Investment Update Q1 2021: Optimistic realism in a vaccinated recovery with Brexit

We close a difficult year with a sense of relief, and the tools to deal with the challenges ahead.

24 December 2020

Like a last-minute fill-in for St Nick, Prime Minister Boris Johnson announced on Christmas Eve that the UK and the EU have agreed a free trade deal in principle for goods.

This agreement is still to be ratified by the UK Parliament, which is expected to convene for a vote on 30 December, as well as by the EU Council and the EU Parliament. Parts of it may need to be agreed by member countries’ parliaments too, depending on what’s included in the deal. After negotiating through the night, reportedly with several interventions by EU President Ursula von der Leyen and Mr Johnson, the two sides broke the deadlock on several issues which held up talks for months. These include fishing rights and attempts to ensure a fair playing field for cross-border business.

Trade deals are fiendishly complex, yet news discussion of them typically boils down to very broad-brush terms and issues. We are awaiting the final terms of the deal so that we can see exactly what has been agreed. We will then be updating you in more detail on the effects it could have on your investments. One point we will make now, however, is that non-tariff barriers (extra paperwork and labelling requirements, etc.) are by far the greater costs and a trade deal doesn’t negate these. The Bank of England expected around 80% of the total reduction in trade as a result of ‘no-deal’ Brexit to be attributed to non-tariff barriers. Others estimated upwards of 90%.

Brexit and the UK valuation gap

Still, a deal is good news – it shows the two sides can work together and there will be a lot more negotiations in coming months and years building on this deal. The threat of Brexit jeopardised the UK’s prospects of a good economic recovery from COVID. Outside of the UK, business surveys show investment intentions improved in the third quarter, but in the UK they remain stuck at their lowest level since the survey began in 1997, and even substantially worse than during the financial crisis. Before COVID, UK business investment spending hadn’t grown at all since the vote to leave, in other major developed economies it averaged 10% growth. That’s a huge gap. Now, with new COVID restrictions further constraining the UK’s consumer services, it needs all other parts of the economy to be growing as quickly as they can. And that of course includes business investment spending, which accounts for 10% of GDP.

"The UK is on track to have one of the worst outcomes this year out of the 42 developed and developing countries that we monitor."

Unfortunately, there is a long list of reasons why the UK may lag other major economies. Brexit only added to it. Indeed, the UK is on track to have one of the worst outcomes this year out of the 42 developed and developing countries that we monitor. One reason for this is the UK has suffered the fourth-worst health outcome (behind only Belgium, Spain and Italy). That raises the relative risk of more stringent restrictions lasting into 2021. Another reason is that the UK has a larger consumer services sector than most other countries, and therefore is more sensitive to those restrictions. Key sectors were already ailing before the pandemic, and there’s some evidence to suggest the UK may have had a greater share of so-called “zombie” companies (uncompetitive businesses that are kept afloat by ultra-cheap financing). Our private sector is more indebted than that of many other countries, which increases fragility and limits the extent to which firms could bounce back in a vaccinated world.

The Brexit deal is good news for UK equities, but only to an extent. Surveys of institutional investors suggest global fund managers have avoided British companies since the vote to leave. The gap between the prices of UK and overseas equities relative to their book value (assets minus liabilities) has widened to a degree not seen since the 1970s, when the UK had to ask the IMF for a bailout. But there are non-Brexit reasons why we think this valuation gap will remain wide for the time being. Historically the UK has offered a high – and high-quality – dividend yield. But that’s more questionable today, as we wrote early on in 2020. The UK also has outsized exposure to financial companies and oil and gas, whose profits have been held back by bigger structural forces for the last decade. And exposure to resource extraction may have driven some underperformance as investors now look for more environmentally friendly companies.

The year that was

In our last InvestmentUpdate of the year, we typically look back on our predictions from 12 months prior to review what we thought, and what we got wrong and right, and why. Reviewing your decisions and assumptions is an important discipline for investing.

With the global equity market benchmark up 10% year-to-date, we could argue that our December 2019 forecast for a year of modest equity returns was spot on. But goodness me would that be disingenuous! We did not foresee the 33% peak-to-trough fall that benchmark took along the way, and we did not foresee the economic contractions that in many countries were the worst since the post-World War Two recession. And in others, including the UK, were the worst since National Income Accounting began.

Indeed, a year ago we even referred to one of our proprietary quantitative tools that suggested just a 2% chance of the US falling into recession in 2020! It just goes to show that quantitative analysis, while important, should only ever be a starting point.

Thankfully, we began the year relatively cautiously. We were invested, but ignored the strategists at investment banks peddling the need to rotate into the companies most sensitive to the business cycle and those with the most beaten-up valuations after a year of decelerating economic growth. We believed that falling interest rates in the West and combined monetary and fiscal stimulus in China would start to lift activity by midyear, but that the economy and profits were vulnerable to another setback in the meantime.

When COVID-19 spread around the world and markets plunged in March, this fortuitous bias to growth, quality and defensive factors made our portfolios relatively more resilient. 

Optimistic realism

Entering 2021, investment banks are again peddling a theme of deep-value and deep-cyclicality. Again, we’re sceptical. We think investments that lack structural or fundamental drivers, and with investment cases relying solely on the COVID recovery, should be avoided.

That doesn’t make us pessimists. We are optimistic, for sure, and we close the year with a sense of relief that one of most difficult years many of us have ever experienced – professionally and, for some, personally too – is behind us. The approval of COVID vaccines has changed the risk-reward profile of equities in 2021. Markets are probability weighting mechanisms after all, and the new spread of probabilities warrants a less cautious stance. We have upgraded our outlook on more cyclical markets such as Japan and Europe accordingly, and downgraded our outlook on defensive currencies such as the dollar and the yen.

"We have upgraded our outlook on more cyclical markets such as Japan and Europe accordingly, and downgraded our outlook on defensive currencies such as the dollar and the yen."

We think it makes sense to look to increase exposure to equities again throughout 2021, given the extremely low opportunity cost of owning them. Even if we were to assume pessimistically that nominal dividend payments didn’t grow for the next 10 years, global equity prices would have to fall by more than 25% in inflation-adjusted terms over the next decade for stocks to underperform 10-year Treasuries held to maturity). However, we must acknowledge that there are still significant cyclical risks to the recovery over the next three to six months, and therefore a somewhat elevated risk of a market correction.

Additional stay-at-home orders and social distancing measures designed to combat notably fierce new waves of infection and hospitalisation are compounding the declining economic trends we were already observing. This was true in the innovative, high-frequency indicators of activity that have helped us track the industrial and retail recoveries in almost real-time with a surprising degree of accuracy. Traditional leading economic indicators, such as the PMI surveys of business confidence in Europe, are also falling. Italy’s PMI index in November fell at the quickest rate since May despite the game-changing news of vaccines, highlighting that company management teams are continuing to focus on the near-term risks even as their investors are looking well beyond them. Yet, historically changes in business confidence surveys have tracked changes in equity markets. Consequently, the prospect of negative macroeconomic data surprises poses a risk; they have had a strong correlation with equities over the last 11 months.

Headwinds met by a wall of cash

At the same time, bullish sentiment has surged. In recent months, inflows into equity funds have been some of the biggest on record. The ratio of options to sell equities relative to options to buy them has fallen to multi-year lows. And bullish sentiment among retail investors has soared, according to the American Association of Individual Investors (AAII) weekly bull-bear poll. These tend to be contrarian indicators, especially the AAII poll.

Of course, these risks are just that – they are not a certainty, and the backdrop of extraordinary fiscal and monetary support may continue to help investors look through short-term turbulence to a vaccinated economy. Over the last century, the great failures to recover from economic shocks have been characterised by an inadequate fiscal and monetary policy response – think Japan in the 1990s or the US in the 1920s. That’s certainly not the case this time.

Even after the second quarter’s extraordinary collapse in output, aggregate Return on Invested Capital (ROIC) is still likely to be comfortably above corporate borrowing costs (bond yields) in 2020 (although this will vary greatly between sectors and companies). When this spread has been positive in aggregate, equities have tended to outperform bonds or cash.

This is even more likely in 2021 of course. Households and firms are starting to spend liquidity buffers built up in 2020. There is no precedent for the extent to which these buffers were built up. Deposit growth at America’s financial institutions has increased by 20% year-on-year; including money market funds and savings deposits, this is an increase of $1.5 trillion. That’s a formidable wall of cash. While we are less optimistic than some of our peers about the speed with which this pent-up demand will be released, it’s still likely to boost consumption and investment. 

Still, consensus estimates for 2021’s earnings per share are stretched, and valuations high, and investors need to be aware of that as we move through the winter months and vaccine rollouts. Bringing together everything we have discussed so far, instead of rotating into pure-value and deep-cyclicals whose prospects rest solely on the COVID recovery, we believe investors should favour cyclical companies with quality factors (e.g. low debt levels, strong profit margins, consistent returns on capital invested, etc.), which fall somewhere between growth and value.

Brexit and other unknowns

There are other risks that investors should bear in mind too. Mutations of the virus could forestall vaccine success. Setbacks to the approval, distribution and acceptance of vaccines could also yield a more negative outcome. There are also political risks, such as increasing wage and regulatory costs if the Democrats control Congress by winning both Senate seats in Georgia’s 5 January run-off, or tensions in the South China Sea. And there’s the threat of inflation. Our analysis suggests that these risks would be high-impact events for markets, but ones to which we should assign a low probability.

Inflation risks

For sure, it’s likely that we’ll see inflation spike temporarily in March/April due to the unusually depressed prices in those months of 2020. Central banks have made it clear that they will look through it and won’t consider tightening policy.

"The history of pandemics suggests they depress the demand for goods and services more than they depress their supply – that’s disinflationary."

In a July InvestmentUpdate we set out in detail why we think inflation is unlikely to trouble investors in 2021. The big lesson of the last 10 years is that it’s not just about the supply of money – not just about extraordinary stimulus and the monetisation of fiscal deficits – it’s about the desire to spend it. We won’t have the protracted deflationary impulse of a financial crisis this time, but we do think a lower so-called “velocity of money” will continue to offset the inflationary impulse of a higher supply of money for another 18 months at least. In other words, while a lot of money has been pumped into the economy, the rate at which that money changes hands will remain low. Companies are repaying emergency debts, households are fearful of losing their jobs and have a stronger desire to save too.

The history of pandemics suggests they depress the demand for goods and services more than they depress their supply – that’s disinflationary. And look at China: it’s had a relatively good economic outcome with very strong growth in the second half of 2020, and yet its CPI inflation came in at -0.5% last month, well below already meagre consensus expectations.

Some strategists point out that inflation in the US would be back to the 2% target if the price of apparel, hotels and air tickets normalised, but, as they do, inflation in other goods will ease as people start to substitute services back in to their spending patterns when vaccination programmes start in earnest. Inflation in services is highly unlikely given that prices here are driven more by the cost of labour, which will struggle to rise with so much slack in the labour market.

Debt burdens

In a more recent InvestmentUpdate we set out in detail why we are not concerned about the extraordinary increase in government debt – at least not yet. Indeed, we believe that most governments should continue to use it to support growth. Yes, there is some long-run evidence that low economic growth is associated with high public debt burdens. But “associated with” is not the same thing as “caused by”, and in fact work that tries to establish causation points in the opposite direction – deficient growth causing high debt.

The only real constraint on government debt is inflation. The ratio of debt to GDP should be sustainable so long as the cost of debt is less than the nominal (non-inflation-adjusted) growth rate of the economy. Despite the huge rise in government debt burdens this year, the cost of servicing that debt is highly likely to be lower over the next five years than it was over the last five because of the steep, structural decline in bond yields.

US stimulus

With that in mind – and despite US gross government debt likely to rise to more than 160% of GDP by year end – we’re pleased that Congress has agreed a new round of fiscal stimulus to help Americans navigate a path through new emergency COVID restrictions (although as we write it’s possible the White House may hold up its passage). The $900 billion relief package extends emergency unemployment benefits for 14 million Americans until mid-March by topping up benefits for 11 weeks. Many households will receive stimulus cheques of $600 per qualified individual and child, phasing out for those with incomes over $75,000. Among other items, there is $280 billion in aid to small businesses, as well as grants for live venue operators and airlines, and broad-based deferment of payroll taxes until 31 December 2021.

The deal is late and won’t entirely offset an economic slowdown this winter. In part that’s because only a little over a third of those $900 billion of measures constitute new spending – the rest re-appropriate funds left unspent from the prior stimulus bills of 2020. With weekly death tolls reaching new highs in economically important states such as California and Pennsylvania, we expect activity to stumble. But the positive market reaction to the stimulus bill suggests it is sufficient to placate investors’ concerns. Downside risks to markets from US fiscal policy in 2021 include the inability to pass a new package should the economy need it in March (especially given that there won’t be an unspent envelope to appropriate). But that downside risk needs to be balanced with the possibility of a significant bipartisan infrastructure package focusing on transportation.

US election implications

As we discussed in another recent note on implications of the US election there aren’t many bipartisan issues these days. Nevertheless, loggerheads in Washington tend to leave space for above average stock market returns.

Before the election, we set out what was then a contrarian argument that a Biden presidency with a split Congress was a very market-friendly outcome over the medium term. Little changes in terms of the scale of the fiscal or monetary policy supporting the economy and its financial markets, relative to the status quo, but foreign and trade policy uncertainty will ease significantly. The substance of Biden’s trade policy is similar to Trump’s, at least on China. But the style will change. And the maverick, unpredictable approach will likely be replaced with more measured, rules-based tactics and renewed cooperation with allies and the international institutions that have presided over decades of strong corporate profitability. Contrary to what many surveys of institutional investors predicted, markets did indeed welcome the result.

This change is likely to benefit non-US equity markets more than US markets. From a global perspective the election was arguably about whether global policy uncertainty will continue its dramatic ascent in recent years. Huge increases in uncertainty, particularly around what American protectionism meant for foreign export-oriented economies, augmented the outperformance of US versus global equities and the long upward trend in the dollar. Uncertainty has become greater outside of the US than within it because the US is a more insular economy, with a lower ratio of trade to GDP. In our view, that’s benefited US assets relative to non-US assets because its stock market is less cyclical than many others and less sensitive to the global trade cycle. And the dollar has benefited from its safe-haven status.

"Uncertainty has become greater outside of the US than within it because the US is a more insular economy, with a lower ratio of trade to GDP."

The dollar has already weakened against major currencies. The tight historic relationship between the exchange rate and the performance of US equities relative to the rest of the world suggests that non-US equities may be overdue a relative bounce. The scope for a bounce is not yet evident when looking at the dollar’s relationship with emerging market currencies and equities. We’ll be writing more about the outlook for the dollar in one of the articles in our next InvestmentInsights, which will be published in early January.

China (note Taiwan)

We believe Biden’s presidency will benefit Europe and Japan more than it does Greater China. Anti-China trade policies have become a bipartisan issue. Biden is the culmination of the Democrats’ anti-China shift, and some of Biden’s proposals go further than Trump even.

Biden may return to Barack Obama’s “Pivot to Asia” policy, which was about countering China with a reoriented globalisation. Biden would also be more likely to work with other major powers to combat China’s bid for economic hegemony, and in this regard may well present more of a threat to China and China-related investments. In a December interview with the New York Times, Biden indicated that he would not reduce tariffs until he had increased leverage on China with a multinational coalition. These things take time.

Some commentators have raised the possibility of a fourth “Taiwan Straits crisis”, observing increasing military posturing in the region. The geostrategic research we have read suggests that such a military conflict would be difficult for either side to win, but it is a tail risk that cannot be ruled out.

Chinese exporters’ profits have been supercharged this year due to substitution effects in Western countries: as Westerners cut spending on local services, they increased spending on electronics, furniture and other household goods, particularly those offered by online sellers. This was a boon to China, which capitalised on the trend early because it was the first to recover from COVID, picking up market share from competitors that were dealing with longer-lasting lockdowns. In a vaccinated world, some – though not all – of this trend could unwind.

Chinese policy is becoming less supportive, and this tends to lead activity by six to nine months. Recent reports from the People’s Bank of China emphasise that it is time to exit from the pandemic-era monetary policy. It pledged to maintain ample liquidity needed for the real economy (not including the financial elements), but also rules out flooding the economy with too much of it, stressing the need to build a financial system that can serve the real economy more effectively. Defaults at state-owned entities have increased abruptly; at a time when the economic data have been strong, this suggests credit risk in China hinges more on the policy stance than on fundamentals.  For sure there are good investment opportunities in Asia, where we can access megatrends in healthcare and the green and digital economies at more attractive valuations than in Western markets. But it is important to keep in mind the cyclical and structural backdrop before raising exposure to a more volatile area at this time.

A more sustainable outlook

We are pleased to see that, far from derailing progress, the COVID crisis seems to have been a catalyst for a more sustainable approach to future growth among businesses, investors and policymakers. As we set out in our 2019 report Responsible capitalism, we see environmental, social and governance (ESG) factors as increasingly important in our management of investments for long-term returns. We firmly believe that having an additional ESG lens can help us improve risk-adjusted returns. Over the coming year, we’ll be building on our work to embed.

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