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].
As we started the New Year the reflation trade was already underway with commodities and resources stocks showing a strong performance and the 10-year US Treasury yield rising back above 1%. Markets were happy that the Presidential Election in November had not resulted in a “blue wave”. However, by Inauguration Day the Democrats’ sweep as a result of the Georgia Senate elections was instead seen as the path to higher stimulus due to the seriousness of the escalation of the pandemic taking centre stage. Banks are still supporting financial markets, government fiscal stimulus continues to support economies in lockdown, and the roll-out of the vaccinations can be viewed as a third stimulus, shortening the path back to normality.
Albeit slightly dimmed due to uncertainty, the light is now visible at the end of the tunnel. With continuing high levels of stimulus and evidence that the majority of investors share very similar expectations for the coming year, it is of little surprise that the return of inflation has emerged as the main risk to the central scenario. The threat of another “taper tantrum” as in 2013 could affect risk assets negatively, so the biggest risk for governments and central bankers is that any change in policy that feels like a tightening of conditions could trigger a surge in Treasury yields. A more aggressive rise in 10-year US Treasury yields to 1.5%, or even 2% in the medium term, could see investors become more nervous, while an orderly rise in yields due to a mild rise in inflation could still see risk assets thrive.
Our original thesis, that the reopening of economies would see risk assets continue to perform during the first half of the year before absolute valuations become relevant, is being challenged by the continued lockdown of major economies under the weight of new, more virulent strains of Covid-19. The first week of the year saw the beginnings of a New Year rally, with the MSCI World gaining 2.5% before the weight of the pandemic came to bear. Renewed global lockdown measures will have probably suppressed the economic recovery trade, and the optimism of investors towards a return to a semblance of normality is slipping, as the realisation of the here and now is brought sharply into focus. The question now is whether the recovery will be affected by further delays or whether the pent-up demand from consumers unable to spend will be just as strong but over a shorter time period. Absolute Strategy Research (ASR) has raised their US growth forecast for the year this week from 3.5% to 7%, based on the stimulus package being proposed by the Biden administration, and Global nominal GDP to grow around 8%ii.
We are currently in the middle of fourth quarter earnings reporting and so far, the results have been very encouraging. Bank Julius Baer report that S&P500 earnings have come in well ahead of expectations both in strength and breadth. The bank now expects Q4 will show a decline of 2% year-on-year vs. -8.8% at the beginning of the earnings period, and guidance for the first quarter suggests 82% will guide ahead of market expectations vs. a historical average of 33%[i]. This chimes with December manufacturing PMI’s also looking strong, including new orders and prices paid, although services indices remain weak. Earnings surprises to the upside will give further confidence to investors that 2021 overall will be a favourable climate for risk assets despite the impatience currently on display. IBES global twelve months forward earnings are now forecast to rise 26%, and ASR also suggest a central forecast for global earnings-per-share of 25% year-on-year in 2021[ii]. Most developed equity market indices have fallen off in the second half of the month. The NASDAQ Composite clung to positive territory, up 1.4%[iii] on the month, the S&P500 was down 1.1% and the UK FTSE All-Share and German Dax finished down 0.9% and 2.1% respectively. Asian markets have fared better as they have dealt with the third Covid-19 wave more effectively. The Korean KOSPI Index was up 3.6% in January, the Nikkei 225 Index +0.8%, and the Shanghai Composite Index +0.2%.
We still believe that the environment favours equity risk on a relative basis and absolute valuations will be overlooked until major economies have re-opened. The main challenge for multi-asset investors as to how to off-set equity risk and volatility becomes more acute as valuations are further stretched. The traditional 60 / 40 portfolio has never been more questioned not just because of equity growth, but the inability of government bonds to hedge performance risk due to their own expensive valuations. The situation is arguably different in each developed economy depending on the Central Bank view on the use of negative rates. In Europe, negative rates have been a well-used monetary tool leaving 10-Year German Bund yields currently at -0.51% offering questionable support to investors anxious of equity valuations. In the US, the Federal Reserve has been adamant that negative rates are not appropriate, even under intense pressure from President Trump in 2020, meaning that while the zero bound is unlikely to be penetrated ten-year yields of 1% also offer little protection to investors. In the UK, Bank of England governor Andrew Bailey has refused to rule out the use of negative rates, but with 10-year Gilt yields at 0.33% the level of plausible protection is still low. Therefore, allocating effectively away from government bonds in order to offset potential equity volatility may need ingenuity and an understanding of the alternative asset space.
From a macroeconomic perspective, the Covid-19 pandemic has the potential to see the 2020’s evolve much differently than the 2010’s. The long and sophisticated supply chains that have developed through globalisation have proven fragile in the face of a pandemic, encouraging many companies to shorten or onshore their manufacturing processes, potentially raising costs and adding to the upward pressure on inflation. The result of QE has clearly bolstered financial markets with questionable effect on the real economy, whereas the switch from monetary to fiscal policy will inject funds directly into the real economy again adding to the long-term upside pressure on inflation. Finally, we enter the 2020’s with much higher debt levels as companies and governments make use of cheap debt, leaving government debt levels in most developed nations at levels unprecedented during peace time. One of the ways of reducing debt is to inflate it away, and some recent central bank policies suggest that inflation may be allowed to run above trend creating negative real interest rates in the longer term. Real assets have also started the year mixed with Gold challenged by real interest rates and a stronger dollar down 2.7%[iv], Brent crude oil is up 7.9%, while a broad basket of commodities is 2.6% to the better.
Preliminary discussions into allocating to Alternatives at the expense of government and investment grade corporate bond exposure, has covered Macro Fund strategies, capital protected structured products, and managed futures or CTA’s (Commodity Trading Accounts). The inflation protection offered by real assets has caused us to increase our direct commodities exposure already, but managed futures potentially offer further protection against volatility, and astute Macro funds managers have historically offered downside protection during equity bear markets. While government bonds may still offer an element of diversification there is less protection available when equities are under pressure, and they are vulnerable to a potential pickup in inflation risk. Therefore, it is becoming more important for us to consider how effective a strategy current asset allocation is at mitigating equity market downside risk and the options that are available.
[i] Bank Julius Baer, THE WIRE – Europe Bell, January 26, 2021
[ii] Absolute Strategy Research, Bonds at Risk as Policy Goes “Big”, January 28, 2021
[iii] Asset pricing and performance data sourced from Bloomberg
By the end of November, the MSCI World Equity Index had reached a record high, having gained 12.7% in November as three surprisingly positive vaccine test results removed two key sources of uncertainty for investors. By the time the Investment Committee had convened in December the Pfizer / BioNTech vaccine had received emergency approval in the UK and the US with the first vaccinations underway. Furthermore, The Federal Drug Administration (FDA) has approved the Moderna vaccine for emergency use in the US, increasing the options and potential doses available, and the EU has also now approved the Pfizer / BioNTech product. While there may be light at the end of the tunnel, the journey may not be smooth with a potentially tough winter ahead before widespread vaccinations can be rolled out. Renewed lockdown measures in Europe, the UK and the US in the face of a third wave, including the discovery of a new variant of the virus in the UK that has seen travel tunnels and borders from the UK closed, will have already suppressed economic recovery, especially in the areas of economies in desperate need of holiday revenues to survive a crippling year.
On balance, it is likely that fourth quarter growth will slow in the developed world as a result of the most recent lockdowns and restrictions, flash PMI’s were already slowing, and this loss of momentum leaves risk assets in a quandary. Equity market valuations remain historically very expensive despite strong earnings in the third quarter, value as a factor still remains depressed although its outperformed growth by 4% in November, and Europe was the biggest regional beneficiary as the post-vaccine rotation got underway. However, December has seen a partial reversal of the rotation trade once more as the pandemic restrictions are toughened further in an attempt to keep new cases under control. All asset classes are expensive on a relative basis which may explain why equities have broken to the upside on the vaccine breakthrough and 10-year US Treasury bond yields have backed up towards 0.90%. In December so far, the MSCI World is 2.0% to the better leaving it over 10% up year-to-date. An effective vaccine will eventually allow the services sector activity to normalise but in the meantime do investors focus on the immediate, or the fact that we have a timeline to return to normality?
On December 11, the 27 EU members approved the $1 trillion EU budget including the coronavirus stimulus package, and the European Central Bank added $600bn to its bond purchasing stimulus programme. The December US FOMC meeting showed forecasts for inflation and growth moving higher into 2023 while confirming that interest rates would remain on hold, showing the willingness of central bankers to keep the environment accommodative[i]. Furthermore, on Sunday December 20 Congress agreed a new $900bn stimulus package which will avert a government shut down before the holidays, providing more evidence that the headwinds that have threatened to de-rail risk assets are dissipating. While new stimulus packages are still providing support to economies, and vaccines are shortening the bridge to normality, the risks of economies overheating in the medium term are to the upside.
The biggest risk for governments and central bankers is that any change in policy that feels like a tightening of conditions could trigger a “taper tantrum” similar to the surge in Treasury yields experienced in 2013. The reflation trade experienced in October has largely been reversed by the rise in new virus cases this month, and Europe is still suffering deflation. However, a more aggressive rise in 10-year US Treasury yields to 1.5%, or even 2% in the medium term, could see investors become more nervous, while an orderly rise in yields due to a mild rise in inflation could still see risk assets thrive.
Should bond yields surprise to the upside, the path of risk assets may be upset because it has been the falling bond yields that have propped up equity markets by protecting the equity duration trades in technology and healthcare. Although we believe it is unlikely that inflation becomes a problem in 2021, it is the threat that higher inflation uncertainty is skewed to the upside that can cause financial markets to react. We have already highlighted that commodities are a useful inflation hedge for investors and the Bloomberg Commodity Index has returned 3.6% month-to-date although still down 5.6% since the beginning of the year, and gold has regained some of its composure after a poor November to be up 5.25% so far in December reflecting market anxiety at the current news flow.
The final risk to the continuation of the rally in risk assets was highlighted in the recent Asset Allocation Survey carried out by Absolute Strategy Research (ASR). According to ASR, the survey represented the most bullish outlook that they have recorded in the six years that the survey has been running with the highest level of conviction[ii]. The risk is that if everyone is looking for the same outcomes and is positioned the same way, then who is making a market?
Despite the downside potential, we believe that the vaccination programme has the capacity to turn the K-shaped recovery that we have seen during the pandemic into a U-shaped recovery in the first half of 2021, as the valuation gap between the COVID “haves” and “have nots” is given the opportunity to close. The likelihood, in our opinion, is that risk assets remain in favour during the first half of 2021, but eventually absolute valuations cannot be ignored, unless earnings expectations can justify higher levels.
At the time of writing EU-UK trade talks are still continuing in overtime, but the signals from EU President von der Leyen and Prime Minister Johnston suggest that there is now a narrow pathway to a potential deal. The UK parliament has been put on alert to reconvene to debate a potential bill and sterling had strengthened on the positive tones emanating from the main protagonists. Since the start of October, £2.4bn have been pulled from UK equity funds by investors fearing a no-deal outcome, £30bn since the referendum, meaning UK risk assets are under-owned by global investors despite the deep value opportunities being presented[iii]. Brexit uncertainty has caused four years of underperformance by UK risk assets, and if there is a light at the end of the tunnel there may be some interesting opportunities for investors. Month-to-date, the FTSE All-Share Index is up 2.6% while the German DAX Index is down 0.7% and the France CAC 40 Index is -1.4%.
Elsewhere, President Xi has recently suggested that China could double its GDP by 2035 and, while we think this is unlikely, there is little doubt in our minds that China will be the engine for growth in 2021[iv]. The knock-on effect of the increased investor interest in the region especially as China’s weighting in global indices increases, will likely have a positive effect on Asian economies and financial markets. The MSCI Asia ex Japan Index is up 3.4% month-to-date and 19.6% year-to-date showing that investors are already pricing in the reflation trade in the region.
It looks as if developed equity markets will finish the year on a sour note as immediate anxieties dominate developments, but with the passing of the Winter Solstice we may start to see brighter days ahead.
[i] Morgan Stanley Research; December FOMC – Quick Takeaways; December 16, 2020
[ii] Absolute Strategy Research; Q4 2020 Asset Allocation Survey – the Great reflation Trade of 2021; December 10, 2020
At the time of writing investors are anxiously weighing up the chances of the UK – EU negotiators brokering a trade deal in this week’s make-or-break talks and sterling continues to be the main Brexit barometer. We seem to have had many rounds of make-or-break negotiations, but most people would agree that time is now close to running out for a trade deal to be ratified by the 31st December 2020 deadline.
On Tuesday, Boris Johnson’s government pulled parts of the Internal Markets Bill that breached the existing Withdrawal Agreement. This followed a separate deal brokered by Cabinet Office Minister, Michael Gove, and EU Commission vice-president, Maros Sefcovic, regarding the implementation of the Northern Ireland protocol. The move was supposed to be seen as a grand gesture that signaled the UK’s willingness to compromise on the outstanding issues. Nevertheless, an impasse has led to Johnson himself joining his negotiating team in Brussels for the final push, arranging dinner with EU President Ursula von der Leyen for tonight.
It is no secret that the results of the talks this month could be instrumental in deciding the UK economy’s path to recovery and the monetary and fiscal policies that will need to be employed. Back in May it became obvious that the central bankers of the major economies were considering the potential effects of implementing negative interest rates based on the experiences in Europe. In the UK, the Bank of England (BOE) Governor, Andrew Bailey, originally felt it necessary to be quoted suggesting that he was not contemplating such a move, before stating that negative interest rates could not be ruled out. The increase in sterling volatility has been attributed to investor fears that a no-deal could see the UK’s economic contraction worsen and could lead to the introduction of a negative interest rate policy by the UK central bank.
In its latest Economic Outlook Report in November, the OECD forecasts the outlook for the UK to be the second worst amongst the 20 largest national economies, including the eurozone, except Argentina. The UK is expected to still be 6% below its 4th quarter 2019 position by the end of 2021 having contracted 11.2% in 2020 and only forecast to grow 4.2% in 2021. In its assessment the OECD considered the UK economy to be at a “critical juncture” with Brexit, cited as the biggest downside risk to its forecast.[i]
The UK Government’s independent spending watchdog the Office of Budget Responsibility released a report in November that stated that “no deal” was a “material risk” that would reduce UK GDP growth in 2021 by 2% as well as push unemployment over 8%. Their forecast for 2021 economic growth would, therefore, fall to 3.5% following temporary disruption to cross-border trade. In its main forecast the UK economy returns to its pre-crisis level by the end of 2022 but in a case with no negotiated EU trade deal, this would be pushed out to the end of 2023[ii]. Furthermore, the BOE has warned that the transition to new arrangements will see UK GDP cut by 1% in the first quarter of 2021, and it is estimated that only 70% of companies are ready for the changes.[iii]
For those who harbour a mistrust of forecasters and statisticians perhaps the view of equity investors may provide an alternative view on the outlook for the UK under new arrangements. Year-to-date, the S&P500 index in the US is up 14.50%; Japan’s Nikkei 225 is also up 13.36%; the Shanghai Composite Index is +10.55%; the German DAX is up 1.31%; the SMI Swiss index is down 1.58%; Italy’s MIB index is -5.88%; in France the CAC40 is down 6.42%; while the FTSE All-Share index is down 11.3%. Clearly, investors believe that the effects of a no-deal will hang heavier on the UK than its European counterparts and have allocated away from the UK stock market despite the international bearing of the Top 100 companies.
Karen Ward, chief market strategist, EMEA, JPMorgan Asset Management, believes that sterling would fall by 10% in trade-weighted terms in the event of no-deal, and it is assumed that the value of repatriated overseas earnings, therefore, rises. As 77% of FTSE 100 revenues are earned abroad then, by definition, the value of the FTSE 100 index should appreciate, and many money managers are recommending favouring blue-chip companies with significant overseas earnings in the event of a no-deal[iv].
However, Karen Ward points out that over the past 10 years the relationship between index returns and trade-weighted sterling has had an average correlation of close to zero and sometimes negative[v]. 40% of FTSE 100 revenues come from Europe, 27% from the US and 30% from Asia and Emerging Markets, and the index is disproportionately weighted towards financials and resources. Therefore, any effect on global sentiment from the breakdown of talks that leads to the protraction of global economic weakness could be the worst-case scenario for the UK’s main index.
However, in the light of vaccine optimism we have witnessed the beginnings of a rotation away from technology and healthcare sectors into sectors that will benefit from the re-opening of global economies such as consumer cyclicals and consumer discretionary. The FTSE 100 index has a number of dynamic consumer goods companies with global revenue streams and brand loyalty that have proven resilient in a changing environment, and, in our opinion, should continue to do so.
Despite the optimism of the most fervent Brexiteers we hope that the negotiators can over-come the remaining hurdles at a time of great flux, for the greater benefit of economies and markets alike.
We concluded last month’s investment review with the opinion that whilst October had ended in a sombre mood, as the second wave of Covid-19 gathered pace, November could be a pivotal month with the US going to the polls and there being some hope that news regarding a vaccine could be on the horizon. A few short weeks later and the MSCI World Equity Index has reached a record high, having gained 12.7% in November, as a well-received US election outcome and three surprisingly positive vaccine test results removed two key sources of uncertainty for investors.
In the weeks before the election, investors had adopted a positive view of the prospect of a Democratic “blue wave” delivering the key to unlock additional fiscal stimulus. However, as is became apparent that the Republicans would likely retain control of the Senate, barring the Democrats winning in Georgia on January 5th, investors changed tack to focus on the benefits at a company level, with President-elect Biden’s ability to pursue interventionalist policies restrained. Investors also remained sanguine about the outgoing Administration’s post-election disruptive policy decisions, including the Treasury’s termination of some of the emergency lending facilities that were put in place as a response to the pandemic and Donald Trump’s executive order prohibiting US investors from holding shares in companies with suspected ties to the Chinese military.
Whilst the election result would have dominated the news in most months, it was the announcement of surprisingly effective vaccines from Pfizer / BioNTech, Moderna and Oxford / AstraZeneca that proved the real game changer for markets. Equity markets soared and the ten-year US Treasury rose to nearly 1%; levels not seen since last March. Sectors that stand to benefit most from the reopening of economies, including autos and construction materials posted double-digit gains, but it was the banks and energy companies that lead the way. By contrast, this year’s beneficiaries of the pandemic including technology, healthcare and staples lagged. Barclays attributed the flight to value stocks as mainly short covering rather than an outright shift away from growth stocks by long-only investors, the vast majority of whom missed the sudden rotation. Nevertheless, the recent movement should be welcomed as it has improved the breadth of the market [i].
The swift rotation also brought an unfamiliar look to the monthly geographic performance tables with the growth-biased Chinese (CMI 300 +5.6%) and US (S&P500 +10.8%) equity indices lagging those in the UK (FTSE100 +12.4%) and Europe (Euro Stoxx 50 +18.1%), where value is more prevalent. Yet, to put the last month’s moves into perspective, the S&P500 has gained 12.1% this year and broke through the 3,600 level in November to record a new all-time high, while over the same period the Euro Stoxx 50 is down by 6.0% and the FTSE100 is struggling to break through 6,500, having started the year above 7,500.
Gold was out of favour amid the more positive environment and declined by 5.4% during November, representing its worst monthly performance in four years. The progress in the search for a vaccine has reduced uncertainty and could result in higher real yields, both negative developments for gold. We continue to hold the yellow metal in portfolios for diversification and to hedge tail risks [ii].
While there may be light at the end of the tunnel, the journey may not be smooth with a potentially tough winter ahead before widespread vaccinations can be rolled-out. Renewed lockdown measures in Europe are having the desired effect in suppressing the virus, but at a cost. Mobility data has slowed and the European Commission has lowered its previous recovery projection for 2021 by 2 percentage points to just 4.1%.
In the UK, chancellor of the exchequer Rishi Sunak announced the economy would shrink by 11.3% this year, the largest contraction in 300 years, and warned that fiscal consolidation may eventually be necessary. Meanwhile, the Office of Tax Simplification, which advises the government on improving the tax system, has recommended the rate that investors pay on realised gains (currently 20% for the highest earners) should be more closely aligned with income tax, where the highest rate is 45% [iii]. Any such moves could lead to interesting discussions within the Tory party where some of its MPs are already mobilising to warn the chancellor against touching taxes on profits, capital gains or pensions [iv].
In the US, even before the vaccine news came to light, the speed of the recovery had exceeded forecasts. In April, the IMF predicted that the economy would contract by 6% this year, but recently scaled back the severity of the decline to 4%. Meanwhile, unemployment peaked at 14.7% in April before declining to 9% in June, where the Federal Reserve had expected it to remain until year-end; it has continued to decline and currently stands below 7%. America is not expected to suffer a double-dip recession, unlike Europe, and will probably not impose lockdowns as severe as those across the Atlantic [v]. Nevertheless, tighter restrictions are being implemented in individual states as cases continue to rise, while the infection rate in the days following Thanksgiving will be closely monitored.
On balance, it is likely that Q4 growth will slow in the developed world as a result of the most recent lockdowns and restrictions, and this loss of momentum could carry into the early part of next year before vaccinations are rolled out. Therefore, looking at a six-month time horizon, we would continue buy equities in the event of any pullback in the short-term. A major question is whether the recent rally in value stocks has legs.
The key could lie in the government bond market. Ten-year yields spiked higher immediately following the initial vaccine news from Pfizer before ending the month broadly unchanged. A rise in long-dated government bond yields as a result of stronger economic fundamentals weakens the case for paying a premium for growth companies, while a steeper yield curve would unlock banks’ revenues through a revival in net interest margins. For the recovery in Value to be sustainable, yields would need to move higher. This scenario is not inconceivable with the US 10-year Treasury yielding sub-1% at a time when the US economy forecast is to grow by 7.5% next year, according to Morgan Stanley [vi]. Of course, any recovery will have to be backed-up by earnings but with revenues having been decimated in many value companies this year, the bar should be set relatively low in 2021.
[i] Barclays – Equity Market Review – Hope vs. reality; November 20, 2020
[ii] Absolute Strategy Research – Gold losing its shine; November 27, 2020
[iii] FT.com – What does CGT review mean for investors? November 13, 2020
[iv] The Economist – The Spending Review reveals the strains on the Tory party; November 28, 2020
[v] The Economist – What a vaccine means for the America’s economy; November 14, 2020
[vi] Morgan Stanley – Sunday Start; November 22, 2020
Modern Portfolio Theory, created in the 1950s, stressed the importance of diversifying assets to reduce volatility and smooth returns. Government bonds have played a key role in diversification, providing a stable income source as well as the hedging of risk assets. These safe-haven assets perform well in times of market stress, and as such have been one of the best performing asset classes of 2020[i], returning an average of 6.3% Year to Date (YTD). Even one of the best performing indices of the year, the NASDAQ which has returned 32.8%[ii], did not significantly overshadow the 30-year Treasury index which has still registered returns of 20.7% YTD[iii]. However, bond yields have reached all-time lows in the past few months and investors are rightly reassessing whether assets with low or negative yields should still feature in their portfolios.
There have been very few success stories for economies this year. Spending and employment have slumped worldwide, and it is only recently looking like there is an end in sight to the turmoil. Government bond yields have been uncomfortably meagre for the past decade, and in September, the daily rate on a 10-year Treasury yield fell to an all-time low of 0.52%[iv]. Recently yields have edged higher as a result of hopeful vaccine efficacy news and the 10-year Treasury yield has held at 0.85% at the time of writing[v]. Regardless, returns from investing in government bonds look likely to disappoint for the foreseeable future. Real yields are flat at best and the German bund nominal yield appears to be firmly cemented in negative territory. It is clear that government bonds no longer provide a substantial and stable source of income but there are still two enduring justifications for holding them.
Gilts and Treasuries continue to provide a hedge in recessions
Ever since inflation stabilised at lower levels in the 1990s, one of the most attractive qualities of these ‘risk-free’ assets has been the largely uncorrelated returns to equity markets and the tendency to appreciate in recessions when equities were at their worst. When funds need to be moved or withdrawn during a recession, the offset that government bonds provide to portfolios is extremely valuable. Equity prices can remain suppressed for years and dampening the effects of market shocks remains an attractive quality for portfolios with any level of intolerance to risk. J.P. Morgan conducted a study on the performance of government bonds in the COVID-19 market slump in Q1 this year[vi]. They found the appreciation in positive-yielding bonds offset a significant proportion of the equity market’s negative performance [Figure 1]. In fact, the 10-year US Treasury provided a similar level of hedging potential to portfolios as it did back in the 2000s. Conversely and concerningly, negative-yielding government bonds, such as the German bund, offered very little offset to the equity market drop. Many analysts believe yields can only drop so far and that there is a lower bound where investors look elsewhere to store their cash. It is suggested the non-hedging behaviour of the bonds with negative rates is a reflection of being closer to that lower bound.
Figure 1: The percentage of equity drawdown in each market that is offset by the corresponding 10-year government bond[vii]There is no direct alternative
Government bonds offer security, hedging and liquidity. Unfortunately, no other asset offers these qualities to the same levels. A government bond is described as risk-free because there would need to be almost inconceivable levels of economic stress for developed country governments to default on their borrowings. Although governments are currently borrowing at unprecedented levels, there is still very little concern over default within the G12 countries. The guaranteed capital return of these fixed-expiry securities is unmatched by other offerings. Cash held in a UK bank account is only provided protection of up to £85,000 through the Financial Services Compensation Scheme (FSCS) in the event of default and offers a lower yield. More secure cash depositories are costly and explain why bond holders are willing to accept a negative yield on their investments.
With regards to hedging, many investors have turned to alternatives to provide higher yields as well as downside protection. The traditional 60/40 portfolio (60% equity, 40% bonds) has been augmented over the years to include property, commodities and other alternative investment funds. Absolute return funds aim to provide a constant income regardless of the economic environment and gold has been known to rally much like Treasuries in a market crash. These assets offer further diversification to portfolios and are a rational alternative when partially allocating away from government bonds. There has been widespread interest across the industry and the assets under management are predicted to hold level this year at $10.74tn in defiance of the weaker market[viii]. Despite the enthusiasm for alternatives, investments in government bonds have stood strong. The bottom-line is that government bonds behave in a unique and desirable way. To provide but a few examples of how alternatives do not fill the same shoes; gold is highly volatile and does not offer the guaranteed return that bonds do at expiry; alternatives can use hedging through derivatives on the downside but at the cost of considerable illiquidity or expense; some alternative funds have appreciated in crises, much like government bonds, but often this feels like picking a needle out of a haystack.
Over the next economic cycle, holding government bonds could prove a drag to portfolio performance figures. As economies recover and interest rates creep upward, government bonds will depreciate, and returns may enter the red. If inflation were to return to markets, and the argument for it is noteworthy, bond performance would be hampered further. Yields would push higher to remain consistent on real-terms and bond values would deteriorate. Nevertheless, caution should be taken before insinuating that yields and interest rates can only go up. Many investors have lost out by following this mantra in recent years. Furthermore, it is never known when a negative shock might hit the economy, at which point government bonds prove their worth. There is sufficient justification for investment managers to look elsewhere for income, but for now, while at positive yields, government bonds will continue to be a core holding in almost all portfolios. That said, should Treasury yields turn negative in the future, the game may change entirely.
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