True Potential Portfolios Key Themes – May 2021

Chris Leyland, True Potential Director Of Investment Strategy, looks back on the key themes around the True Potential Portfolios over the past month

Over the month, the global economy has continued on its path of reopening.  Vaccination rates are higher and economies in the developed world are progressing through a cycle of easing activity restrictions. Against this background, we believe the recovery will be staggered regionally. China and the US are out ahead, followed by the UK, and further behind are Europe, Japan, and Latin America.

Economic data continues to be strong, although some data points are starting to soften. The US Manufacturing ISM was 60.4 for April demonstrating ongoing expansion, although lower than March’s figure of 64.7. As we look forward, there will be a gradual shift downwards in economic data over the coming quarters from current very high levels. Solid economic growth is expected into 2022. The reopening of services, supported by vaccination programmes, will help cushion any rollover in manufacturing data. The challenge will be identifying evidence of genuine economic growth from transitory factors (base effects).

Our central investment thesis of a cyclical recovery remains in place. We are conscious of the speed of movement through the recovery, however, opportunities continue to present themselves. Within the True Potential Portfolio proposition, we still favour cyclical assets but have been broadening exposure at the margin, rotating from the more cyclically focused sectors within the value style that performed strongly after the vaccine announcement into higher-quality sectors, such as pharmaceuticals, food retail, consumer discretionary and staples. We view longer duration growth style stocks as less attractive but hold them to provide diversification should events challenge our central case. Those challenges could be problems with the vaccination program, virus mutation, or a policy misstep. Equities continue to be attractive in this environment and an asset class we are overweight.

Although sovereign bond yields are higher than coming into the year, they remain unattractive with better yield available elsewhere within fixed income such as high yield bonds, emerging market debt and additional tier 1 bonds. However, the diversification properties of holding some exposure to sovereign bonds are intact. The True Potential Portfolio proposition is underweight fixed income overall.

The Federal Reserve continues with their position that inflation will be transitory and interest rates will not rise until 2024. We believe the Fed will only taper back bond purchases when they are confident that the economy is strong enough and on track to achieve their objectives of full employment and inflation around 2.0% (Flexible Average Inflation Targeting regime). Policy support remains intact for Central banks outside of the US, including the People’s Bank of China who we believe will be careful not to make a policy misstep when tightening monetary policy. Rising inflation is the key worry for market participants. Recent inflation prints have surprised to the upside in the US with CPI for April +4.2% year on year ahead of expectations of 3.6%. The question of inflation is one of time frame. Over the short term, we know higher inflation figures will come through as a base effect of the pandemic-related collapse in prices last year. Over the longer term, we believe inflation will not run significantly higher, with the pre-pandemic dynamics of de-unionisation, population demographics, and the ascendance of technology re-asserting themselves. The psychology of individual’s reactions to higher prices is difficult to judge.

Higher input prices due to supply challenges and how companies deal with them are important. With the potential for higher prices to be transient, it is difficult for companies. Many of the companies held within our portfolios have guided they will pass on cost increases through higher pricing e.g. Nestle. This will not happen immediately, and our expectation is that price rises will come through later in the year. We have individual names within the proposition that have benefited from the supply chain bottlenecks. An example of this would be Applied Materials, a company that supplies equipment, services and software for semiconductor manufacture.

A difficult component of the inflation landscape is wage growth. The stimulus packages in the US were important to help individuals deal with Covid but potentially overgenerous. This has left some sectors struggling to employ workers. We do not see significant wage inflation as of yet, although pressure is coming through within certain sectors e.g. travel and hospitality. Unemployment in the US is not expected to come back to pre-pandemic levels until Summer 2022 and the Fed has been very clear in communicating their objective of full employment.

The Q1 earnings season has been exceptional. Nearly 90% of companies beat earnings expectations, higher than Q4 2020 and much higher than the 71% average over the last decade. The beats have been significant, but expectations were generally low, due to uncertainty around Covid and a lack of management guidance.

Positioning within commodities has increased over the year. As an asset class, this has performed very well over twelve months, we see the continued reopening of the global economy, supportive fiscal policy and supply constraints all providing continued support. This asset class can be viewed as a pure-play on cyclicality.

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