Having historically been a relatively quiet month owing to summer holidays, August proved no exception as most regional equity indices delivered low single digit returns while developed market sovereign bond yields traded in a fairly narrow range.
The Jackson Hole Economic Symposium panning August 26th to the 28th had been eagerly anticipated by market participants who were keen to gain some insight as to the Federal Reserve’s current thinking on macroeconomic data and monetary policy. As a reminder the Federal Reserve has a dual policy mandate tasked with fostering economic conditions that achieve both stable prices (i.e. average inflation of 2%) and sustainable employment, with Chair Powell having the difficult task of presenting the FOMC’s current thinking on these issues in his speech on August 27th.
Turning firstly to inflation we received confirmation that the Federal Reserve now views this side of its mandate as having been fulfilled. From a short-term perspective, Powell noted the concentration of price rises in the durable goods sector which the Committee continue to view as temporary due to ongoing supply constraints and staff shortages.
Longer term measures of inflation also remain well anchored. In terms of wages there has been some mild upward pressure but only to an extent that is consistent with the Fed’s longer-term objective of 2%.
From an employment perspective the data has continued to improve in recent months although it is worth noting that total US employment is running some 6 million jobs below their February 2020 level (5 million of which are within the service sector). Whilst the total unemployment rate has declined to 5.4% the Committee believes this is “still much too high….and significantly understates the amount of labor market slack”.
Payrolls are expected to have increased by an additional 732k in data released this week and a simple (perhaps optimistic) extrapolation of this rate would imply a full recovery in 8 months time. As such the Committee maintained expectations that they will begin the tapering of their balance sheet prior to year end 2021. Interestingly, however, Chair Powell was very keen to emphasise the separation between balance sheet tapering and hiking rates;
“The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test………
Jerome Powell – Jackson Hole, 27th August 2021
As such our view is that the Federal Reserve will indeed proceed with tapering, perhaps at some point as early as this month. This marks the beginning of a slow withdrawal of liquidity in a market that has very much become accustomed to its provision.
On top of this liquidity withdrawal we also of the view that the peak of accelerating economic growth is now firmly in the rear view mirror. Many of our cross-asset cyclical indicators have been telegraphing this deceleration for several months and have since been confirmed by lower readings across leading economic indicators.
This confluence of factors causes us to adopt a more cautious approach toward markets in the very near term.
One market we are monitoring closely is China, which has seen a very high degree of volatility in recent months as a direct result of government actions. The Chinese government have been tightening their grip on the internet & technology sector since late 2020 through various investigations into monopolistic practices and offshore listings, which have only intensified over the course of 2021 to date.
In our view the crackdown stems from China’s crudely implemented effort to redistribute capital and human talent toward specific sectors within Technology (outside a narrow subset of dominant e-commerce names). The 14th 5-year plan (2021-2025) was released in February of this year and very clearly prioritised the pursuit of ongoing innovation and an increase in technological self-reliance across ‘core’ sectors such as semiconductors and biotech.
The second aspect of their relates to equality. The online Education sector has effectively been forced (via regulations implemented in late July) to become a non-profit sector, with the aim being one of ensuring education is more accessible to its lower earning citizens.
Both of these episodes serve as a useful reminder of the risks inherent to investing in a socialist economy, however we believe recent volatility has also created a number of interesting opportunities in individual businesses.
From a macro perspective China is also not immune from the wider slow-down in global economic data, with the New Orders component of the Chinese Manufacturing Survey having recently fallen into negative territory and the spectre of default risk having risen from the likes of China Evergrande (China’s 2nd largest property developer).
As such the PBOC has already moved to reduce the reserve requirement ratio (the amount of capital banks are required to hold against their lending portfolios) and just last week alluded to likely doing so again in the near future. Allied with a more positive outlook for fiscal expenditure into year-end we expect more accommodative policy to deliver support for Chinese equity markets.
In the years leading up to the great financial crisis British bank Northern Rock had expanded aggressively, turning to international money markets to fund exceptional growth in its loan book. By the summer of 2007 it had become clear that issues originating in the US sub-prime mortgage market would quickly spill over into Europe.
As they did so Northern Rock’s primary source of financing all but evaporated and on the 14th September 2007 the bank’s perilous position was made public. Despite liquidity support from the Bank of England the news triggered the first run on a UK bank for over 140 years. The subsequent 18 months would see the bail outs of Bear Sterns and AIG, the failure of Lehman Brothers, the merger of Lloyds TSB with HBOS, the nationalisation of Bradford & Bingley and the rescue of RBS (among countless other government support programs).
The crisis marked the beginning of major regulatory reform for the banking industry with the aim of increasing resilience across the global financial system. In the years since the banking sector has undergone a significant transformation under the Basel III regulatory framework. These are an internationally agreed set of measures developed by the Basel Committee on Banking Supervision which serve to strengthen the regulation, supervision and risk management of banks.
The result has been a banking sector focused primarily on strengthening and rebuilding its capital position at the expense of both profitability and shareholder returns.
UK Banks – Aggregate Core-Equity Tier One Capital Ratios since the Global Financial Crisis
Source: Bank of England Financial Stability Report, July 2021
A bank’s fundamental role in the economy is to engage in both maturity transformation (i.e. borrowing short dated funds to lend longer dated funds) and credit extension (lending to those whom the bank believes have the capacity and willingness to repay), processes which are hampered by the flattening of interest rate curves. As longer dated interest rates move closer to shorter dated interest rates the available ‘spread’ on bank lending becomes less profitable. These are the very conditions that have prevailed since (and perhaps to some extent because of) the financial crisis.
GBP Yield Curve – 10yr minus 2yr Yields
Source: Refinitiv
In the context of banks striving to rebuild balance sheets, attempting to keep up with incoming torrents of new regulation and wrestling with market conditions that serve to directly reduce their profitability it becomes relatively easy to understand why long-suffering shareholders have experienced so little in terms of returns over the past decade. The below chart highlights this point all too clearly.
FTSE 350 £ Banks Index – A lost decade…
Source: Refinitiv
In our view there are, however, clear signs that this prolonged period of difficulty for banks could be drawing to a close. Here in the UK banks find themselves in the position of being very well capitalised (even relative to the regulatory constraints imposed in the aftermath of the financial crisis) with major UK bank capital ratios some 3 times higher than those heading into 2007 according to the Bank of England. Indeed we can think of no greater test of their supposed resilience than the onset of a global Pandemic resulting in an almost overnight closure of the domestic economy.
According to the Office for National Statistics UK Gross Domestic Product (a measure of the size and health of a country’s economy) contracted by some 20.4% in the second quarter of 2020, the largest decline since comparable records began in 1955.
UK Gross Domestic Product, Quarter-on-Quarter Growth
Source: UK Office for National Statistics
As a precautionary measure in March 2020 the UK’s Prudential Regulatory Authority (tasked with the supervision of banks and other financial institutions) stepped in to request that banks suspend dividends and buybacks until at least the end of the year and, in addition, that the payment of any outstanding 2019 dividends and restricted cash bonus payments to staff be cancelled. We believe this was absolutely the right thing to do given the uncertainties associated with the pandemic and the outlook for economic growth. These actions no doubt helped to stabilise share prices.
Since then the PRA has also begun to undertake its annual solvency stress test for 2021, which assesses the resilience of the UK banking system to ‘a very severe macroeconomic stress’. The interim results of the test were released in July’s Financial Stability Report and have been sufficiently encouraging for the PRA to have lifted the restrictions on bank capital distributions.
Update on shareholder distributions by large UK banks, July 13th 2021
Source: Bank of England, Prudential Regulation Authority
In our view this paves the way for a significant increase in the ongoing return of capital to shareholders at a time when the valuations of many UK banks are exceptionally low (likely a result of their torrid past). Recently announced results have only served to strengthen our belief in this view, with many of the UK’s largest banks having declared significant equity buy-back programs coupled with the resumption of ongoing dividend distributions.
Total distributions* across the domestic UK Banks sector since 2005, £m
Source: Numis Securities
In addition to our outlook for UK banks at the ‘micro’ level (an uplift in capital returns couple with attractive valuations) there is also a ‘macro’ tailwind which we believe could well be on the horizon. Owing to many of the factors discussed above banks around the world have not been growing their loan books at an especially high level (outside of mortgages, which could be a separate blog in its own right). This has had the effect of constraining earnings in a sector which had become far more conservative. Recent data from the US, however, indicates that we could well be entering a period of increasing loan growth which would tie in well with our more constructive outlook for the global economy.
The Senior Loan Officers Opinions Survey is conducted by the US Federal Reserve on a quarterly basis across 80 bank participants and seeks to gain insight on current standards of lending practices and conditions. One of the outputs of the Survey is the net percentage of domestic banks who are currently tightening standards for commercial and industrial loans to large and mid-sized firms (i.e. banks that are making their lending requirements more stringent). Whilst this is clearly US data, the release for July 2021 shows the lowest proportion of banks tightening lending standards on record, a situation which has historically preceded significant expansions in bank lending.
Net Percentage of Domestic Banks Tightening Standards for Commercial & Industrial Loans to Large & Mid-Market Firms
Source: St. Louis Federal Reserve Database
An expansion in global credit could see consumption driven demand increase significantly which has the potential to drive stronger economic growth, persistently higher inflation and perhaps even higher interest rates, particularly at the longer end of the curve as those at the short end remain anchored by domestic central banks.
As discussed above this is a phenomenon which we believe could significantly increase the ongoing profitability of domestic banks, an expectation which can be seen by a cursory look at the correlation of bank equity prices with the overall shape of the yield curve.
FTSE 350 £ Banks Index (Blue) vs GBP 10yr vs 2yr Yield Curve Slope
Source: Refinitiv
In summary we believe that UK banks are finally a position to lay their past to rest and begin to refocus on profitability coupled with shareholder returns. General investor perceptions of the sector remain negative as can be seen through the lens of valuations which we believe remain low in the context of both history and future potential.
The success of the vaccine roll-out in western economies seems to have checked the economic impact of the increased cases of the Delta variant with increasing evidence that the relationship between new cases and hospitalisations and deaths has been disrupted, while the developing world where vaccination penetration remains low, risks remain elevated[i]. This has caused some jitters in financial markets that the removal of restrictions may be delayed with the inevitable effect on global growth.
The IMF released its latest report this week on global growth, warning that limited access to vaccines risks hindering the global recovery by splitting the world into two blocs. However, by cutting the forecast for emerging markets and increasing the forecast for the developed world the overall global growth forecast remained at 6% for 2021. The UK gained the biggest uplift to 7% with the economic impact of the rise of the Delta Variant in the developed world difficult to calculate. The second risk is that inflation may prove to be more persistent than currently anticipated prompting a more aggressive central bank reaction[ii].
Interestingly, fund flows into fixed income have overtaken equity flows year-to-date in July, according to Barclays, although equity flows are also still positive. The level of Treasury holdings on bank balance sheets has soared in line with the savings rate and there has been a public warning from a consortium of 30 private and public sector experts including Timothy Geithner, Larry Summers, and Mervyn King regarding the stability of Treasury markets. Recommendations include a single marketplace, and a mechanism by which the Fed can provide participants with a short-term swap for cash to provide liquidity that can dry up at times of extreme stress as was seen in March 2020[iii].
The US Treasury ten-year continues to ignore the current strength of inflation preferring to believe that temporary supply bottlenecks are the route cause, due to an uneven reopening, with the yield dropping to 1.24%. Moreover, there are signs that some pressures are easing with prices in lumber and other raw materials lower, and the semi-conductor shortage working its way through in the auto sector[iv]. It would appear that markets have suffered a growth shock rather than fears surrounding elevated inflation which has expressed itself in a curve flattening as long duration bonds reflect global growth fears.
Morgan Stanley challenges the notion that global growth is weakening instead seeing a strong economic recovery underway. They believe second quarter US GDP is going to be approximately 12% and continue to estimate global growth for 2021 of 6.5%i. We continue to believe that despite the recent value to growth rotation, the movement towards stocks with stable earnings, strong cash flow generation and robust balance sheets will provide an element of consistency and protection to valuations.
Second quarter earnings have started strongly with Absolute Strategy Research (ASR) predicting 55% year-on-year gains although guidance remains key for investors particularly when valuations are so stretched[v]. Interestingly US Treasury thirty-year yields have dropped to 1.89% while the S&P500 dividend yield is 1.76% and until bond markets start reacting more consistently to the expected path to higher inflation this will help underpin equities. Most notable to us has been the strong results from the global banking sector which has seen loan reserves reduced following unexpected corporate strength during the pandemic, the resumption of dividend payments in many regions, and strong revenue gains. We believe that a strong performance from banks will further underpin equity markets and add to investor confidence.
The outperformance of US equities has been related to the strength of the US dollar over the last two months, in our opinion, and the rise of long-term growth stocks as bond yields have fallen. The S&P 500 gained another 2.3% in July versus 1.7% for the MSCI World Index. If the rotation back into growth stocks proves to be a short-term reaction to the rise in Covid-19 cases, then we would expect to see European equities come back to the forefront. The EU’s Next Generation Recovery Fund sees 71% of spending aimed at key green and digital transmission investments which are expected to have long term productivity enhancementsiv.
Fears of global slowdown, rising coronavirus cases, weaker commodity prices, a Chinese Producer Price Index inflation rate of 9% and a stronger dollar, was not a comfortable environment for developing markets although the difference between commodity exporters and importers saw Latin America outperform Asia and the broader index albeit to the downside[vi]. Declines in Chinese internet stocks such as Alibaba, and Tencent have been significant as Chinese regulators continue to step up their oversight and plan heavy penalties in the technology, private education and food delivery sectors causing anxiety amongst investors[vii]. This also leaked into the heavily debt-laden real estate sector where the authorities are trying to cool demand with new restrictions. We believe a renewal of the long-term trends including a return to dollar weakness should see emerging markets recover once more.
Following last month’s research into corporate debt markets we believe corporate credit spreads offer little value to investors with added duration risk, and in line with our views on the relative attraction of emerging market currencies we see emerging market local currency debt as an area of fixed income that still offers opportunities to investors. The expected path of developed market government bond yields and the expectations of a continuation in the steepening of the curve leaves investors looking to reduce bond exposure in the interim. We continue to favour the relative valuation of developed equity markets and the strengths of quality stocks particularly in the UK and Europe. The flash GDP release for the Euro Area rose by 2% quarter-on-quarter in the second quarter well above consensus expectations of 1.5% marking the beginning of a cyclical rebound that could see pre-crisis levels by the fourth quarter[viii].
[i] Morgan Stanley – Summer Doldrums _ Where Do We Stand? – July 25, 2021
[ii] IMF World Economic Outlook – Fault lines widen in the global recovery – July 2021
[iii] Financial Times – Flawed $22tn US debt market a threat to stability, warn grandees – Colby Smith, July 29,2021
[iv] Absolute Strategy Research – Investment Committee Briefing – July 1, 2021
[v] Absolute Strategy Research – Supply Constraints and Inflation Favour Cyclical Stocks – July 15, 2021
[vi] Comparison of MSCI Indices on the Refinitiv platform by Hottinger Investment Management
June, much like May has been dominated by concerns regarding rising inflation. The statement following this month’s Federal Open Market Committee (FOMC) meeting was more hawkish than expectations but rather than suggesting the US Federal Reserve (Fed) is going to pull back from Average Inflation Targeting we believe pointed to the fact that the committee had started to discuss a timetable for reducing or tapering Quantitative Easing. There was actually no change in policy and little change in economic outlook, although the committee members’ “dot plot” interest rate projections showed seven members electing to pencil in the first hike for next year and most had moved to two hikes in 2023. This probably indicated that the Fed was potentially behind the curve and is now more aligned with markets[i].
The rebound in global demand and the continued increase in job openings has seen several bottlenecks emerge in supply side production, as well as logistical constraints, that have pushed US core inflation to its highest rate since 1995[ii] leading many investors to question the transitory nature of the strength in inflation. For our part we tend to agree with the Fed and the Bank of England that the current jump in inflation is tied to irregularities in the reopening of economies and the continuing fiscal support offered by governments making employment in low paid sectors less attractive meaning that this may prove to be the peak in near term inflation pressures[iii]. There is little doubt in our opinion that the risks point to higher inflation over time and that the loose monetary and fiscal conditions probably rule out future deflationary trends.
From a developed equity perspective, markets had a wobble following the FOMC meeting as the change in rhetoric caused a rotation into defensive stocks away from cyclicals sectors. Absolute Strategy Research (ASR) point out that this actually started in May when indicators suggested inventory conditions were tight and the FOMC meeting purely underlined this message[iv]. Morgan Stanley have been ahead of consensus with their mid-cycle transition from consumer discretionary into consumer staples but are receiving push back from clients due to the belief that the savings glut will perpetuate the re-opening trade. Morgan Stanley counter that over-consumption in 2020 will likely curtail the re-opening trade and discretionary spending is more early cycle than mid-cycle[v]. Interestingly, June saw Russell 2000 Growth Index significantly outperform the Value Index by approximately 5.29% with Banks and Resources stocks under pressure, suggesting that the reflation trade may have peaked near-term. However, we believe the underlying current in equity markets remains optimistic and investors took advantage of opportunities in the recent re-balancing to invest in long term equity holdings.
In our opinion, we have reached the stage where owning robust, fairly valued stocks in companies with strong cash flow and low debt; that have shown an ability to perform in different parts of the cycle will likely offer an element of downside protection in long-only portfolios. This description lends itself most naturally to defensive, value stocks but we also see many examples of expensive equities in such sectors. This could be an opportunity for good stock-picking to overcome sector allocation, and growth vs. value, however, we still favour banks and materials as the best way to play rising long term inflation trends.
Regionally, we have positioned ourselves to take advantage of the green energy investment that is being rolled out in Europe and continue to believe that the discount currently experienced by UK equities vs. other developed markets will close. We posit current M&A trends suggest the value in the UK has been recognised at an institutional level and we believe that equity investors will also want to increase their participation in UK markets[vi]. During June the FTSE All-Share index was flat on the month while the MSCI Europe ex UK Index gained 1.89%. Finally, Japan is the last developed value market that continues to underperform developed markets, the Nikkei 225 Index was 0.24% weaker over June. There are good reasons for Japan to outperform in this environment as pointed out by ASR – weaker Yen, rising US Treasury yields and stronger dataii. However, the vaccine roll-out has seen a slow take up by the population so the threat of another wave of the Delta variant cannot be ruled out, and the slowdown in China has potentially also affected Japanese sentiment- in our opinion.
Developments in bond markets, most notably the lack of further upside in 10-year US Treasury Yields despite rising inflation concerns also point to the markets belief that current inflationary pressures will prove transitory. The current 10-year benchmark yield started the month at 1.61% already well off the high of 1.73% and is currently 1.46% with inflation break-evens already pricing in high inflation expectations. Our investigations into credit markets concluded that the tightness of spreads, with the likelihood that developed markets could only tighten further, leaves very little return for investors.
Moreover, we believe it is unlikely that the outlook for the second half of the year will disrupt credit markets so our emphasis should perhaps shift to Emerging Market debt. The case for Emerging Market currencies to strengthen over the course of 2021 further suggests to us that a local currency emerging market debt fund may be an efficient way of capturing positive returns.
The expected path of developed market government bond yields and the expected continued steepening of the curve leaves investors looking to reduce bond exposure in the interim. With the risks to inflation firmly to the upside the move to include commodities, real assets, and alternative strategies at the expense of traditional fixed income exposure will continue to occupy this committee and other multi-asset investors. Gold had rallied strongly in May but failed to hold on to those gains in June falling from a high of $1908 to $1770 over the month. The future path of Gold will probably be a trade-off between a weaker dollar and rising real yields following already stretched break-evens rather than any correlation to Bitcoin, suggesting to us a move lower under this scenario in the medium term.
[i] The J.P. Morgan View – FOMC meeting isn’t a game changer – June 21. 2021
[ii] Absolute Strategy Research – Investment Committee Briefing – June 2021
With the global pandemic now firmly in the rear-view mirror we have been reflecting on the performance of various economies and markets over the past 12 to 18 months. Since the pre-pandemic peak in late February 2020 global equities (as measured by the MSCI World Index) have delivered returns of c.17% to UK investors. Europe has closely followed suit (delivering a 14% return) but the clear laggard has been the UK itself, with the FTSE 100 being effectively flat over the same period.
This is perhaps unsurprising given the number of headwinds over recent years, but as the clouds begin to part we find ourselves becoming increasingly optimistic on the outlook for the UK.
Enthusiasm for UK equities, which had already been dampened by protracted Brexit negotiations, has struggled further under the weight of the pandemic given a particularly high market exposure to those sectors most affected by lock-downs.
Even prior to the Brexit vote global fund managers have generally been underweight the UK market, preferring instead to maintain exposure to those markets geared toward secular growth dynamics (US Tech being the clearest example);
This makes absolute sense in a world where economic growth is scarce and interest rates are low. However, for now at least, that does not appear to be the situation we find ourselves in.
Successful vaccine roll-outs are beginning to take hold and continued re-opening looks set to drive a wave of demand from consumers all across the developed world, many of whom are waking up to the fact that their bank accounts are full of unspent earnings and/or unemployment benefits.
Household savings rates here in the UK remain elevated and from our (perhaps optimistic) perspective this provides a supportive backdrop for spending in the months ahead;
Source: ONS
The true scale and duration of fiscal support packages is yet to be seen given the politics involved, however there is little doubt that it will come through in one form or another. This provides yet another leg of support for the stool of economic growth.
As a thought exercise we felt it useful to identify and expand on some of the key reasons why we feel the UK market is especially well placed to deliver more attractive returns on a forward-looking basis;
An increasingly robust intellectual property base – The UK offers an almost unparalleled breadth and depth of IP, spanning its football clubs (almost half of the top 30 global football clubs by revenue) to its universities (3 of which consistently feature in the world’s top 10 universities). This is not to mention the disproportionate impact UK scientists had on the impressive and rapid development of a Covid vaccine.
Economic strength – Whilst not boasting the headline GDP growth numbers sported by some other countries the UK can hold its head high in having maintained a consistently low unemployment rate (particularly when compared with those in Europe & the US).
Funding strength – One consequence of higher bond yields (which we have seen over recent months) is that it increases the cost of a governments borrowing. This is likely to become more of an issue over time and it is worth noting the UK has by far the longest average term to maturity of its debt across the developed world (17.8yrs vs just 6 in the US). This essentially means the UK has fixed its borrowing costs for a much longer period and thus has lower refinancing risks than many other economies.
Falling political risk – Clearly Brexit and the associated uncertainty has weighed heavily on the UK as a whole. However, with the most critical negotiations now behind us we see many reasons to believe that excessive risk premia associated with Brexit should begin to recede. It also feels increasingly clear to us that leaving the EU also allows the UK government to turn its attention more toward stimulating domestic investment and growth.
Cheap equity valuations, cheap currency – The UK market continues to trade at a significant discount to other developed markets and has more recently traded at lower earnings multiple than the (arguably much riskier) Emerging Market equity universe;
This is a fact that does not appear lost on overseas investors given the significant pick up in M&A activity YTD, with overseas corporate and private equity investors looking to take advantage of this apparent dislocation.
All in all, we can think of far more reasons to own UK equities here than not to. Whilst it is very possible that we are being overly optimistic about the outlook the balance of risk and reward appears to be very much in our favour.
Equity markets appear to have stalled during May as the two main catalysts of reopening economies and reflation seem to have run their course in the short term. The MSCI World Index is up 1.26% in dollar terms during the month and despite the continued apparent “buy-on-dip” mentality which is still holding markets firm, the bounces in growth and reopening plays have been shorter lived each time. The S&P 500 outperformed the NASDAQ again in May 0.55% versus -1.53%, but the near-term catalysts do not seem to be enough to drive valuations from here at present. Towards the end of the 1st quarter the correlation between increased volatility and returns was high, suggesting strong risk appetite amongst investors, but this month the same measure for global equity risk appetite is far more neutral[i]. Furthermore, as noted last month, the share price reaction to the Q1 US earnings beats continues to be muted by historical standards as investors look at the guidance for signs that companies will be able to sustain margins[ii]. The question is whether this leads to a broader weakening in risk appetite that would point to a near term high in bond yields.
The European earnings season is by contrast slower to evolve than its US counterpart with 217 out of 600 companies having reported at the time of analysis, however, earnings have beaten expectations by 31% which would be the best result in over a decade according to Absolute Strategy Research (ASR)[iii]. This would point to a quicker recovery than initially expected with year-on-year earnings growth of approximately 150% and the sales-earnings ratio points to a profit margin exceeding pre-pandemic levels. ASR confirm that this would be the highest level for 15 years further underlining our belief in the prospects for European equities[iii]. European equities have had a solid month with EUROSTOXX gaining 1.87%, the CAC 40 gaining 2.83% and the DAX 1.88%.
We believe the UK could be the cheapest of the main equity markets based on historical metrics, with a high weighting towards both value and the reflation trade through energy, basic materials, financials, and consumer staples sectors. The FTSE 100 has had a flat month up 0.76% while the more domestically oriented small cap index gained 1.97%. The vaccination rollout has gone well and the government looks to have strong approval ratings following recent elections, so the domestic landscape in the UK should be attracting investors. We posit that the contraction in Q1 GDP reflected the tighter restrictions following the rapid spread of COVID variants, while statistics suggest a rapid recovery is now underway and that the gap that exists to other developed markets could close by the year end.
Despite warnings from many economists that a transitory increase in inflation should be expected as restrictions ease, the markets have still been surprised by the strength of supply side inflation and an unexpected tightness in labour markets. We are now in a period where base effects will push the annual rate of inflation higher, but we are also witnessing considerable supply chain cost pressures coupled with increases in demand. Although these pricing pressures are expected to dissipate over the coming quarters, markets were jolted by May’s employment report which determined that just 266,000 new jobs had been added versus an expectation of 1,000,000. Many new openings are reportedly unfilled by a workforce that seems unenthused by the prospect of employment[iv].
The pandemic has seen a move from monetary policy responses, such as quantitative easing after the Global Financial Crisis, to an increase in fiscal policy by developed economy governments looking to build an infrastructure capable of supporting the bounce back in global growth. The increase in infrastructure spending has also seen increased momentum in green infrastructure spending, particularly in Europe, in the build up to the COP26 climate summit in November. The need to provide plans on how to achieve the transition to a sustainable world will also highlight the costs to both public and private finances, with ASR pointing to an estimate of $1trn of additional spending per year[v]. Increases in government spending normally lead to a focus on the tax regime for funding. While there is more emphasis on employee welfare and the living wage, it is widely reported that the Biden administration under Treasury Secretary Janet Yellen has been pushing for a landmark agreement that will see a new base in place in the developed world for corporate taxation that will inevitably reverse the trend in lowering the corporate tax burden. This will potentially affect future earnings, increase the pressure on margins, and further add to investors anxieties regarding valuations in our opinion.
The uneven vaccine rollout still seems to be hindering the growth trajectory in many developing countries as countries such as India struggle to cope with hospitalisations. We believe that the disparity that exists in vaccine access could be a long-term drag to global growth and could be detrimental to developed and developing economies alike as the pervasive spread of the virus will significantly heighten the chances of new vaccine-evasive variants mutating. Although the Shanghai SE Composite Index bounced 4.89% in May, Chinese equities have also been weak for most of the year as credit conditions have tightened, restraining economic activity particularly in areas such as real estate. We expect this will influence global growth and may create a headwind for commodity prices in the medium term. Copper eked out a gain of 2.12% after a volatile month while Gold rallied 7.79% again suggesting that perhaps investor risk appetite may be waning.
We have noted on many occasions that historically there exists a negative correlation between equities and bonds and have used this as a reason to hold over-priced government bonds in a multi-asset portfolio. However, at inflection points we see that all asset classes tend to align, and ASR have noted that over the past 3 months the US stock-bond correlation has been at its highest in 20 years at 44%, meaning that on several days of equity weakness over the last month, bond markets have not rallied as expected[vi]. The US Treasury 10yr yield still sits at around 1.58%, similar to where it started May. This positive correlation may point to an increased investor concern at the inflation risk premium and the inherent uncertainty, or it may prove transitory much like the inflation currently being observed in western economies. Nonetheless, we believe it is further proof that bonds do not currently provide the same hedge of equity risk that they once did.
As inflation expectations reach an inflection point, the nervousness in financial markets has led to our continued focus on alternative investments. We are monitoring our existing alternative and multi-asset strategies with a view to comparing them to other options and strategies with lower correlation to traditional asset classes over past periods of volatility to ensure we have the blend of exposures that we currently desire.
[i] Absolute Strategy Research – Risk appetite reaches inflection point – May 26, 2021
[ii] Absolute Strategy Research – Strongest Earnings Season in 15 yrs – April 29, 2021
[iii] Absolute Strategy Research – European Earnings on a Tear – May 11, 2021
Last Friday (May 7th) saw a major disappointment for US economic forecasters. The Department of Labor’s closely followed employment report showed the economy having added just 266,000 jobs over the month of April [1]. Whilst this is an unquestionably large number it compared starkly with a consensus expectation of over 1,000,000 newly employed Americans.
The resulting unemployment rate leaves the US economy needing to add back over 8 million jobs in order to regain pre-pandemic levels. This is a huge feat and it could be argued that April’s report was a disappointing first step.
Looking across a broad spectrum of economic indicators suggests the outlook for growth in 2021 remains incredibly robust, with the supply side scrambling to regain its footing sufficiently quickly to meet the incoming wave of demand as economies reopen. The National Federation of Independent Business (NFIB) produces a monthly survey [2] in which over 44% of respondents reported having job openings that they were simply unable to fill during April.
In our view there are a number of specific issues reducing the speed with which US businesses are able to take on new workers;
Unemployment Insurance – The US Treasury introduced a number of emergency assistance programs for American workers in the wake of Covid-19. The primary source of income for those affected stems from the ‘American Rescue Plan’ which was initially introduced in March 2021 and will continue to distribute $300 per week for qualifying individuals until early September 2021.[3]
Fear – A US Census Bureau survey conducted in late March found that over 4.2m adults are currently not working because they are afraid of contracting or spreading the virus. [4]
Early Retirement – Many of those in the later stages of their careers are taking the decision not to go back to work at all as and when life returns to normal. A recent survey from the New York Federal Reserve showed that the number of people expecting to work beyond the age of 67 fell to a record low of 32.9% last month [5]. This makes some sense in the context of equity markets (and hence retirement accounts) sitting at all-time highs coupled with ongoing strength in the value of US housing.
Childcare Availability – Many schools and childcare centres remain closed, with some likely to remain so indefinitely given low operating margins, reduced enrolments and higher costs as a direct result of the pandemic.
One issue that has so far received little media attention is the idea that the virus has given people sufficient time and space to consider a much broader re-assessment of their working lives. A recent study from the Pew Research Center found that 66% of those surveyed have seriously considered changing their occupation or field of work altogether since becoming unemployed [6]. It is not a huge stretch to imagine that we could be facing a skills mismatch which is under-appreciated by markets.
Some of these challenges will, of course, resolve themselves naturally over the coming months but any hint of persistence in labour market tightness will only add to the already long list of existing challenges faced by goods and service providers who are struggling intently to keep up with demand.
So, what does this mean for markets? For some time, we have maintained a bias within portfolios toward more inflation-sensitive assets such as UK & European equities, Commodities, Real Assets and Inflation-Linked Bonds having steered gently away from those assets where valuations appear to be particularly vulnerable to higher interest rates [7].
Our analysis of government bond yield curves, inflation-linked assets, commodity, and equity markets all point to a market which, in our view, firmly expects that current levels of inflation will prove to be transitory in nature. This analysis holds true even in the wake of last week’s Consumer Price Index (CPI) data, which came in at a much higher rate than generally expected (4.2% per annum, a rate last seen in September 2008) [8].
The longer term dynamics of inflation are perhaps beyond the scope of this article but the balance of risks suggest to us that, at least for now, inflation could well prove to be higher and more persistent than many appreciate.
Most importantly this is an outcome that we believe is not currently being priced by markets, hence one that we feel comfortable in maintaining some exposure.
The key development in Q1 has been the rise in US long bond yields as curves have steepened, leading to the outperformance of financials as shown by the strong Q1 results season for banks. Better than expected earnings per share performances resulted from lower-than-expected loan loss provisions, while strong corporate and investment banking results were supported by sustained M&A activity and private equity gains. We believe the operating environment is likely to remain strong as the developed world starts the reopening process, which should stabilise loan books and increase core fees. Whilst higher bond yields do suggest a reduction in GDP from a macro perspective and a higher discount rate for equities, the stronger outlook that has been the driver of the move in yields is likely to offset these consequences. A main threat that we envisage would be to weaker, indebted, corporates and Emerging Market debt should the dollar strengthen further due to higher yields and improved US growth prospects.
Since the Global Financial Crisis, we have seen the use of cheap debt by corporates to fund financing including share buybacks, and we believe this has led to a major shift in debt vs. equity finance on company balance sheets. Furthermore, due to the level of cheap debt, many private companies have managed to stay private for longer delaying the need for them to seek equity financing or release equity for the founders through IPOs or Special Purpose Acquisition Companies (SPACs). There are signs that this is changing with the number of new SPACs so far in 2021 outstripping 2020 and the increased level of IPOs coming to market could be a sign that insiders wish to take advantage of extremely high valuations. Rising bond yields may give cause for companies to reduce their debt burdens rather than cut CapEx as M&A and equity raising heightens to record levels despite the pandemic[i]. We think an IPO boom would also be good news for bank profits and corporate finance fees as companies look to reverse the de-equitisation theme.
April has seen the start of the Q1 reporting season and S&P500 companies have reported an average 27% upside to analysts earnings estimates so far. Absolute Strategy Research (ASR) is predicting that global and US Q1 earnings could beat 20%, meaning year on year growth could reach 60%, although many are focusing on the Fed’s forward guidance for signs of permanent economic scarring. Interestingly, the share price reaction to such strong results has been the weakest for 25 years, suggesting sustainability of earnings may be a concern particularly given increasing cost pressures[ii]. It may be that companies with pricing power may hold the key. We can see that the strength of the reflation trade, that has led to strong performance in European markets this year, has been partially reversed this month under the pressure of further global outbreaks of Covid-19, the threat posed by potentially vaccine-evasive variants, an asymmetric vaccine roll-out programme and growing geo-political tensions primarily between Russia and the US. This has led to a release of pressure on the US 10-year Treasury yield, dropping from 1.7450 to 1.5452 before settling at 1.6425, and a weakening of 2.10% in the US Dollar Index[iii].
European economies have also been a victim of a surge in Covid-19 cases and a less-than-perfect vaccination plan that has resulted in Brussels seeking legal action against AstraZeneca for limited supply. Although all developed equity markets have had a promising start to Q2, value has underperformed growth meaning the NASDAQ is up 5.6% and S&P500 5.2%, while the Dow Jones Industrial Average has returned 2.7%, UK FTSE All-Share 3.9%, CAC40 3.3% and the Dax 0.9% – where political tensions have taken their tolliii. It may be tempting for certain investors to consider rotating back into expensive, defensive sectors often associated with the 2nd phase of an economic cycle after the reflation trade. However, inflation expectations are pointing higher in Q2, US GDP growth could surprise to the upside for FY 2021, and fiscal stimulus remains firmly on the political agenda, therefore, we continue to favour the reflation trade.
In general, economic data remain strong, especially in manufacturing as the service sectors are still restricted, and ASR point to the relationship between Frankfurt airfreight data and Global GDP. If volumes are maintained at the current levels, ASR expects H1 2021 world trade growth could reach double-digits[iv]. Therefore, while we have seen a reversal in reflation themes over the course of the month it is still early to assume that the cyclical upturn has been fully discounted. Over the course of the month Brent crude prices gained 6.7% and general commodity indexes jumped 7.6% including gold climbing 3.6%iii.
Notably, copper has just moved above $10,000 for the 1st time since 2011 due to increased demand from China but also fresh demand from the rest of the developed world due to the role copper plays in many environmental, “green infrastructure” sectors. The EU Recovery Fund, the US Infrastructure bill, and the focus on COP26 later this year could potentially maintain the demand for copper in the longer term as the metal is expected to play a vital role in the shift from hydrocarbons to sustainable energy sources. As reported in the Financial Times (FT), Goldman Sachs has dubbed copper “the new oil”[v] and ASR reported that the Copper Alliance state that many renewable energy systems use 12 times more copper than traditional systems, while electric vehicles can use 4-5 times more copper than vehicles using the internal combustion engine[vi]. The FT notes that this is only the 3rd time in 20 years that copper could significantly rely on refined inventories to match growing demand meaning that the risk to the price is firmly to the upside.
The IMF amongst others has been concerned about divergent economic performances globally as developed economies open before developing, however, ASR point to global PMI’s that show that 22 out of 24 are higher than a year ago and 16 are up over the last 3 months from January 6[vii]. It is, therefore, likely that the strength of inflation will remain the main risk to financial markets over the coming months which will continue to support the reflation trade. Excess liquidity created by fiscal stimulus plans and above average savings rates will continue to provide support to markets in the short term. The retail ‘Reddit’ phenomenon looks as if it may be more than a passing trend and seeing as amateur traders can be responsible for up to a third of all stock market trading on a given day[viii], we believe that small investors will continue to play an important role in shaping the movements of the US equity markets as well as the increased volatility that goes with their participation. We think the combination of higher nominal GDP and the strength of global liquidity can support higher equity valuations, at least until inflation starts to be a factor, as US indices continue to hit all-time highs.
All in all, the reflation trade took a rest in April as markets began to worry about the pace and shape of the re-opening of the global economy, but we still believe that the risks are to the upside and continue to favour the reflation trade. We feel both equities and bonds remain expensive on an historical basis, but we expect continued support for equities in the medium term with the markets potentially under-estimating global economic strength. We continue to evaluate alternative revenue streams and bond proxies in the light of inflation risks leading to higher bond yields.
[i] ASR Investment Committee Briefing – April 1, 2021
[ii] ASR Equity Strategy – Strongest Earnings Season in 15 yrs – April 29, 2021
In March 2020, the world ground to a halt as a result of the coronavirus pandemic. Whilst we’re still feeling its effects more than a year later across almost all sectors, tourism and hospitality have perhaps been more affected than most.
We still talk in terms of ‘getting back to normal’, but is that really going to happen? For the travel sector, at least, I don’t think so.
Some pre-existing trends have accelerated as a result of the pandemic and some new ones have emerged. Opportunities for both domestic and international travel will return as restrictions ease, but the sector will be forever changed.
The shifts in demand that we’ve seen over the past year will not only alter the products and services offered by the industry, but also the economics of the travel sector. This will create opportunities for savvy investors.
What luxury travel trends are emerging as a result of the pandemic?
Covid has sent a gradual trend towards lower-volume, higher-spend tourism into overdrive, and we don’t think it is going to reverse entirely when the pandemic is over.
Time with family has become more precious than ever after more than a year of enforced separation[i]. We see people wanting to travel in their own bubble and stay in their own, segregated space. This is playing out in increased demand for single-household self-catering properties and smaller boutique hotels, to the detriment of larger chains and hostels with communal facilities.
A desire for ‘slow travel’ is emerging. People who would ordinarily try to cover as much ground as possible in a trip – perhaps moving to a new location every single night – now want to slow down the pace and find themselves a base for multiple days at a time. After a period of so much uncertainty, the value of familiarity has increased, which is good news for providers as it increases the likelihood of repeat business.
Flexibility is the number one request by post-covid luxury travellers. Having seen how quickly things can change, they want to know they will not lose out if circumstances outside their control prevent them from travelling. Providers of accommodation and transport have had to keep pace with this in order to make any bookings at all, often taking on a great deal of risk themselves in order to offer travellers the flexibility they crave. Non-refundable deposits, advance prepayments, and lengthy lock-ins appear to be a thing of the past. It will be interesting to see if travellers will allow providers to revert to type once the pandemic is over – we suspect not. This could be challenging for smaller operators whose minimal cash reserves mean that late-notice cancellations and refunds hit hard. The counterpoint is that demand for the very best places is higher than ever, so travellers may find themselves having to pay a premium or accept inferior conditions to secure the location or accommodation they want.
Coming from a financial services background and being familiar with a heavily regulated environment, navigating the requirements of the Package Travel Regulations and putting in place financial protection for clients’ bookings was non-negotiable when setting up my business. It’s paying dividends now as clients increasingly look for reassurance, membership of an industry group (such as ABTA or ABTOT) and the peace of mind they gain from regulatory protections.
Travel and hospitality businesses have had to get used to doing things very differently in the last year. In times when face-to-face contact was considered dangerous, luxury hotels – for example – had to make a normally high-touch service work with as little human interaction as possible. Those who invested in technology were able to automate their processes and provide a slicker customer experience, allowing them to stay open for longer[ii].
Despite the lack of physical contact, travellers still value a human touch in the planning and booking process[iii]. They want access to knowledge that others may not have from an experienced person who will listen to their preferences and provide recommendations.[iv]. This puts tour operators in a great position – their expertise is now not only valuable in helping someone have a great holiday, but potentially also in keeping them and their family safe[v]. The stakes couldn’t be higher.
In summary, post-covid luxury travellers are holidaying in smaller groups with space of their own, and they’re demanding a more personalised, flexible and protected booking process which they don’t mind paying for. The net effect is a move up market. For destinations like Scotland, this has accelerated a shift that was already underway, but the pandemic has propelled it forwards much more quickly than expected.
‘Staycation’ boom – the good, the bad and the solution
Driven by concerns about flying, fear of crowds in airports, and nervousness over fast-changing regulations at home and abroad, demand for domestic travel has increased enormously since early 2020, with a boom in ‘staycations’ widely reported in the UK. This has exacerbated already extant tensions between communities resident in popular tourist destinations and the tourists who flocked to them as soon as restrictions were lifted. Locals who had been shielding since March reported being afraid to go out due to the crowds. Rubbish bins overflowed, a lack of public toilets had predictable results, and narrow roads were blocked by inconsiderate parking. Infrastructure that barely coped in a normal year was overwhelmed, especially in some of the UK’s most remote locations.
Responsible tourism is the answer to these challenges – it’s not only the right thing to do for the environment and local communities, but travellers are increasingly likely to demand it[vi]. As a tour operator, we can help by spreading demand, marketing less-visited hidden gems and stretching the season to include the shoulder months of March, April, October and November.
I made the conscious decision when setting up The Tartan Road that we would not actively market the main tourist hotspots in Scotland during the summer, and in some cases we would actively discourage travel and offer alternatives if we felt this would be in the best interests of the client and/or the local community. The Isle of Skye, Scottish Highlands and NC500 route are justifiably very popular, but there are equally lovely – and much less busy – areas of Scotland to discover during the peak summer months. An escape is no longer an escape if thousands of people flock to the same spot at the same time!
Our efforts this year are focused on Dumfries & Galloway in the south west of Scotland – easily accessible from England by car and packed with history, outdoor activities and beautiful scenery, including some of the best (and emptiest!) beaches in the country. The north-east coast is another gem, from Inverness and the Moray Firth round to Aberdeenshire and Angus, and inland to the Cairngorms National Park. These areas are just as stunning as the west coast and western Highlands, but likely to be far less busy in the summer.
We feel it’s our job – as responsible business owners and travel organisers – to help prospective visitors find out about places they may not have considered. If it works, there will be less overcrowding in the key hotspots, much-needed business for quieter areas, and travellers will get the escape they crave. Everybody wins.
What does this mean for investors?
If the trends discussed above play out as expected, firms focusing on luxury, small group and single-household trips are likely to perform better than those catering to larger groups or budget and mass-market tourism.
Travel and leisure companies whose stocks have traditionally performed well may have to invest heavily in order to navigate the new normal, which is putting some investors off. That said, stocks in this sector already took a significant tumble in January this year[vii], so they may still represent good value if you expect demand to bounce back over the longer-term.
Opportunities are emerging for shrewd investors to acquire shares in struggling boutique hotels, B&Bs and other tourism and hospitality businesses with the aim of turning them around and benefitting from the expected recovery. We are seeing new structures emerging here in Scotland: new funds focused solely on distressed hospitality and tourism ventures, and innovative management models with equity-based rewards replacing the usual cash retainers.
What we expect this summer
It seems clear now that travel between the UK and overseas destinations will resume in some form during the course of 2021. Having initially refused to give much clarity at all, the UK government has recently been speaking more positively about the prospect of foreign holidays this year[viii].
The bigger question is whether travellers will be put off by the level of complexity, the necessary testing and isolation requirements and the potential for rules to change quickly and leave people stranded. At what point does the reward of going on an overseas holiday no longer justify the level of risk and effort? Thresholds may be different for each individual, but there will be a limit beyond which demand is just not there.
Regardless of the exact rules that emerge, we expect to see fewer people than normal heading overseas this year, and more holidaying domestically as a result. Some of this demand is likely to persist even as unrestricted overseas travel resumes.
What can Scotland offer travellers?
From outdoor adventures, unspoilt landscapes, incredible wildlife and dramatic scenery to vibrant cities, world-class food and drink, art, culture and history, there’s a real quality and breadth to what Scotland can offer visitors.
Here are some of the most fun trips we’ve recently put together for our clients:
A self-drive trip for a history enthusiast taking in some of the most beautiful and scenic areas of Scotland. Castle visits and historic tours every day and stays in a castle hotel every night, including the fabulous 5* Fonab Castle Hotel in Pitlochry.
A chauffeur-driven whisky extravaganza taking in the isles of Arran, Islay and Jura and the cult whisky capital of Campbeltown on the Kintyre peninsula. 14 distilleries in 8 days to celebrate a 40th birthday.
A week-long family adventure – playing on the beach, exploring the place that inspired JM Barrie’s Peter Pan, hunting for fairies, trekking with alpacas, water sports, fishing, farm animals, guided cycling and a private falconry show.
A mother-and-daughter gin itinerary, including distillery visits, learning about botanicals, and distilling their own spirit at ‘gin school’ and a cookery class making cocktail-based desserts.
A whistle-stop tour of some of the most remote islands in Scotland, using helicopter transfers to bring these normally inaccessible locations within reach for a trip lasting just a few days.
A long-stay family holiday with pre-arranged activities each day, including fishing, foraging, photography, horse riding and 4×4 off-roading, based at the spectacular Fife Arms in Braemar.
Availability is fast becoming the number one challenge for travellers to Scotland this summer. A perfect storm has occurred, with 2020 bookings rolling over and combining with extremely high demand for the 2021 season. The Three Chimneys on the Isle of Skye and the Torridon in Wester Ross – just two examples of the country’s popular and remote high-end boutique hotels – have already completely sold out for the summer months and well into October.
The indecisive may therefore find themselves having to wait until 2022 for their Scottish adventure, but we’re absolutely sure it will be worth it!
The Tartan Road is a bespoke luxury tour operator specialising in single-vehicle, single-household trips in Scotland. Drawing on local knowledge and a select network of excellent suppliers, we put together tailored packages combining accommodation, transport, activities and experiences built around the traveller’s unique needs and preferences. Find out more at www.tartanroad.co.uk
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
Wasps Rugby club confirmed that Hottinger Group, a leading international private wealth management firm, has agreed to become an Official Club Partner.
The agreement, which will run until the end of the 2021/22 season, will also see the Hottinger brand feature on the right sleeve of the Wasps Rugby Men’s 1st team playing kits.
Mark Robertson, Hottinger Group Chief Executive, said: “This is the first deal of its kind in the company’s history. Hottinger Group and Wasps are a fantastic fit as both share a philosophy of putting family and performance at the heart of what we do.
“I am thrilled to be working with Wasps and have been really impressed by their vision for the future. This partnership will provide a unique opportunity for us and our clients.”
Adam Benson, Wasps’ Chief Commercial Officer, added: “We are delighted that Hottinger Group have agreed to partner with us.
“They share very similar values to our own and we look forward to welcoming them and their clients to Ricoh Arena as soon as supporters are allowed back.”
Another strong US reporting season has left European companies in the shade and the focus on the passage of President Biden’s $1.9trn stimulus plan through Congress has left any thoughts of the EU’s own stimulus plans behind. The US stock market has been the investment leader throughout the pandemic at a time when low interest rates, quantitative easing and ownership of the world’s reserve currency has favoured long duration, growth stocks operating in the most forward-looking sectors. However, the differential between US and European earnings estimates may actually be an indication of investor sentiment that is over confident of US earnings and overly pessimistic of European earnings prospects[i].
The re-opening of developed economies will see the more cyclical sectors recover, and the signs are that there is significant pent-up demand from consumers to return to the service industries reminiscent of the “Roaring 20’s”. Tragically, the burden of a recession caused by lockdown has fallen on the bottom 20% of society and disproportionately on the young, however, the rest of society, unusually for a recession, has managed to improve their liquidity to some degree. If the anecdotal evidence of the pick up in activity within the travel industry is anything to go by, we expect the sizeable accumulation of household savings during the pandemic will see growth bounce back forcefully. Export dependent economies, like many in Europe, are likely to be major beneficiaries of spending and European luxury goods and capital goods’ companies in particular are expected to see the return of strong demand[ii].
The global reflation trade has seen government yield curves steepen which pressurises long duration growth stocks in our opinion because the interest rate used to discount future earnings increases. Further, flat yield curves and negative rates are a poor environment for financials and depress banks’ net interest margins. We expect steepening yield curves to provide an environment in which value outperforms growth or more precisely, financials outperform technology. Year-to-date the S&P500 Technology Sector (XLK) is 0.33% weaker while the Financial Sector (XLF) has gained 17.10% showing that this rotation has been significant so far this year[iii].
Source: Bloomberg as at 11 March 2021
The next question is whether European banks can outperform their US counterparts.
Absolute Strategy Research believe that Eurozone equities will find it difficult to outperform US equities unless European banks re-ratei. A period of consolidation in the European banking sector across borders is now actively encouraged by European regulators that now see the fragmented banking sector as a disadvantage and are looking to complete the EU single market in financial services now that the Brexit negotiations are overii. European banks still play a very prominent role in corporate funding and supporting the growth in the real economy. A European “Big Bang” could prompt financial innovation which would also support the green deal going forward.
The inauguration of Joe Biden as US President saw the US swiftly return to the Paris climate accord which bodes well for the increased focus on environmental standards in future world trade. Following European agreement of the EUR750bn EU recovery fund that was triggered on January 1, 2021, the EU plans to put EUR1trn to work in sustainable investment over the next 10 years as part of the Green Deal making Europe one of the global leaders in sustainable energy[iv]. For example, JPMAM’s Karen Ward points out that three quarters of global wind assets have company headquarters in Europeii.
The EU recovery fund has introduced a level of fiscal union to complement the single currency monetary union for the first time, the absence of which could be blamed for the severity and slow recovery after the Global Financial Crisis. The risk premium that has been attached to the inflexibility of the European equity model sees the MSCI Europe Index ex UK trade at 18 times forward earnings when the S&P500 trades at 23 times forward earningsii. The structural changes underway within Europe will support European Banks, the re-opening of the global economy will support cyclical goods and services within established export channels to the growth areas within China and Asia, and the embracing of the environmental challenge will push European innovation and growth. European equities remain under-owned and cheap relative to more growth orientated sectors and regions in an environment that increasingly plays to its strengths.
[i] Absolute Strategy Research – Eurozone Equites: Focus on the Banks, February 11, 2021
[ii] Financial Times – The Consensus is Wrong on European Stocks by Karen Ward, JPMAM, February 15, 2021
[iii] Statistics referenced from Bloomberg Professional Terminal data.
[iv] Portfolio Adviser – Why European Equities could rise as the US Stock Market lustre fades by Cherry Reynard, October 14, 2020.
Despite the current restrictions, we still expect to see a significant rotation from growth into cyclical stocks as the ongoing vaccine roll-out in developed nations leads to the re-opening of economies, albeit later than originally anticipated. The combination of a Biden administration fiscal package of over $1trn coupled with the supportive forward guidance of a Federal Reserve on hold continues to offer an environment that favours risk assets. The semi-annual testimony to Congress by Fed Governor Jerome Powell was designed to calm markets with dovish rhetoric as the US Treasury yield curve continues to steepen putting pressure on growth stocks. 10-year rates are approximately 0.35% higher in February, 0.45% year-to-date, yielding 1.41% by the close while 2-year yields have remained relatively anchored to 0.13%. Powell re-iterated the stance of the FOMC[i] that interest rate hikes would not be considered until full employment that was both “broad and inclusive” had been reached, and the inflation rate remained resolutely above the 2% target in line with its new flexible average inflation target. Even with the prospect of significant fiscal stimulus, the Fed is unlikely to slow the pace of asset purchases this year, in our opinion, and interest rate hikes are likely several years away.
Most equity markets managed to register a positive result in February as the strong earnings season outweighed the risks posed by steeper yield curves. The S&P500 outpaced the NASDAQ Composite +2.61% vs. +0.93% as the rotation away from growth stocks seen since the beginning of the year continued. This is best illustrated by the performance of Banks and Technology sectors as an indicator of the underlying moves in growth vs. value. The S&P500 Financials sector gained 10.61% in February (+9.60% year-to-date) while S&P500 Technology sector only managed 1.37% (+0.52% year-to-date). Furthermore, it is also noteworthy that value indices such as the UK FTSE All-share that gained 1.66% in February, the German DAX +2.63% and Paris CAC 40 +5.63% underline the value bias within European markets.
Moreover, newly appointed Treasury Secretary Janet Yellen’s announcement during her January 19 inauguration speech that it was time to “act big” on fiscal easing is already being referred to as her “Draghi moment” referring to Mario Draghi’s “whatever it takes” speech in July 2012. Having a former Fed governor as Treasury Secretary could lead to greater collaboration and have a significant impact on the real economy, whereas we saw that the monetary intervention following the Global Financial Crisis (GFC) probably did more for financial assets. Absolute Strategy Risk (ASR) have pointed out that strong economic and earnings growth coupled with low rates could lead to further upside in US equities, despite the current extreme valuations, and have markedly revised their real US GDP growth forecast for 2021 up to 5%[ii].
As we inch closer to the ending of pandemic restrictions the strength of pent-up demand is palpable and the expectation for both a strong recovery in economic activity and earnings is expected; ASR now expect earnings to grow 25% year-on-year[iii]. We can draw on the experiences of Japan in the 1980’s when we witnessed financial repression combined with loose fiscal policy which led to investments driven by excess liquidity and fundamental valuations being of secondary concern. We believe it is likely that asset allocation decisions will be key to returns over the next 18 months with many rotations within asset classes being more significant than headline returns, and traditional asset classes unwinding some of the excesses of the extended bull runs in both bonds and equities. Recently we have witnessed online retail investors drive a disconnect between fundamental valuations and the share prices of certain popular stocks, such as GameStop, however this is not a new phenomenon. The participation of central banks in financial markets since the GFC with an indifference to valuations has already been central to the movements of assets over the last decade sowing the seeds for profound returns and the potential for equities to rally further from already elevated levels.
We have signaled since the start of the year that a significant move higher in long-dated US Treasury yields based on inflation fears could spook equity markets, particularly growth stocks that have been market leaders, and the first clear signs of this came at the end of the month. The 10-year US Treasury yield hit a high of 1.6% during the session on Thursday 25 before settling below 1.5% once more. Bear in mind that many forecasters had set a target of 1.5 – 2% for yields by year-end so the anxiety amongst equity investors is understandable. Furthermore, yields for long bonds are now comparable with the dividend yield on the S&P500 which means that bonds become a viable alternative to equities again for many fundamental investors. However, for multi-asset investors rising duration risk remains key to future returns and we continue to advocate substituting government bond exposure for alternative assets to lay-off potential equity risk.
During 2020, dollar weakness led to an increase in emerging markets as the main beneficiaries of the improving global outlook, however, the uneven Covid-19 vaccine roll-out has put this scenario on hold. Increasing yields and the expected lifting of pandemic restrictions in the developed world ahead of the developing world we believe should push the emphasis back to US and European markets once more, offering medium term support to the US dollar. The subsequent rally in sterling since the EU-UK trade deal deadline has seen “cable”[iv] reach a near term high of 1.4130 with many forecasters seeing 1.42 – 1.43 as fair value in the short term. A general dollar bounce will present near term headwinds to gains in the developing world and the outlook for broader global growth.
The current nervousness around financial markets as inflation expectations reach an inflection point has led to our continued focus on alternative investments including commodities and private investments. The weakness in gold this year of 8.71% (6.51% in February) on the back of increasing real yields has also led us to the decision to concentrate more on broader commodities, particularly industrial metals and oil. Over the month, the Brent Crude price has reacted to the re-opening trade gaining 16.25% while a broader basket of commodities has returned 5.62%[v]. We are also analysing other real asset solutions, private investments, and products providing lower correlation to traditional asset classes, over past periods of volatility in order to assess the potential current level of protection available to investors.
[i] FOMC – Federal Open Market Committee makes key decisions about interest rates and the growth of the United States money supply.
[ii] ASR Equity Strategy, Back to the 1950’s as Biden Boosts Value, February 18, 2021
[iii] ASR Asset Allocation. Bonds at Risk as Policy Goes “Big”, January 28, 2021
[iv] The term “cable” is a slang term for the exchange rate between the pound and dollar, referring to the time when the exchange rate began to be transmitted across the Atlantic by a submarine communications cable.
[v] Represented by the WisdomTree Enhanced Commodities ETF.
Bitcoin peaked at $49,376 last week. To put that into context that is almost a quintupling of price in a year[i]. Were there many other assets that provided similar returns over that period? Surprisingly there were plenty. Tesla, Wayfair and Novavax are a few of the stocks that have rocketed for one reason or another and retail investor influence on the likes of GameStop will be infamous for years to come. To avoid appearing as a disgruntled non-participant, I will refrain from making the association between some of these investments and jaunts to your local bookies. In seriousness, it is the job of reasonable investors to continually reassess whether they have missed a trick and whether there are more tricks to be had. Announcements of adoption from the likes of Paypal, Mastercard and Elon Musk have led to prolonged upwards price momentum and hope of widespread use. As such, Bitcoin has once again captured the attentions of media, companies and investment houses and the same question plays on most of their lips; are we seeing a repeat of 2017 or something more?
Figure 1: The price of Bitcoin in USD. Cryptocurrencies have recently reached prices of over twice their 2017 “bubble” peak.
Cryptocurrencies have been in circulation for over ten years. Since then, they have amassed a total market value of over one trillion dollars[ii], a large part of which has accumulated in the past six months. The details of crypto creation and transactions are complex, however the same can be said for our traditional and electronic money systems. Regardless of the structure or blockchain used, cryptocurrencies aim to do the same thing – make transactions more direct, efficient and decentralised, much like what the majority of fintech companies aspire to do in their respective sectors. Unfortunately, these valuable attributes act as a double-edged sword in several ways. For example, the removal of governance means that crypto has developed a shady reputation for housing fraud and money-laundering.
Crypto transactions are anonymous and generally cannot be reversed, which is risky for the average consumer and creates frictions with the direction financial regulation has been moving. Contrarily, an early study on the past year of financial crime in cryptocurrency estimates that only 0.34% of transactions were related to criminal activity, the lowest proportional figure in recent years and lower than 2019 in nominal terms[iii]. The concern hidden within these figures is that two criminal activities which benefit greatly from transaction anonymity have continued to grow: the darknet and ransomware. Artificial Intelligence monitoring has been suggested as a potential remedy, yet it remains to be seen whether regulators and cryptocurrencies can resolve the policing conundrum whilst retaining decentralised identities and low transaction cost. Regulation, classifications and investigations have been expectedly prevalent and are widely predicted to be cryptocurrency’s making or undoing. Backing from regulators and governments would be a powerful device for widespread adoption and reductions in volatility. Nonetheless, endorsement will not be given lightly and may only be given to an asset that is structurally quite different to the current main players in the market.
Cryptocurrencies are pitched as the next gold. Bitcoin has a finite nature with a maximum of 21 million coins to be allowed in circulation and is not tied to a currency. As such, like gold, crypto should be disassociated from inflation, monetary policy and potentially from economic shocks. Should volatility stabilise, the traits of Bitcoin could become a gold substitute and some analysts put a $500,000 price tag on the coins in this scenario[iv]. Inflation disassociation may be on the cards, however, cryptocurrencies will always be reliant on government policy, perhaps more so than traditional assets. To say that a cryptocurrency is and will be fully decentralised is to live in an anarchic wonderland. Bitcoin and Ethereum may be global in aspirations, but governments still have control over marketable products and the restrictions placed on them. As such, cryptocurrencies still hold large amounts of political risk. China possesses more than 50% of the world’s cryptocurrency mining capacity[v]. If their infrastructure were hampered indirectly or directly through regulation, there would be severe disruption to transaction recording and prices. This highlights that the risk in cryptocurrencies is not just in regulators but also in large crypto institutions. Mining is oligopolistic in nature, and transactions are facilitated through concentrated mechanisms and exchanges. Tether, a stable coin tied to the dollar using asset-backing, accounts for the majority of trading between cryptocurrencies and effectively facilitates the market at the moment. Tether is also under investigation in New York under allegations of fraud and there could be wide-ranging ramifications for all cryptocurrencies should any lines of thread begin to unravel.
Figure 2: 30-day price volatility of currencies and assets. Bitcoin has long demonstrated extreme levels of volatility, even when compared to small cap equities and the South African Rand.
As mentioned, a key requirement for cryptocurrency to reach its full potential as an alternative asset class is volatility stabilisation. However, as shown by Figure 2, the volatility of Bitcoin is still on average more than four times as high as that of other volatile currencies and assets. This is because the current valuation of Bitcoin is not dissimilar to that of a many unicorn stocks; there is a division between investors as to whether it should hold any intrinsic value at all. It is easy to see the argument for zero value; cryptocurrencies are generally not backed by an asset, making them a digital figure with no government support. That said, it should not be forgotten that value is fickle. It does not need to depend on input materials or labour, but relies upon the beliefs of the many, which has been demonstrated globally in several cases of hyperinflation over the years. The more investors that believe in a value, the less volatile the price will be. The difficulty for cryptos in achieving ‘stable status’ is that other value stores, the likes of cash and gold, have either had government support to help assure their value or have had the benefit of indoctrination over millennia. Adoption by some institutions goes some way to providing the required price confidence Bitcoin needs, yet the current commitments are supple and but one step in what will continue to be a difficult climb.
To call the recent performance of Bitcoin a bubble is audacious. Not only are bubbles difficult to label until they burst, the anonymous nature of crypto transactions makes it even harder to determine alarming investor behaviour. Metrics such as active addresses and trade volumes appear mostly healthy[vi], but could easily be fabricated by a few big players. Equally, Bitcoin’s continued rise to become a financial staple is not as certain as some analysts and investors may like to think. Instead, crypto should be acknowledged for what it is, a highly speculative play, to be bought in the knowledge that there is a substantial chance you could lose everything[vii].
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Source: Bank of England Financial Stability Report, July 2021
Source: Numis Securities
Source: St. Louis Federal Reserve Database
Source: Refinitiv
