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7 Minutes on Markets - Q3 2021 Market Update

Ahmer Tirmizi, Head of Fixed Income Strategy, Tony Lawrence, Head of Model Portfolio Management27 Jul 2021

Join Ahmer Tirmizi, Senior Investment Strategist, and Tony Lawrence, Senior Investment Manager, as they discuss our latest views on the current environment and the changes that we are making to our portfolios.


Ahmer: Hello everyone and welcome to another 7 minutes on markets with 7IM. I’m Ahmer Tirmizi, a senior investment strategist here at 7IM, and I’m joined by my colleague and senior portfolio manager, Tony Lawrence. Now the quarter has been, the last quarter anyway has been a bit different to the proceeding two or three quarters. It feels like some of the momentum is held up a little. A lot of it feels like it's down to an interaction, a complex interaction between re-openings and huge amounts of stimulus and a really lopsided economy between goods and services. You’ve got COVID variants to think about and vaccination rollouts and a lot of these things aren’t things that we used to dealing with as investors. Tony, as the economic recovery appears to have stalled a little in the second quarter, how have markets reacted to this?

Tony: Thanks, Ahmer. Yes, it was another incredibly strong quarter for equities. Once again, the US led the way with an 8% return which is quite staggering. What was different this quarter was the price action in the bond market. Here we saw a retracement of the sell-off we witnessed in Q1. Just as a reminder, if you had held a broad basket of gilts in Q1 this year, you would have experienced a 7.5% loss, quite something for what is perceived as a defensive exposure. This corrected somewhat in Q2, recouping around 2% of those losses. But although this was relatively minor, it did have a profound knock-on effect market leadership in the equity market. For a while, more value orientated cyclical focused approach worked wonderfully at the start of the year, so here, think your energy companies, your banks, your industrials. Growthier, more defensive type companies typically prefer it when yields start to move lower, as we saw in Q2. So, your Facebooks, your Amazons etc. So our value equities meaningfully outperformed in Q1. Growth was back in the ascendancy last quarter, with around 5% extra return, a meaningful out-performance.

Ahmer: It's interesting that you bring that up Tony, the way that equity markets are hanging off every little move of the bond market. If you look at the correlations for instance, by correlations I mean this is how things move in sync with each other, those big, growthy text docs that you mentioned, have never been so positively correlated with bonds. On the flipside, those value cyclical names that you mentioned, the energies, the banks, have never been so negatively correlated. So, in other words, it sounds like it's never been so important to get that call on bonds just right. And I guess for us when we think about, that was a review of the previous quarter, but if I think about our forward-looking expectations, we do expect the economic recovery to resume and with that for bond yields to go back up again. Mainly because there’s still lots of easy growth to go around, there’s still lots of jobs to be filled and there’s still lots of stimulus to be spent. But having said that though, we aren’t just tilting our portfolios towards the economic recovery. You want investments that can do well even if we're a bit wrong. Now if you put the work in, you can find opportunities that aren’t necessarily geared towards the economic recovery. Most of these opportunities tend to be in the credit space. Tony, you take a lead on this within the team, what are our favourite parts or favoured parts of the credit market?

Tony: Thanks, Ahmer. Yeah, it’s certainly one of the more exciting places for finding slightly “off the beaten track” opportunities. To set the scene, right now 25% of developed Global government Bond issuances are negative yielding, requiring you to pay for the privilege of lending to them, and at the same time big investment-grade companies have never offered you less compensation for lending to them instead. This is quite the dilemma when building a credit book, a fixed income book. To put further context, credit spreads, the measure for this extra compensation ended Q2 at the lowest they've been since 2004/2005. So, while we are very constructive on the economic backdrop and we think that companies with fundamentally sound in paying back that debt, in our opinion in not being paid enough to take that risk. So Ahmer, to answer your question, we have been looking outside traditional corporate credit to find opportunities that provide that increasingly rare mixture of diversification and yield that adequately compensates you for the risk you’re taking. The best example of this I think, is the position we have in US residential mortgages. US consumers have never had so much cash in their pocket or a house that's worth so much. Combine this with mortgage rates at all-time lows, and you create the perfect backdrop for re-mortgage activity. People either want to stay where they are and pay less or move onwards and upwards to a bigger house. So we have a position that directly benefits every time someone re-pays their mortgage, and this equates to an extra 2% yield over and above what you can get if you lent to a corporate credit of similar quality. Another example of where we’re finding opportunities, again, slightly “off the beaten track”, slightly away from the comfort zone of most other investors, is in bank financial capital. Now, going back to the financial crisis, regulators required that the banks issued a special type of capital called “Additional tier 1”. This was in order to protect the financial system. These bonds are a little bit different, which makes them ineligible for traditional indices and just because they are that little bit harder to analyse, a lot of investors shy away. But what we see, is a well-capitalised, low-risk, national champion bank exposure, that is paying 2% more on this debt, than what they are paying on their other more traditional bonds, with very little extra risk when it comes to repaying that debt. This is a second example. I can go on and on, but back to you Ahmer.

Ahmer: Yeah I think it’s an interesting point that you make. People often shy away from the beaten track, they shy away from credit because it can seem more complex, but that share of complexity can be a bit overdone. Afterall, the way that you explain mortgages, the way that you explain about debt, it's not as complex as people see it. But that varies why these asset classes do offer those opportunities and should do well even if the economy doesn't play out in the way we expect. But that is how we manage money at 7IM. We do put in the work to forming our views, to tilting our portfolios towards those views, but above all we look to remain diversified because it’s the risk to our clients’ portfolios that is the most important thing to manage. I think that's it for today. This has been 7 minutes on markets with 7IM. Thank you all for listening and we’ll speak next quarter.

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