We are (still) melting up
This is turning out to be another strong year for equity markets. Year to date, the MSCI World index in now up 14.7% and the S&P 500 17.2% as of 5/8/2021. Is this justified? We think largely yes, but the risk of a rapid melt up (much like we saw in the late 1990s) is increasing, something that we would have mixed feelings about. To illustrate this point we can look at the earnings of the S&P in 2020 and 2021 and compare this with the rise in the overall index. In 2020 the S&P rose 15% and earnings fell 13%. In 2021 the S&P has risen 17.2% and earnings are forecast to rise 43%. Indexing these numbers back to the start of 2020 it shows that the S&P has risen c35% whilst earnings have grown c24%. So there has been a rerating of equities in the United States, but nothing too stretched, hence why we think the move in that market (and others, which have a similar dynamic) is largely justified. The big question is what happens next. We would much prefer a period of market consolidation, even pull back, to keep valuations and earnings connected. We are not convinced we are going to get it.
The reason we think a continued rise in equity markets is more likely than a healthy consolidation is that these are near perfect conditions. Bond yields are low, economic growth is strong and central banks are accommodative. Whether or not higher inflation proves to be transitory (bond markets appear to be saying yes) or permanent is the last point to prove. We are not inflationist at heart. Over many decades, society has made steady progress in doing more with less, often using technology as the lever. An occasional oil price shock or war has dented an otherwise disinflationary trend, but generally inflation has been on a downward trend on a multi decade view. Should supply chains adjust to the stresses of reopening the global economy in recent months it seems likely to us inflation concerns will subside. At that point we will have nothing left to worry about, which, in my view, typically is the point to start worrying. It would be the crowning glory of an equity bull market that started in 2009, taking levels of optimism to new highs and cause the many investors who have not participated it to become involved. Arguably we are seeing this already in the US, with meme stocks. This optimism is not yet pervasive though, but it may soon become so.
Overvalued markets are very inconvenient for long-term investors
It seems counterintuitive to wish that our investments go up less, rather than more, in the coming months. Surely a melt up is good for those already invested? Not necessarily, with the most relevant comparison the technology led market melt up the late 1990s (the technology boom and bust). The latter stages of equity bull markets are usually the highest returning as share prices detach from earnings and rerate significantly. They are also often accompanied by a subsequent bust. The arrival of the internet in the 1990s was the driver back then, which allowed ‘blue sky’ thinking which quickly turned into dark clouds. Steady progress in investing is much better than boom and bust.
For long-term investors who believe investment returns are created in the holding – rather than the buying and selling – of shares, high levels of market optimism can be very inconvenient if what we own becomes overvalued as it creates dilemmas as to how to respond. To be clear, this is not the situation we are in now, but we would much prefer the share prices of the companies we invest in move up in line with increases in their value, not because of excess optimism in markets. Were this to happen though we have an obligation to look for alternative investments to the ones we have – if they become detached from their inherent value. This is the inconvenient part as we must sell what we know well and replace it with newer ideas that are more appropriately valued. Even this is difficult as at the end of bull markets not much is ‘cheap’. So, in summary our vote would be for market consolidation for a period of time long enough to keep earnings growth and share price growth connected. But to repeat, we are not convinced we will get it.
Was the value rotation just a ghost?
The most talked about topic in the first months of 2021 was the value rotation, but did it really happen? Consider this. In 2020 the MSCI World Growth Index rose 31.4%, whilst the MSCI Value Index fell 4.9%. Year to date in 2021 the MSCI World Growth Index has risen 15%, and value 14%. Were you to have missed the last 19 months in markets there would not have been a value rotation observable to you based on these numbers. Was it a ghost? Indexing these numbers back to the start of 2020, growth has delivered a return of c51% and value c8%. Looking at these numbers it would appear the case for growth investing has strengthened, and that for value weakened. Based on the prospects of those companies put in each of the two buckets this is something we would wholeheartedly agree with. This earnings season has made one thing very clear: the strong are getting stronger. Anything can happen in markets, and it usually does. Value may well do better in the future, but this evidence suggests strongly that the case for growth investing is stronger than ever.
How are we performing?
Performance across our range of funds has continued to strengthen with all of them now ahead of their sectors year to date. After a strong year last year, and some notable headwinds this year in commodity markets, where we don’t invest due to our sustainable approach, we think this is a good outcome. The defining factor continues to be the operational performance of the companies we invest in, and this has been demonstrated through the recent results season. The trend towards decarbonisation, digitisation and better health and hygiene standards is alive and well. Over the long term we believe investment returns correlate almost perfectly with the financial performance of the companies we own, not with market trends. A high return on capital business will deliver a higher investment return than a low return on capital business if bought at a sensible price and held for long enough. This is why we are so sensitive to the financial performance of the companies we own, which itself is driven by their sustainable credentials and their broader role in society. On this metric, we believe the funds are in good health.
The World for Sale
This is a highly readable and fascinating insight into the people who created and led the markets which trade commodities today. It is an insight into how a small number of people became incredibly wealthy buying and selling a whole range of metals, agriculture and energy-based commodities. One of the things we have seen in equity and debt markets in recent years is the idea that investing is no longer an amoral exercise, where investors have no regard for the societal and environmental consequences of their actions. This has clearly been beneficial for sustainable funds and has made the asset management industry much more socially relevant too. Commodity markets are another example of an amoral approach, whereby key commodity traders dealt with controversial regimes with commodities to sell, such as Libya and Russia, with little regard as to the consequences. Equally the environmental impact of the commodities traded was of no consideration either. This allowed commodity traders to connect reserves of commodities anywhere in the world with anybody and at the same time become fabulously wealthy. It is another illustration of the difficulties our sustainable funds have with investing in commodities. We can appreciate they are needed to deliver Net Zero, we can’t build wind turbines out of fresh air, but the ‘how’ of this being done is riddled with ESG issues that so far we have found insurmountable. A great summer read for those with some time to spare!
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.
Royal London Sustainable Managed Income Trust, Royal London Sustainable Managed Growth Trust, Royal London Sustainable Diversified Trust, Royal London Sustainable Word Trust and Royal London Sustainable Leaders Trust are held within RLUM Limited Unit Trusts, which is an authorised unit trust scheme. The Manager is RLUM Limited, authorised and regulated by the Financial Conduct Authority, with firm reference number 144032.
The RL Global Sustainable Equity Fund is a sub-fund of Royal London Equity Funds ICVC, an open-ended investment company with variable capital with segregated liability between subfunds, incorporated in England and Wales under registered number IC000807. The Authorised Corporate Director (ACD) is Royal London Unit Trust Managers Limited, authorised and regulated by the Financial Conduct Authority, with firm reference number 144037.
The RL Global Sustainable Credit Fund is a sub-fund of Royal London Asset Management Bond Funds plc, an open-ended investment company with variable capital (ICVC), with segregated liability between sub-funds. Incorporated with limited liability under the laws of Ireland and authorised by the Central Bank of Ireland as a UCITS Fund. It is a recognised scheme under section 264 of the Financial Services and Markets Act 2000. The Investment Manager is Royal London Asset Management Limited. Most of the protections provided by the UK regulatory system, and the compensation under the Financial Services Compensation Scheme, will not be available.
For more information on the funds or trusts or the risks of investing, please refer to the Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Information page on www.rlam.co.uk.