as the mother of a 12 year old boy I would wholeheartedly endorse), the regulatory crackdown has undoubtedly increased investor uncertainty in China. Particularly so given the power of the authorities.
Nevertheless, it is important to note that China is responding to the income equality challenges we are also seeing in the West. Indeed, the US Federal Reserve’s emphasis on “inclusive growth” is a symptom of the same cause.
What does this all mean for markets?
Beyond the current supply disruptions, we do believe that a shift towards a more inflationary regime is likely. A focus on “inclusive growth” and a lower labour participation rate is likely to put upward pressure on prices. Also, in the medium term, the need to transition away from fossil fuels will lead to higher energy prices as we adapt to new technologies.
This confluence between inflation risk and an emphasis on the sustainability of returns is new.
At Schroders we have invested heavily in data and analysis over the last few years to help us understand the highly disrupted times we live in.
Accounting data is not enough, we need to assess the broader impact of a company on the environment and society, especially if we are likely to see more regulation on carbon, for example. At the same time, correlations between asset classes are less stable as investors weigh the shift from a deflationary to an inflationary regime.
I don’t usually opine on the “active versus passive” debate in the investment industry, as I obviously have a vested interest. I think our clients benefit both from the innovation that active investment management spurs and the downside pressure on prices driven by passive management. But I do believe that the challenging current environment requires a forward-looking approach which lends itself to being active.
Identifying those companies that can protect their pricing power through the identification of structural themes can help to protect returns.
The emphasis on environmental, social and corporate governance (ESG) considerations may lead some investors to an unfortunate box-ticking mentality and lazy investment in well-known “green names”. What is actually required is a genuine focus on underpriced transition opportunities and working closely with companies to enact change.
The “easy" money has already been made
In the realm of fixed income, we need to consider the impact of government intervention in markets to suppress yields against inflationary risks. Jettisoning fixed income, entirely based on low yields and inflationary pressures, is not the answer. The need remains to diversify portfolios due to stretched valuations across asset classes and the unrelenting search for yield in a world of still negative real rates.
The easy money from the “reopening trade” has been made. Looking ahead over the next 12 months, we expect markets to get a bit more tricky as we confront the likelihood of receding liquidity and peaking earnings momentum.
Compared to the beginning of the year, the main shift in our views has been in our assessment of risks around our central scenario. Our forecasts now tilt more towards stagflation than reflation.
The positioning of our fixed income team, for example, reflects this. My colleague Paul Grainger, Head of Multi-Sector Fixed Income, tells me he sees more limited upside on government bond yields due to constraints on growth from limited supply.
Similarly, fund manager Simon Webber from our global equities team indicates that supply bottlenecks and shipping issues could last well into 2022.
This expectation of sticky inflation and softening growth momentum has also been reflected in our multi-asset portfolios where pro-cyclical positions have been reduced. In terms of generating returns, equities still offer the best opportunities, with an emphasis on identifying those companies which can sustain pricing power. Commodities also continue to offer diversifying opportunities.
Stay invested for now, but be ready for a bumpier ride.