Strong returns despite continued effects of pandemic

Market update for the quarter ended 30 September 2021 from our investment manager Russell Investments.

Global equity markets ended the quarter flat while fixed income markets edged lower. Positive market momentum which dominated the first two months of the quarter reversed in September. Equity markets sold-off and government bond yields spiked higher as inflationary pressures, uncertain growth expectations and the anticipated tightening of monetary policy by global central banks weighed on investor sentiment.

In the US, the Federal Reserve (Fed) confirmed in September that it will taper its asset purchase programme by the end of the year. Additionally, policy makers brought forward their future interest rate expectations to a possible increase in 2022. The US 10-year Treasury yield climbed in the latter half of the quarter to end the period 2 basis points (bps) higher at 1.48%. The Bank of England (BoE) unanimously decided to keep its interest rate unchanged for now but acknowledged that inflation could peak at 4.0% and remain at that level until the second quarter of 2022. In the eurozone, the European Central Bank (ECB) decided to keep its interest rate unchanged but added that it would move to “a moderately lower pace” in its €1.85 trillion pandemic emergency purchase programme initiative. However, ECB president Christine Lagarde stated that she will not “overreact to [the] transitory supply shocks” which have driven inflation higher.

Within global equities, the higher rates environment helped the financials sector to outperform. Robust oil prices owing to supply disruptions also strengthened the energy sector, whilst technology and health care also outperformed. Weaker commodity prices and a stronger US dollar made materials the worst-performing sector for the quarter, closely followed by consumer staples, consumer discretionary and industrials. In factor performance, momentum, growth, large-caps and quality outperformed. Quality is the best performing factor thus far this year. Yield, small-caps and value underperformed.

Despite the continued effects of the pandemic, investment markets have again delivered strong returns. UniSaver members have continued to benefit from this, with the Conservative option returning 4.4%, Balanced +13.2% and Growth +19.3%[1] in the 12 month period to 30 September 2021.

Outlook

The COVID-19 delta variant, inflation and central bank tapering are unnerving investors. We expect the pandemic-recovery trade to resume as inflation subsides, infection rates decline and tapering turns out to not equal tightening. Amid this backdrop, our outlook favours equities over bonds, the value factor over the growth factor and non-U.S. stocks over U.S. stocks.

The post-lockdown recovery has transitioned from energetic youthfulness to awkward adolescence. It’s still growing, although at a slower pace, and there are worries about what happens next -- particularly around monetary policy and the outlook for inflation.

While the inflation spike has been larger than expected in both the US and New Zealand, we still think it’s transitory, caused by consumer price indices remaining low during the lockdown last year and by temporary supply bottlenecks. We believe that inflation may remain high through the remainder of 2021, but should decline in early 2022.

Another market concern is the highly contagious COVID-19 delta variant. The evidence so far, however, shows that vaccines are effective in preventing serious COVID-19 infections. With vaccination rates accelerating globally, we believe that the broader economic reopening should continue through the rest of 2021.

Our cycle, value and sentiment (CVS) investment decision-making process leads us to conclude that global equities remain expensive, with the very expensive U.S. market offsetting better value elsewhere. Sentiment is slightly overbought, but not close to dangerous levels of euphoria.

The strong business cycle gives us a preference for equities over bonds for at least the next 12 months, despite expensive valuations. It also reinforces our preference for the value equity factor over the growth factor, and for non-U.S. equities to outperform the U.S. market. We view cyclical value stocks as relatively cheap compared to growth factor stocks with them reporting stronger earnings upgrades than technology-heavy growth stocks.

[1] Returns net of fees, expenses and tax at 28%, 12-month performance as at 30 September 2021.

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