A view from the desk
“Yesterday is history, tomorrow is a mystery, today is a gift of God, which is why we call it the present.” – cartoonist, Bil Keane.
The fact that my opening quote is so often misattributed to Eleanor Roosevelt seems to me to be a very apt place to start - to be typical of a world where deciding what is real and what is "fake news" has, perhaps, never been so difficult or important. These remain "strange" times when there are three times as many American soldiers in Washington as there are in Afghanistan and Iraq combined, simply to ensure an orderly transition of power as President-elect Biden takes on the top job in the "free world".
As we all bid good riddance to 2020 - its pandemic, its politics, and its market volatility - the picture coming into view looks brighter. The arrival of vaccines sooner, and more effective, than expected remains a key catalyst and offers the prospect of a faster and broader return to normal activities. Global markets have been robust but extended winter lockdowns in the UK, Europe (and France has just announced a 6pm national curfew) and the US could well have tipped the fourth quarter into a second dip, but brighter days clearly lie ahead.
My intention in 2021's first A view from the desk is to reflect briefly on how 2020 finished, before looking forward to what we believe to be the most important factors affecting both economies and markets in 2021. I will also look more specifically at what the Peregrine & Black crystal ball is telling us about the two markets that most influence our clients and their portfolios - the US and the UK. Of course, I will not be avoiding the elephant in the room that is COVID-19, but I will be able to do so with a more positive tone than had seemed likely just two months ago, as a new phrase "vaccine confidence" enters our vocabulary.
Despite the daunting infection data that we are witnessing in the US, Europe, Latin America and the UK, world markets generally ended 2020 on a positive note, even if the same could not quite be said for world economies. There has been an extraordinary divergence between asset prices that have been rising almost universally and a world economy suffering one of its sharpest downturns since World War Two (and the UK has, arguably, suffered its sharpest downturn in 300 years).
To see the likes of gold (up 21% in 2020), global equities (up 13%) and UK Government Gilts (8%) all ahead at the same time is unparalleled. Additionally, we witnessed robust returns in a wide range of uncorrelated areas from infrastructure to commodities, from hedge funds to domestic property. By contrast, the world economy has suffered a traumatic 12 months.
Markets have certainly priced in a sharp, dramatic, and apparently synchronized recovery. Yet, I wonder just how sharp and synchronized a global economy we can expect. Asia continues to power ahead (China made up its GDP losses in just one quarter), but the recovery may not deliver as many jobs in Europe amid post-crisis corporate restructuring, and the US fiscal debate may soon turn to deficit reduction. Given lingering damage from the pandemic, continuing risks to vaccine roll-out and likely divergences in government policy, I have seen 2021 as being described as the year of “Not Quite Recovery”.
Sadly, the UK looks like being one of the last economies to recover but we ended 2020 with three potentially positive events. Firstly, we signed the Brexit Deal. It looks like a thin deal, but it nonetheless provides a base to grow and further negotiate from. It could be positive for foreign flows back into UK equity markets which still stand 70% below the world equity markets since the Brexit vote (and I shall return to the UK stock market later).
Secondly, the advent of the Astra Zeneca/Oxford vaccine is a major step forward in the fight against COVID-19. It is cheap and robust and will be distributed to emerging markets at cost in perpetuity which will be a key component of a wider global recovery. It is still likely to take best part of 2021 to roll it out, and do not forget that we need to arrange global distribution of the vaccines as otherwise new mutations might take place that can spread back around the planet.
Thirdly, victory in the two Georgia "run-off" elections has given Joe Biden control of the Senate, Congress, and the House, enabling a more reflationary agenda together with a new fiscal impulse. He has now announced his two-step plan ("Rescue and Recovery") within which the headline was a $1.9trillion stimulus proposal. This includes a direct payment of $1,400 per individual (as was also being proposed by the still incumbent President Trump) assuming Congressional approval, on top of the $600 December pay-out. Other measures include $400 per week in supplementary unemployment benefits through to September; $350billion for state and local governments; raising the minimum wage to $15 per hour; $130billion for schools to reopen and $160billion to fund a national vaccination programme. It should be noted that Biden also alluded to all "paying their fair share" and "closing loopholes", which may imply tax hikes that are unlikely to be taken well by the markets once the "sugar high" of the stimulus wears off.
So, let us stay with the US. When Biden was victorious in last November's Presidential Election the market was relieved that it was not a landslide and at that stage most electoral pundits in the US (who to be fair have had the sort of shocking record in predicting results that would have seen them sacked many "matches" ago in the Premier League) were confidently anticipating that the "run-off" results would see them remain Republican. Everyone expected a close result – which it was – but not that both incumbents would lose to their Democratic challengers in very tight races, with (significantly) incredible voter turnout. If Donald Trump has done one thing well then it has been his ability to reinvigorate political participation by the US electorate at record levels.
However, the feared (by markets) "Blue Wave" now looks more like a “Blue Ripple” and much less binary or partisan than would otherwise have been thought. Regardless of all the headline noise, the overall election results were very close: -
Biden took only 51% of the popular vote (and let us not forget that with 72 million votes Donald Trump secured more support than any other "winning" President in history).
Democratic control of the House narrowed considerably - they saw a 35-seat majority cut to 10 seats and are now only 4 above the number (218) needed for a majority.
Democratic control of the Senate is as thin as possible - technically, the seat count is 50 to 50 and their control is only via the Vice President's tie-breaking vote.
Why does this matter? These election results serve to underscore how divided the US really is as a nation at present. This perhaps plays into the hands of a natural conciliator like Joe Biden. Here is a man who has spent 40 years on Capitol Hill shaking hands and "working the room". He, and his key advisors, will understand that centrist ideologies will resonate more than extreme leftist socialist ones (by US standards of "socialism"). This eliminates a lot of the more radical proposed legislation that would be the most egregious as it simply could not pass given the razor thin Democratic control. The already infamous “Capitol storming” has almost certainly given greater scope for cross-party compromise moving forward.
Biden's focus will be on the economy, the pandemic, additional stimulus, infrastructure, environmental issues, and tax reform. His number one priority will almost certainly be his COVID response (direct relief payment cheques, COVID stimulus package, increased Medicaid funding, fighting the pandemic, accelerating vaccine distribution, lockdown considerations). As the absolute numbers for COVID infections and positivity rates continue to hit all-time highs in the US, Biden will, for example, have to work with the healthcare industry as the only defence, rather than propose any punitive healthcare legislation as had been mooted.
So, what will be the main factors affecting Economic & Financial Markets in 2021 (and beyond)? As mentioned already, financial asset prices are being driven by COVID concerns. However, government and central bank stimulus will eventually come to an end and what will the world we go back to look like?
There seems to be broad consensus (with some caveats) that: -
It is highly probable that in 2021 global growth will rebound, fuelled by policy support as vaccines start to unlock the economies.
Inflation will stay becalmed.
Central banks will maintain current policy rates for some years.
Government bond yields will move modestly higher as growth recovers and central banks scale back asset purchases.
The dollar will fall moderately as riskier assets continue to improve.
Stock markets will continue to strengthen.
Double-dip recessions look highly likely in the US and UK for the last quarter of 2020 and the first quarter of this year because of expanded or re-imposed lockdowns. However, if the vaccine rollouts do what we hope then there is likely to be a strong bounce-back in global growth as "pent up" demand is released.
In the US, the savings rate is at an all-time high and there is estimated to be $15.8trillion waiting in consumer cash balances. Savers tend to spend this when they feel confident and consumers across the pond represent 70% of US GDP. Spending patterns will no doubt change as whilst overall spending is down, consumers have been buying "things" and this will continue, but we will also likely see consumers transition into buying services: food, recreation, transport etc. Just this week travel firms in the UK have reported a "silver surge" in holiday bookings from the over-50s as the rapid vaccine roll-out is giving them "vaccine confidence".
However, after a strong bounce-back, the world post-COVID restrictions is likely to see lower growth. People could well become more defensive and want a higher level of precautionary savings, as will businesses. We have seen huge increases in public and private debt which will act as a headwind to growth in the ensuing years. The trend in growth was weak post the Global Financial Crisis of 2008, yet financial assets were strong as policy makers engaged in Quantitative Easing and other supportive policies such as lower interest rates. The difference this time is that these policy responses are already at full steam.
Many economists are suggesting that inflation could become more of an issue moving forward. During COVID we have had both a negative demand shock (deflationary) as incomes in aggregate have fallen (due to increased unemployment, people moving into furlough etc) and a negative supply shock which is inflationary. Once we are all 'released' there is going to be a lot of pent-up demand but will supply increase in time to avoid significant demand-led price increases? For example, will restaurants that have closed causing "negative supply" be able to open quickly enough to satisfy demand or will prices rise rapidly as demand outstrips supply?
A longer-term inflation risk is one of demographics. The "dependency ratio" is accelerating. Simply put this is a measure of retired people in comparison to those of working age i.e. fewer active workers have to pay for the pensions of more retired people. People who work consume and produce (producing more in aggregate than they consume) whilst the retired are, in essence, consumers of what is left over. Older people are seen as inflationary whilst workers are deflationary. In recent years, this dependency ratio has moved upwards.
Since the 1990s there has been significant deflationary pressure on the global economy as the likes of China have brought more employees into the mix. As the world becomes more integrated and investors in emerging markets can move their capital freely to developed markets and vice versa, capital goes to work where it can get the best return. However, Artificial Intelligence and other technologies might come along to assist increased productivity. Would this be enough to thwart inflation given how negative the demographics are in the developed world? Globalisation has enabled the offshoring of production to alleviate potential wage and inflation pressure domestically where supply fails to meet demand. COVID could be a negative influence here as we start to see some more "on-shoring", and the US has already started this process. It is even possible to argue that globalisation has peaked with regards to its ability to be deflationary.
Even if inflation goes up moderately towards central bank targets (at 2% or so) that should not be too problematic for financial markets. A bigger concern, though, would be that we see a period of strong growth but then head into "a disappointment phase" of the economic outlook looking worse than pre-COVID. Central banks have no additional tools to help economies (and, therefore, financial markets) should inflation prove even stronger. Government bonds would not be attractive in this scenario and inflation-hedges would be so, perhaps, it is equities (maybe paradoxically given current valuations?) as well as inflation-linked bonds and gold, that should do well.
Let us now look at the US and UK stock markets. There is little doubt that US stocks per se are 'expensive' on conventional historic measures for equity valuations. This is extremely important to equity investors as if we do see a correction in US markets then it is highly likely this would be contagious elsewhere and everywhere.
The US stock market has scaled new heights with the S&P 500, the Dow Jones industrials, Nasdaq and Russell 2000 (covering smaller companies - which are still pretty large businesses given it is America we are talking about!) already hitting records in 2021. For some highly experienced commentators the disconnect between western economies and the markets has reached a potentially dangerous point. Jeremy Grantham, the revered 82-year-old founder of investment firm GMO said publicly that we are in an "epic bubble" that would "burst within weeks" or, at the latest, by this summer. He quite rightly pointed to the fact that Shiller’s cyclically adjusted price/earnings ratio (CAPE) for the S&P 500 has only once been higher since inception in 1881 and that was during the dot com bubble at the turn of the 20th century. This measure attempts to strip out the “noise” of the business cycle by using an inflation-adjusted average of earnings in the past decade in its denominator.
As ever, though, it "takes two to make a market". One of the most respected UK research houses is Capital Economics and their reply is "We don’t think that there is a bubble in the US stock market. Yet even if we are wrong, it may inflate further before bursting given the outlook for the economy and monetary policy". They are not convinced by the arguments of Grantham et al, for three main reasons.
First, they are wary of inferring from the recent big increases in the prices of some equities that the entire stock market is highly overvalued. Perhaps the poster child of the bull market is Tesla, whose stock has risen nine-fold in a year and whose current valuation makes it more valuable than every carmaker in America, Korea and Europe combined, plus Mazda, Honda and Nissan - a group that together produces 100 times more vehicles than Tesla. Just because Tesla has boomed this does not mean that other major US stocks are not at a fair value or even cheap.
The US economy is always at the forefront of innovation. In 2020 you had to invest in companies on the right side of the digital divide and which have been COVID beneficiaries, but to be fair most companies benefitted from the risk-free rate falling to zero enabling many companies to survive who would otherwise have gone bankrupt. There are always companies that form pockets of "bubble like" characteristics and investors must beware of getting into them too late rather than not at all. In my next letter I shall be looking at the themes that might drive stock markets through 2021 and beyond, but you can be sure that Tech companies will remain in the midst of this.
Despite record levels of spending last year, nearly two-thirds of people in the US anticipate spending more on technology in 2021 than 2020 and 80% expect to pend more on-line this year. The new President is promoting his "Smart Cities" concept driving broadband as part of infrastructure spend. Yes, the Technology sector has out-performed, but then so has its earnings growth, validating valuations. Technology related investment now represents 55% of company investment.
Secondly, Capital Economics point to the fact that the sustainable valuation of the market today is higher than its long-run average because the sustainable levels of “risk-free” rates are lower now than their long-run averages. In other words, whilst cash is cheap and interest rates so low there are few attractive alternatives for investors and savers. Given that the US Federal Reserve has already stated it would want to see sustained inflation of 2% for at least a year before raising base rates then the interest rate status quo is likely to be in place for a while yet.
Thirdly, there is no evidence of the kind of leverage (borrowing) or financial imbalances that have typically accompanied bubbles in the past.
Just because we might have some sympathy with the Capital Economics view, though, does not mean that we are ignoring the valuation "noise" in the US. We continue to seek opportunities on a global basis, and I shall look at some of these in my next A view from the desk in a couple of weeks. However, it might also be a case that for 2021 we could do a lot worse than looking closer to home for value in equities?
COVID-led disruption, stuttering Brexit negotiations and weaker investment returns relative to other developed market peers all acted as headwinds to UK equities in 2020. Brexit uncertainty has led to what Aberdeen Standard investments refer to as a “buyers’ strike” among many international investors ever since the 2016 referendum. However, we, like them, believe prospects for the asset class in 2021 offer investors considerably more upside. Underpinned by the roll-out of the vaccine programme, there is cause for optimism for the global economy and UK companies alike as we move into next year. While at some point the withdrawal of government support schemes around the world will offset some of the economic rebound, this is a positive starting point for equities.
But why consider UK equities in particular? At the headline level and across sectors, UK equity valuations remain compelling versus other markets. Investors can expect relatively attractive dividends from UK equities in 2021, and there is also now a sustainable base for multi-year dividend growth. In a world of historically low interest rates, that is an attractive starting point.
The UK market has globally leading standards of corporate governance. If you are a minority shareholder your rights are as well protected in the UK as anywhere in the world. For long-term investors, this is critical in providing confidence that the businesses you own will be managed in line with your interests.
Finally, the UK market is about much more than just the UK domestic economy as over 70% of the revenues generated by UK-listed companies come from outside the UK. We can access global growth across the full range of industries by investing in UK equities. Clarity on the UK’s relationship with the EU will be a positive sentiment driver for the market and will no doubt encourage inflows. Challenges remain, but we believe that these factors in the context of underweight investor positioning, looks set to potentially provide robust support to UK equities.
At our first Investment Committee meeting of 2021, we agreed a "cautiously optimistic" stance as we seek to live in "the present" that is 2021. Stock markets are, by their very nature, forward-looking, attempting to anticipate the next winners and avoid those companies and sectors that will struggle or falter. It has never been truer to say that this is a year when one major "tail-wind" will be crucial to all of us. The successful roll-out and efficacy of COVID vaccines will be key to everything, but if we can trust in this then asset allocation and stock/fund selection will once again become the key drivers of investment returns - not R rates, lockdowns and political shenanigans. And I think we would all raise a "socially distanced" glass to that........
Graham Withers – Head of Discretionary Investment Management January 15th, 2021