At last! There are welcome early signs that lockdown restrictions are easing from those most difficult days of winter and we can begin to look forward again to hugs with family, ‘actually’ meeting friends and a tiptoe return to normality. After such a deep shock, the definition of what ‘normality’ actually looks like is uncertain and there remains an uncomfortable level of opacity over our near-term futures. However, as sure as the strength of the sun begins to warm our backs, so too does the vaccine rollout and continued economic support begin to unfreeze the economy from its own very dark winter.
Equity markets began the year on a wave of vaccine-induced euphoria but a spike in bond yields, admittedly only to levels similar to those immediately prior to the pandemic, has been difficult to digest. We see this as the early stage of a normalisation process, away from the ultra-low yields seen during the early part of the pandemic, but we are still a long way short of ‘normal’ in any aspect. The ‘lower for longer’ interest rate and bond yield narrative continues, quite likely for several more years, with consensus not expecting any Fed move until 2023. A slowly rising interest rate environment, with a lower terminal rate, is our base case. The rise in bond yields has driven a significant market rotation and growth companies, so strong in recent years, gave ground to those unloved ‘value’ sectors, such as energy and financials. With supportive central banks, large amounts of fiscal stimulus and a backlog of pent up consumer demand, consensus global growth expectations for this year and next are strong, at 5.2% and 4.1% respectively. The table below, with February data courtesy from our friends at Schroders, breaks this down in more detail.
The Great Rotation?
We previously wrote about the relationship between low market interest rates and the support this gave to equity valuations and how a rise in interest rates could also lead to a big reversal in the growth over value style trend that has dominated markets for a decade. Well, as you have it, we didn’t have to wait long to see this in action as the yield on the US-10 year swiftly moved from 0.9% at the beginning of January to 1.7%, with most of that step change happening since February.
This has allowed the sun to shine on some areas that had long been in the shade and has helped the UK equity market move off the naughty step versus its global peers, as sectors such as energy and financials – which are typically heavily weighted in the UK market – found themselves in a state of rebound.
The move in bond yields has also challenged the dominance of growth stocks, namely those tech and e-commerce stocks that have held the market’s attention for many years now. It is too early to say whether this is the beginning of a longer-term rotation, but with bond yields rising and an expectation of a steepening yield curve, a headwind for value stocks that has dominated since the financial crisis has softened.
Waterfall: Fiscal Stimulus. Coming, ready or not…
As we step out of what feels like an interminable winter and edge forward in to spring, some of the shadows that have cast their weight over us have begun to feel just a little bit lighter. The vaccine continues to be successfully rolled out and with it comes a greater degree of confidence in the direction of travel. Whilst vaccine supply tensions are clearly apparent, in a world where everyone’s interests remain best served by a successful vaccine programme, our hope is sense can be found and vaccine ‘wars’ avoided.
We wrote in the last quarterly how the economic outlook is improving but returning to a semblance of normality will be dependent on how quickly and successfully the global immunisation programmes can be rolled out. In this regard, the UK’s vaccination programme makes us hopeful that the UK finds itself in a good position to benefit from re-opening before many other global peers. Whilst vaccines are the health cure, fiscal stimulus is the tool being used to trigger an economic re-start.
A torrent of fiscal stimulus is on the way. The US Senate has recently approved a $1.9 trillion 2021 fiscal stimulus package to be delivered over the next 10 years; however the majority, an eye watering $1.17 trillion, is set to be fed into the economy over just the next seven months. This follows swiftly in the footsteps of December’s $900 billion stimulus package and further on from the $2.4 trillion of support legislated for earlier in 2020. Between them, these packages equate to $5.2 trillion of support, which equates to roughly 25% of US nominal GDP. This far exceeds any level of support provided during the Great Financial Crisis.
In the UK, Rishi unleashed a remarkably generous budget, extending the furlough scheme through to September as well as including generous allowances designed to stimulate corporate investment, whilst deferring some future tax rises in an astute ‘let’s wait and see’ mode. It was a ‘spend now, pay later’ budget with fiscal support in the UK now standing at over £400bn.
What is clear is there is a no appetite to employ the austerity driving policies that followed the financial crisis and that fiscal spending will be a key tool in driving future growth and the levelling up agenda. The reality of ‘building back better’ will be how it clashes with the populist style of politics that we have seen in recent years. The challenge lies in the balance between the immediate ‘sugar rush’ style of support, designed to quickly push support into the economy but that also serves to preserve division (such as stamp duty holidays on property in a market out of reach for many), versus long term fiscal support designed to create jobs and spur growth; the path of least resistance being this gets directed toward the ‘green economy’. This path being reflected over the Atlantic, with President Joe Biden announcing plans for a $2tn American Jobs Plan focusing on investments in infrastructure, clean energy and education with an anticipated $2tn American Families Plan focused on education, childcare and healthcare to follow.
The inequality and wealth divide widened after the financial crisis and will widen further still if politicians are unprepared to make strategic and sometimes unpopular decisions that will only deliver their dividend well beyond the time this generation of politicians cease to have their names on the ballot paper.
Interest rates: Can I kick it?
Yes, you can, Jay Powell, esteemed Chair of the Federal Reserve who finds himself in the unenviable position of reconciling high single digit forecast growth in the US and an ultra-low interest rate policy. Kicking the can down the road as they say.
It all comes down to FAIT, or flexible average inflation targeting for those in the know. This new policy, adopted by the Fed last year, gives the green light in allowing higher than usual levels of growth before raising rates, and with it the risk of elevated inflation, as long as over the long term the average inflation rate remains in balance with that of the long term target.
FAIT brings a shift in focus by the Fed, which has a mandate to meet an inflation target, stabilise prices and provide an economy that can deliver full employment. The latter of these being the one which is receiving greater emphasis as the desire to spread the benefits of economic growth more widely is strong, particularly as the number of jobs in the economy is still well below pre-pandemic levels and many of the job losses are disproportionately among lower paid workers.
Supersonic. Consumer spending pulse.
Get ready for the unleashing of pent up demand as we rekindle our friendships, dust off those travel brochures, hit the shops and freshen our wardrobes beyond endless supplies of grey lounge wear!
US households have accumulated ‘excess’ savings of $1.6 trillion and if that cash hits the economy then growth and inflation, will be tremendous. The Economist estimates that across 21 ‘rich’ countries, excess savings of $3 trillion has been stashed away in the last nine months of 2020.
The reality is this cash pile will not get spent fully down, ‘savings’ tend to be held by ‘savers’ and after any economic shock, caution amongst some households will persist. It does not however seem an unrealistic expectation that spending in restaurants, in shops and on holidays will rise! Whilst overall consumption has fallen for many households during the pandemic, incomes have been preserved, so a strong economic recovery can be delivered through normalised spending practices, rather than requiring a decumulation of savings.
The distribution of who holds this cash is also important as much of this cash is held in higher income households that have less need to run their cash savings down in the process of their day to day living. Increased saving has been a feature of this pandemic and is not just a US phenomenon but is also reflected in the UK too where household savings ratios peaked in Q2 2020 at almost 30% of disposable income. This is likely to help drive bumper economic growth numbers as incomes and jobs remain supported with government schemes and animal spirits reawaken.
Valuations. Serving a note of caution.
So, if governments are spending and consumers are spending, then the obvious assumption is for equity markets to continue to strengthen. Well, whilst we still believe returns can be positive for 2021, the recent bond rotation is likely to be no bad thing in reminding us to retain a note of caution. Equity markets are likely to benefit from the tailwind of fiscal stimulus, but their starting point in terms of valuation represents a continued source of risk. The biggest risk to equity markets remain rising bond yields and a ‘bond vigilante’ challenge to central bank hegemony.
Since March last year the P/E ratio on the S&P 500 has moved from 13.1x to 21.6x today. In the recent pandemic crash valuations never looked outright cheap, unlike the financial crisis when valuations fell to a single digit P/E ratio of around 7.5x in the FTSE 100 and 10x on the S&P 500.
So, the recovery from here is more a test of confidence in a return of corporate earnings and less a recovery in valuation. Company earnings and profits need to grow into these valuations and can do so with a backdrop of an easing of lockdown restrictions, increased consumer spending and the likelihood that continued supportive measures will keep economies growing for several more years.
Corporate profits for companies in the S&P 500 are forecast to surpass those pre-pandemic during the course of 2021, but the earnings recovery since the March 2020 lows has been highly differentiated by sector.
As we look forward to an easing of lockdown, it is worth remembering we’re not at the start of the stock market recovery, which has been well underway since March last year led by the US, emerging markets and Asia. In a world in which equity market valuations look elevated and fixed income yields and rates on cash look challenging, easy pickings are not in abundance.
Nil Satis Nisi Optimum (“nothing but the best is good enough”)
Lofty ambitions indeed but seeking to do our best is a trait worth having, even if it cannot always be achieved. Readers of our sister publication, The Wire, will have read that we are delighted to have recruited Emma Clarke as Investment Manager. Emma is a highly experienced and award-winning fund selector who joins us from Beaufort Investment where she was Head of Fund Research. We have also celebrated the 1-year anniversary of Finlay Holland joining us as Fund Analyst. These new recruits have helped in the successful transition that has seen Rob retire after 14 years. Having worked with Rob for over 13 years, the smooth passing of the baton continues in our ever-present determination to build solid portfolios that deliver to our client’s long-term financial planning requirements.
Rob has always been a great friend and mentor and it is worth repeating here an earlier piece of his setting out our investment approach philosophy, which continues today:
Markets are driven by different factors over different time periods Short-term (1-3 months): Technical drivers, news flow, momentum, and tradingMedium-term (1-3 yrs): Business cycle and financial conditions, ‘the macro fundamentals’ Long-term: (5 yrs+): Valuation We are not short-term traders, too difficult!
We try to deliver acceptable returns that meet your long-term objectives, through focusing on the economic and corporate earnings environment whilst keeping a wary eye on market valuations.
Markets can reach points of extreme under (1981) or overvaluation (1999) which offer compelling opportunities but spend most of the time trading around the long-term average. When this is the case valuations do not matter that much. Markets can spend a long time, and produce very good returns, despite being considered ‘expensive’; S&P500 has arguably been so for many years yet has nearly doubled over this time. Similarly, they can spend a long time appearing ‘cheap’ but going nowhere!
A high valuation in isolation rarely leads to a market crash, there needs to be a ‘real world’ catalyst. However, lower valuations offer some protection against bad news; high valuations do not, so the falls tend to be greater.
We place a limited value on the ability of anyone (including ourselves) to accurately forecast economic/earnings numbers or market movements. We take a considered and hopefully informed view of what is known now and what may happen in the near future, not in the distant unknown. We try to construct portfolios that will be resilient across different market conditions.