By Tim Sharp, Hottinger & Co.
The scale and pace of the policy response to the pandemic has been significant and, in the US and UK the vaccine roll-out has also been successful. This has increased expectation of a strong re-opening and led to sharp increases in economic growth projections for 2021. Absolute Strategy Research (ASR) is now anticipating US GDP of 10% by Q421 following the $1.9trn American Rescue Plan[i]. The Federal Open Market Committee meeting in March saw Fed Chair Powell restating policy objectives of full and inclusive employment and average inflation targeting; the UK Monetary Policy Committee voted unanimously to leave rates at 0.10% and again stated that policy rates will remain on hold until the 2% inflation target has been achieved “sustainably”[ii]. The European Central Bank announced after its meeting that it will step up its QE bond purchases to prevent a tightening in financial conditions, and we believe that the comments from the Bank of Japan March meeting suggest monetary policy will remain steady in the hope that a rebound in overseas demand will buoy Japan’s export-reliant economy.
Depending on the rate at which economies re-open and the resumption of elements of global trade, we feel there is a risk that the policy response could be over supportive creating over-heating conditions. The rise in inflation expectations has pressurised bond yields and growth stock valuations, in particular technology stocks, and triggered a rotation into cyclical sectors that has been ongoing for most of this year. Inflation remains the central issue for investors and, while March has been a quiet month for financial markets, investors in growth stocks have been anxiously monitoring the US Treasury 10-year yield, which hit a high of 1.77% as March came to a close. The contrasting performances of the S&P500 and the NASDAQ over the month highlight the vulnerability of growth stocks to rising yields, gaining 4.24% and 0.41% respectively, the latter thanks to a technology led rally into the close. ASR does not expect core inflation rates to rise sustainably in 2021, although there could be an increase in the volatility of headline inflation at a regional level, suggesting investors are right to focus on the rising risk on inflationi.
While policy rates may be on hold, anchoring the short end close to zero, there is little central banks can do to control the steepening of yield curves and a move to 2% in US 10-year yields over the course of the year is largely forecast by markets. However, in our opinion a move to 2.5% cannot be ruled out either which triggers discussions as to how far US 10-year yields can retrench without similar moves from UK and European government bonds that currently sit at 0.84% and -0.25% respectively. Plausibly, a widening of the regional yield differential can only go so far before investor demand prevents anomalies from forming in the medium term. Despite investor scrutiny, it is worth considering that the US 10-year nominal yield has only returned to its pre-pandemic levels, and we believe it would probably take a move to positive real yields before investors are tempted into re-investing in the medium term.
The last part of the reflation story concerns earnings growth, and the consensus view is that global earnings-per-share will recover 20 – 25% in 2021. As ASR point out, profits tend to come from rising prices, and it is difficult to see how margins can rebuild without creating inflation from a rise in pricing poweri. It would be unusual to see an earnings recovery without rising inflation even if these pressures do not materialise until 2022.
During the worst of the 2020 sell-off, dividends were suspended, and share buy-back schemes were put on hold. Banks appear to have excess deposits based upon rising household liquidity that we posit will encourage a return of corporate cash management and M&A. Record low interest rates have seen firms balance sheets re-organise over time in favour of debt re-financing instead of equity finance. Many private companies are delaying listing because it seems they have not needed the equity financing to fulfil growth expectations, or they have preferred the backing of increased private equity funding that provides greater flexibility and less regulatory oversight. However, we envisage excess liquidity will eventually encourage companies to seek cheaper equity capital and the rise of SPACs (Special Purpose Acquisition Vehicle) will continue to provide an alternative route to market and will undoubtedly boost the number of new listings and initial public offerings (IPO).
It is likely that the global economy will expand at a rate not seen since the 1980’s in 2021 and US inflation remains the biggest risk[i]. With long bond yields drifting higher as curves steepen it remains likely that risk assets will outperform. We continue to favour value over growth, both at a sector level and regional level, maintaining our interest in European equities which have risen 4.51% in March. Although COVID-related headwinds look set to prevail longer in Europe than in the US, UK, or Asia Pacific, we prefer the valuation of industrials, cyclicals and other value stocks within European markets that are likely to benefit from the re-opening of trading links with Asia. We also believe that the expected investment in “green” technologies in Europe over the next decade will see the region become foremost in many sustainable energy sectors. Similarly, we believe the UK stock market remains the cheapest developed market based on traditional valuation metrics with biases towards sectors such as energy, mining and financials that are clear beneficiaries of a post-COVID expansion. However, we feel that the problems that have emerged following the post-transition UK-EU trade deal will continue to hold back the UK economy in the medium term and we believe that it is not within the interests of the EU to negotiate a services agreement that is favourable to the UK. Over the course of the month the FTSE 100 Index of major companies has gained 3.55%.
We believe both equities and bonds remain expensive on an historical basis, but as ASR show, higher nominal GDP can support higher valuations at least until inflation starts to be a factor[i]. Excess liquidity created by fiscal stimulus plans and above average savings rates will likely continue to provide support to markets in the short term. Investors continue to be optimistic, favouring risk assets and real assets such as commodities, private equity, and property. In our opinion, the key to returns in 2021 may hinge on the management of the back up in real yields and finding alternatives to bond exposure.
[i] Absolute Strategy Research – ASR Investment Strategy Overview – March 23, 2021
[ii] Capital Economics – UK Economics Update – March 18, 2021
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