The performance of the markets this year has largely been driven by the reflation trade, but the momentum seems to be running out of steam.
It has been an unusual first half of the year, with markets being whipsawed around by the inflation versus deflation debate. You can see this wherever you look, although the clearest picture is from the benchmark US 10-year Treasury yield.
At the start of 2021 the yield was hovering around the 0.93% mark, but it was clearly on the way up and got as far as 1.74% on 31 March, with many investors expecting it to continue to two percent and beyond. It then seemed to lose its way and trade sideways until the last few weeks when it has plunged back down to 1.30%.
The 10-year breakeven inflation rate, which measures inflation expectations by looking at the difference between the nominal yields and the equivalent Treasury Inflation-Protected Securities (TIPS), shows a similar picture. In the US, inflation expectations peaked at 2.54% on 17 May before falling back to 2.28% at time of writing.
Dropping back
The drop off in yields last month was positive for share prices, especially the high growth names with cash flows stretching well out into the future that have a higher present value when the discount rate is lower. This was a particularly good environment for the tech sector, whose open-ended funds were the best performing part of the market with a one month gain of over eight percent.
If there is one investment firm that is synonymous with disruptive growth stocks it is Baillie Gifford, whose funds and investment trusts had a great month. The Baillie Gifford American, Health Innovation and Long Term Global Growth funds were all among the top five performers with returns of between 13% and 17%, while their US Growth investment trust (LON: USA) also made it into the top five closed-ended funds with a gain of 14%.
It was a risk on month that saw a big sell-off for gold with the precious metal falling $135 to finish at $1,773. This dragged the associated funds down with it, with Baker Steel Gold & Precious Metals and Jupiter Gold & Silver two of the worst five performers on the market with losses of around 13% each.
A promising first half
Despite the recent turnaround, the reflation trade was still the dominant force over the first six months of the year with commodities, especially energy, leading the way. The oil price was up almost 50% over the period, which enabled Schroder ISF Global Energy, Guinness Global Energy, TB Guinness Global Energy and Blackrock World Energy to make it into the top ten best performers, with gains in excess of 29%.
Out of all the different areas the most profitable was the UK smaller company funds sector, which recorded an average gain of almost 20%, with the value-oriented Aberforth UK Smaller Companies returning an impressive 32%. The UK Equity Income and UK All Companies sectors also did well, which suggests it was a UK-wide recovery from a low starting base, while the worst performing areas were all bond-related and experienced rising yields.
It is unusual to witness such polarised performance, but if we were to see the return of persistent inflation that forced central banks to tighten monetary conditions in one form or another it would be a real game changer. Whichever way it goes there will be big winners and big losers, so be careful how you play it.