By Tim Sharp, Hottinger & Co.
By the end of November, the MSCI World Equity Index had reached a record high, having gained 12.7% in November as three surprisingly positive vaccine test results removed two key sources of uncertainty for investors. By the time the Investment Committee had convened in December the Pfizer / BioNTech vaccine had received emergency approval in the UK and the US with the first vaccinations underway. Furthermore, The Federal Drug Administration (FDA) has approved the Moderna vaccine for emergency use in the US, increasing the options and potential doses available, and the EU has also now approved the Pfizer / BioNTech product. While there may be light at the end of the tunnel, the journey may not be smooth with a potentially tough winter ahead before widespread vaccinations can be rolled out. Renewed lockdown measures in Europe, the UK and the US in the face of a third wave, including the discovery of a new variant of the virus in the UK that has seen travel tunnels and borders from the UK closed, will have already suppressed economic recovery, especially in the areas of economies in desperate need of holiday revenues to survive a crippling year.
On balance, it is likely that fourth quarter growth will slow in the developed world as a result of the most recent lockdowns and restrictions, flash PMI’s were already slowing, and this loss of momentum leaves risk assets in a quandary. Equity market valuations remain historically very expensive despite strong earnings in the third quarter, value as a factor still remains depressed although its outperformed growth by 4% in November, and Europe was the biggest regional beneficiary as the post-vaccine rotation got underway. However, December has seen a partial reversal of the rotation trade once more as the pandemic restrictions are toughened further in an attempt to keep new cases under control. All asset classes are expensive on a relative basis which may explain why equities have broken to the upside on the vaccine breakthrough and 10-year US Treasury bond yields have backed up towards 0.90%. In December so far, the MSCI World is 2.0% to the better leaving it over 10% up year-to-date. An effective vaccine will eventually allow the services sector activity to normalise but in the meantime do investors focus on the immediate, or the fact that we have a timeline to return to normality?
On December 11, the 27 EU members approved the $1 trillion EU budget including the coronavirus stimulus package, and the European Central Bank added $600bn to its bond purchasing stimulus programme. The December US FOMC meeting showed forecasts for inflation and growth moving higher into 2023 while confirming that interest rates would remain on hold, showing the willingness of central bankers to keep the environment accommodative[i]. Furthermore, on Sunday December 20 Congress agreed a new $900bn stimulus package which will avert a government shut down before the holidays, providing more evidence that the headwinds that have threatened to de-rail risk assets are dissipating. While new stimulus packages are still providing support to economies, and vaccines are shortening the bridge to normality, the risks of economies overheating in the medium term are to the upside.
The biggest risk for governments and central bankers is that any change in policy that feels like a tightening of conditions could trigger a “taper tantrum” similar to the surge in Treasury yields experienced in 2013. The reflation trade experienced in October has largely been reversed by the rise in new virus cases this month, and Europe is still suffering deflation. However, a more aggressive rise in 10-year US Treasury yields to 1.5%, or even 2% in the medium term, could see investors become more nervous, while an orderly rise in yields due to a mild rise in inflation could still see risk assets thrive.
Should bond yields surprise to the upside, the path of risk assets may be upset because it has been the falling bond yields that have propped up equity markets by protecting the equity duration trades in technology and healthcare. Although we believe it is unlikely that inflation becomes a problem in 2021, it is the threat that higher inflation uncertainty is skewed to the upside that can cause financial markets to react. We have already highlighted that commodities are a useful inflation hedge for investors and the Bloomberg Commodity Index has returned 3.6% month-to-date although still down 5.6% since the beginning of the year, and gold has regained some of its composure after a poor November to be up 5.25% so far in December reflecting market anxiety at the current news flow.
The final risk to the continuation of the rally in risk assets was highlighted in the recent Asset Allocation Survey carried out by Absolute Strategy Research (ASR). According to ASR, the survey represented the most bullish outlook that they have recorded in the six years that the survey has been running with the highest level of conviction[ii]. The risk is that if everyone is looking for the same outcomes and is positioned the same way, then who is making a market?
Despite the downside potential, we believe that the vaccination programme has the capacity to turn the K-shaped recovery that we have seen during the pandemic into a U-shaped recovery in the first half of 2021, as the valuation gap between the COVID “haves” and “have nots” is given the opportunity to close. The likelihood, in our opinion, is that risk assets remain in favour during the first half of 2021, but eventually absolute valuations cannot be ignored, unless earnings expectations can justify higher levels.
At the time of writing EU-UK trade talks are still continuing in overtime, but the signals from EU President von der Leyen and Prime Minister Johnston suggest that there is now a narrow pathway to a potential deal. The UK parliament has been put on alert to reconvene to debate a potential bill and sterling had strengthened on the positive tones emanating from the main protagonists. Since the start of October, £2.4bn have been pulled from UK equity funds by investors fearing a no-deal outcome, £30bn since the referendum, meaning UK risk assets are under-owned by global investors despite the deep value opportunities being presented[iii]. Brexit uncertainty has caused four years of underperformance by UK risk assets, and if there is a light at the end of the tunnel there may be some interesting opportunities for investors. Month-to-date, the FTSE All-Share Index is up 2.6% while the German DAX Index is down 0.7% and the France CAC 40 Index is -1.4%.
Elsewhere, President Xi has recently suggested that China could double its GDP by 2035 and, while we think this is unlikely, there is little doubt in our minds that China will be the engine for growth in 2021[iv]. The knock-on effect of the increased investor interest in the region especially as China’s weighting in global indices increases, will likely have a positive effect on Asian economies and financial markets. The MSCI Asia ex Japan Index is up 3.4% month-to-date and 19.6% year-to-date showing that investors are already pricing in the reflation trade in the region.
It looks as if developed equity markets will finish the year on a sour note as immediate anxieties dominate developments, but with the passing of the Winter Solstice we may start to see brighter days ahead.
[i] Morgan Stanley Research; December FOMC – Quick Takeaways; December 16, 2020
[ii] Absolute Strategy Research; Q4 2020 Asset Allocation Survey – the Great reflation Trade of 2021; December 10, 2020
[iii] https://www.ft.com/content/fa786784-f60f-43a7-b0e0-71382dcddc82
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