Summary of Manager’s Report for the 3rd Quarter 2021

By November 2, 2021Articles

After a relatively quiet summer, the third quarter ended in a decidedly “risk off” mood as several global topics are dominating news headlines and coming to the fore of people’s worry list, detracting from the ongoing re-opening of public life, and accompanying economic revival.

Here is a short overview of the current issues (in no specific order):

  • The recent surge in energy prices, particularly the price of natural gas, especially in Europe
  • How these add to already elevated headline inflation numbers
  • Whether this will throw the nascent economic recovery off course
  • Ongoing supply shortages and distribution bottlenecks as demand surges while economies reopen; in the UK these are aggravated by the effects of Brexit
  • The partisan standoff around the imminent debt ceiling in the US (at the time of writing this appears to have been temporarily resolved until later this year)
  • A potential default by a highly indebted large property developer in China, and its consequences for the global financial system
  • The recent regulatory crackdown by Chinese authorities on certain private companies in the technology, healthcare, and educational sectors
  • The effect that “tapering” of monthly bond purchases by the US Federal Reserve, expected to begin towards the end of this year, will have on bond yields and financial markets

How they relate to our investment strategy, you will find at the bottom of this summary.

The unusual nature of the current economic recovery after a deep, intentionally induced economic slump caused by COVID lockdowns, makes the interpretation of economic data very complicated, almost like in the aftermath of a war. 

Unlike during a war, the production capacity of the economy has not been destroyed, consumers have been supported by governments via furlough schemes (in Europe) or direct cash transfers (in the US), so most economists do not expect “lasting damage” to the global economy.  It is however clear that, in moving from an almost complete standstill of much activity to a resumption of “normal” consumption patterns, there are many (temporary) mismatches in supply and demand, bottlenecks, and supply constraints, besides the ones in the energy market described above.  In the UK, the combination of the reopening of services combined with the fact that Brexit caused an exodus of non-British workers means acute shortages of skilled labour in transportation, the meat industry, healthcare, and other sectors.  In the US, the labour force remains some 3 million people short of pre-pandemic levels; partly because some older workers chose to retire, perhaps partly because not all feel safe yet to return to work given the Delta variant, or due to a lack of childcare facilities; in any case a shortage of skilled labour is quoted as a main concern by many companies.

This is putting upward pressure on wages.  Walmart, a huge employer in the US (accounting for 1.6 million jobs), recently announced it would increase its minimum wage to $ 12 an hour, and its minimum wage at its Sam’s Club division to $ 15 an hour, amid a tight labour market.  Meanwhile Amazon, another large US employer (1 million US jobs), is increasing its average starting wage to $ 18 an hour, and recently instated a minimum wage of $ 15 an hour.  This is good news for many US families and for the US economy as it will support US consumer spending.  It will also make inflation perhaps less transient than the US Federal Reserve is expecting.  In the EU, workers have remained more “attached” to their jobs via the furlough schemes, and wage inflation due to a mismatch in supply and demand is less prevalent.

How much inflation is too much?

The past two decades have been characterized by unusually low inflation; policy makers have been battling the risk of “deflation”, especially since the 2008 financial crisis.  The graph below shows US consumer price inflation, for all items (blue line) as well as “core” inflation excluding food and energy costs (black line) for the post World War 2 period.

US inflation – Core CPI vs headline CPI, post WW2


Source: Bloomberg Finance L.P.

The recent jump in inflation is partly due to “base effects”, as figures are quoted as year-on-year change and include the lockdown period of 2020 when energy prices plummeted and demand for certain services completely dried up.  In European statistics, prices for such services (like airline tickets) were imputed for purposes of index calculation, whereas in US statistics these prices simply fell out of the index so the jump in US inflation looks stronger than in Europe partly because of this difference in calculation methods.  Economists estimate that, for G4 economies, 60% of the current inflation increase is due to energy prices, 20% is due to shortages, and 10% is due to “reopening” inflation; together accounting for 90%.  Energy inflation is likely to fall next year as the base level changes; it is still an open question how sticky shortages and demand/supply mismatches in goods and labour will turn out to be.  In some areas with supply shortages, like shipping, it takes time to build new vessels and increase supply.  Also, the demand for semiconductors still outstrips available production.  Labour shortages and resulting wage inflation are likely to remain stronger in the US and UK than in the Eurozone, for reasons explained above.

All in all, we think headline inflation will fall back next year, due to energy prices and base effects, while core inflation will fall more in the Eurozone and Japan than in the US and UK.

In Developing Economies food prices are a larger share of the consumer basket; extreme weather conditions including droughts have pushed up the price of many foods.  Despite this, inflation in Developing Economies is on average just over 4% currently, which is not that high by historic standards.

Are we headed for a period of persistently higher inflation?  And if yes, how will central banks deal with this? 

This has been a topic of some debate and investor angst.  Analysing history makes clear that economies and financial assets perform well during periods of relatively stable, positive inflation, up to around 4%.  Periods of negative inflation (deflation) or high inflation (5% or higher) are more problematic.  The past two decades have been characterized by unusually low inflation, hardly ever exceeding 2% in developed economies.

What does all of this mean for our investment strategy, and portfolio positioning?

  • Global equities remain the most attractive asset class. Though 10-year bond yields may rise a bit, especially in the US, they will be capped by Central Bank purchases for some time to come.  Equity valuations are more reasonable after the recent correction and are justified by low interest rates and continued earnings growth expectations.  We suspect that inflationary trends evident in the US today are a bit less “transient” than the Fed seems to believe.  There is evidence of wage pressures which could lead to medium to longer term inflation in the US and possibly the UK being a bit higher than the 2% to which we have become accustomed.  Historically, in periods of moderate inflation (up to around 4%) equities are the best asset class to preserve investment capital.
  • We are mindful to include some “value” stocks in portfolios but are careful to avoid value traps and maintain a focus on companies and sectors that enjoy secular growth momentum, many of which can be found in the technology, healthcare, communication, and industrial sectors. Companies that will profit from the coming boom in infrastructure investment, and the transition to clean energy, are also firmly on our radar.  We maintain a slight overweight to funds in smaller companies in global equity portfolios, as real (after inflation) interest rates remain deeply negative; usually an environment in which small caps can outperform.
  • We used the positive market sentiment earlier in September to take some profits in equities for clients whose equity allocation had grown to be more than 5% overweight their chosen “neutral” allocation. The resulting cash will be invested in the Alternatives section of the portfolio.
  • Alternative asset classes (private Equity, long/short equity strategies, event driven strategies, global real estate) offer appreciation potential and diversification/hedging benefits.
  • In bond portfolios we retain an overweight to High Yield and Emerging market bonds, and underweight duration.

As always, please do not hesitate to contact us if you have any questions or comments, about the contents of this report or your portfolio in general.  We hope you are safe, and well, and keeping in good spirits in these unusual times.

By Marianne Rameau, ASIP, Portfolio Management Team, ISGAM AG

Publishing Date: 30 September 2021


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