Macro Overview
It is not really worth mentioning too many macroeconomic numbers except to say that when economies re-opened numbers were generally stronger than expected and, unsurprisingly, when restrictions on movement and lockdowns were re-imposed economic activity took a hit. However, the impact of the second wave of restrictions has thus far been nowhere near as bad as round one in the spring as manufacturing has been allowed to continue and many companies have adapted where possible to limit disruption. Examples of intra-lockdown strength were the release in early October of EU company optimism rising to its highest levels since before the Trade Wars commenced; 60% of UK manufacturers forecasting an increase in export orders in 2021; Chinese exports increasing 10% year-on-year in September and one million travellers going through US airports in one day for the first time since early March.
China is now enjoying record high levels of economic activity despite only having to deploy a fraction of the stimulus we in the West have spent.
As one would expect, more service related economies such as Spain, Italy and the UK have fared worst, the latter further impacted by elongated Brexit uncertainty. Whilst the US is a very service-oriented economy their government has not imposed restrictions on anything like the scale Europe has (mostly down to individual states) and therefore the economy has held up relatively well, even if the number of Covid cases has not.
Across the Western world there has been a trend of households significantly upping their savings rates whilst corporations have gone on a debt binge to raise liquidity and extend the maturity of existing debt. This high household savings rate is one of the reasons economists expect a sharp rebound in 2021 as pent-up consumer demand can be readily funded even as unemployment and corporate bankruptcies rise as furlough schemes and government subsidies are removed. Fiscal spending on infrastructure is also expected to pick up the mantle as transfer payments to individuals and businesses are wound down.
With two vaccines now being fully approved and rolled out and with non-negative outcomes transpiring for both Brexit and the US election our post-winter economic future looks brighter than it has done since at least 2017.
Markets
Another strong quarter for equity markets, credit and energy with UK gilts eking out moderate further gains even as US bonds gave up meaningful ground. Sterling exhibited some strength across the board but the big story in currency was significant dollar weakness against almost all global peers. For the year the dollar index closed down c.7%.
Corporate activity was robust with debt issuance reaching record highs, equity issuance the most in a decade and Private Equity sponsored transactions reaching the highest level since 2007. A combination of cheap money, the desire for short term liquidity and disruption in several industries all contributed to this phenomenon.
Medical breakthroughs enabled more cyclical and face-to-face businesses to play a little bit of catch up and small cap in general also made up some of the performance gap against those companies that investors had considered either winners from or impervious to Covid.
UK small cap delivered 20% as markets mostly ignored the Brexit negotiating dramas and decided that a deal would eventually be done, as indeed transpired.
Investor sentiment was further bolstered during the quarter by the Federal Reserve, ECB and Bank of Japan signalling that extreme monetary easing was likely to continue for longer than it did post the 2008-09 Global Financial Crises whilst the US government eventually passed a further (slimmed down) stimulus bill and both the UK and Europe extended furlough schemes.
Investors are now assuming that no developed economy will see short-term policy-controlled interest rates rise for at least eighteen months and there is now more widespread belief that long-term rates will be also be controlled by Central Banks. This is obviously possible but a change in US Central Bank policy to issuing longer dated bonds means, according to JP Morgan, that private institutions and investors will be required to purchase $1.8 trillion in Treasuries maturing in one year or more. And this is after the Federal Reserve have made massive purchases via their QE program.
2020 will probably be viewed as the year that Ethical investing ‘came of age’ or at least came to the forefront of investor thinking. Particular interest was attached to the decarbonisation of the global economy and this bore fruit as widespread travel bans ensured the worst downturn in carbon fuel demand in living memory.
We launched our Ethical Model in 2011 and revamped it in 2018 to include more positive impact solutions such as Sustainability and Clean Energy rather than concentrating on merely the exclusion of ‘sin’ industries. There will be a secular move into companies and industries which adhere to the UN’s Seventeen Sustainability Goals (UN SDGs) and even more to those who successfully address the problems those goals are trying to solve. However, the moves over the last eighteen months have led to a surge in valuations and an ensuing attempt by companies and fund managers alike to present themselves as part of the solution, when only a small fraction of what they do is truly relevant to the ‘ethical revolution’. Furthermore, it has been highlighted several times in the past that despite its laudable goals the ethical investing path can be a bumpy one. Solar Panels are an example of where excess capital was deployed in ‘green’ industries and shareholder returns suffered terribly as a result. Given the surge in capital allocated of late and the attendant rapid rise in valuations the best we can hope for in 2021 is that investors will need to become increasingly discerning in their search for profitable Ethical investments. We have recently taken some profit in the biggest winners of 2020. However, the long-term trend will remain positive over the next decade so plenty of opportunities will present themselves if a shakeout ensues.
Chart 1. “Green energy plays have gone inter-galactic”
In the short-term the reduction in cash levels by institutional investors to below average levels (for the first time since May 2013) and the fact almost all investors are expecting a rapid economic rebound gives cause for some circumspection, although I expect any blip to be relatively short lived and not too dramatic, certainty not by the standards of the last twelve months.
The regulatory noose on Big Tech tightened somewhat in the quarter with the Chinese first forcing the postponement of the mega cap Ant IPO and then investigating Alibaba over anticompetitive practises. In the US, the Justice Department opened an anti-competitive lawsuit against Facebook whilst the EU proposed two significant pieces of legislation (the Digital Services Act and Digital Markets Act) which threaten potential fines of up to 6% and 10% respectively of the global revenue of Big Tech companies if they act in contravention to the rules. Related stocks have fallen meaningfully in China but in the US only slight relative underperformance has occurred suggesting investors do not think that future revenues or margins will be impacted by the increased regulatory scrutiny. Time will tell but it is difficult to argue for further valuation expansion with this global phenomenon increasingly in the foreground.
Activity & Positioning
We retain our full position in equities and our preference for Asia and the UK and expect several equity markets to outperform the US as the global economy recovers from the pandemic, the rules of trade become more predictable post Trump and manufacturing businesses at least know what they are dealing with post Brexit (but alas many service companies don’t).
To bet against equities is to bet the authorities fail in the largest, most globally synchronised simultaneous fiscal and monetary boost in history.
However, as noted before the massive increase in influence of passive and algorithmic trading as part of total trading has contributed significantly to the bifurcation within the market between winners and losers. As economies return to more like the way they operated pre the Covid pandemic (and indeed post prior pandemics) then investors will rediscover there are many shades of grey within markets. There is therefore, plenty of scope for companies to enjoy positive re-ratings or suffer de-ratings as trading conditions transitions from the current extremes, both good and bad, to more like their sustainable paths over the long term.
Indeed, within industries currently troubled, the winners will probably see outsized benefits from market share gains and better pricing as smaller, weaker players fall by the wayside. This is despite some troubled bigger players being able to limp on due to the cheap credit they have raised over the last twelve months.
Corporate activity is likely to remain brisk as larger companies can take advantage of very cheap debt financing and make accretive acquisitions.
In absolute, equity valuations are not cheap at the index levels but as discussed above there is significant scope for revaluations within markets.
Investors withdrew £42billion from UK equities from the referendum in 2016 through November 2020 so I expect at least some of this to return over the next 12-24 months as a layer of uncertainty has been removed and both the corporate sector and institutions take advantage of cheaper valuations available in the UK versus peers, even on a sector neutral basis (source; Liberum). Despite their economies being more dependent on tourism and having big financial weightings in their indices all of France, Spain and Italian equities outperformed the FTSE All Share in 2020.
If equity markets don’t look cheap by their own historical standards they do remain attractively valued compared to both corporate bonds and government debt. Central Banks are obviously supporting the latter two via significant purchases which are anticipated to keep rates at these very low levels, at least for bonds that are shorter term in duration.
As the chart below depicts, the spread of corporate bonds over government bonds is low despite the rate on government bonds themselves being held artificially low by Central Bank buying. If investors fully buy into a sustainable economic recovery then both government and corporate bond yields will rise among longer dated securities. There is at least 100 basis points (1%) of increases required just to get us back to where we were pre-Covid, never mind pre-Trade War.
Chart 3. Corporate bond spreads have narrowed
In terms of activity we took advantage of the extreme moves and valuations within markets and added more to UK equities in November (when a deal became much more likely despite the political rhetoric) and to Japanese and US Equities (an Income fund in the latter which had suffered from the pandemic panic in companies that didn’t benefit directly from Covid). The rally in more economically sensitive, or value stocks, has been far less pronounced in Japan than in other markets, be they Emerging or Developed and we expect a catch up as profit expectations are upgraded throughout 2021.
We also unhedged our Japan exposure as the Yen is about the only other currency which looks as cheap, if not cheaper than Sterling. The Yen usually goes up in tough markets so this also has an element of risk reduction to it.
On the selling side we exited the two Alternatives we were invested in for Income, Growth and Income & Growth. This is because they had not performed as we anticipated in that Allianz Structured Return performed far worse in sharp downturns than expected whilst Schroders QEP Market Neutral only seemed to perform in downturns and had, in our minds, been guilty of some style drift which makes modelling the future path of returns even harder.
We are actively looking to find an Alternatives solution which can deliver modest absolute returns over time whilst providing some element of negative correlation in tough markets.
Figure 2. Portfolio changes in Q4 – RJIS
Conclusion
We expect positive returns from our portfolios over the next twelve months despite the potential of near-term blips due to the latest round of Covid, the potential for longer term interest rates to rise and the fact investors seem ebullient. Brexit and Trade Wars had already impinged upon capital investment and trade was only just beginning to recover when Covid hit and pummelled the nascent recovery. With households having lots of cash, Central Banks promising to keep the spigots open both longer and wider and with most regions (ex-China) expected to see increased public investment we are likely to see a recovery of decent magnitude and duration. Markets had begun discounting economic difficulties as far back as May 2018 so we are only in the early stages of recovery. Furthermore, the market was increasingly narrow in terms of the percentage of stocks that were leading the advance. The broader market rally is barely two quarters old and is a long way from being mature. So, we keep the faith and look forward to both some capital appreciation and increased dividend prospects in 2021. Fixed Income is likely to struggle while real assets will become more popular as economies reopen and movement of people picks up.
Sterling surprised many by finishing the year 3% higher versus the dollar and over the year I expect further progress. However, it has already recovered to over $1.36 from just below $1.16 in March so a short-term pause would not be unusual. For perspective the rate was just under $1.60 when David Cameron proposed the referendum and around $1.45 in the weeks leading up to the June 2016 vote.
The biggest threat to Sterling, apart from the perception of ongoing economic mismanagement by the government, is likely to be the spectre of the break-up of the UK as Scottish and Irish nationalists are both very pro-EU. With the current UK government very pro-Union I fear things could get messy and harm the economies of all of the current UK constituents. I’m just not sure it will be about economics any more (it never was in Ireland).
However, unless the worst-case scenario plays out I expect a robust recovery in the UK after four and a half years without growth in capital investment, austerity long gone and a natural rebound from the Covid induced shutdown. Another positive is that many companies (not just in the UK) were able to move far quicker in response to Covid than they previously thought possible. This leads me to think that productivity will be a lot higher across a swathe of industries as users of technology enjoy the benefits as well as the providers of technology.
Indeed, it will be China that sees the least positive rate of change in 2021 and also the highest probability of a reigning in of policy stimulus.
So, in conclusion 2021 looks good for the economy, more predictable with regards to trade policy and encouraging for corporate profits.
A changing of the guard from passive and algorithmic investment may crimp gains at the index level but this should not unnecessarily hold back potential for a well-diversified portfolio comprised mostly of non-mega caps.
Here’s to 2021!
Current Asset Allocation
Important Information/Risk Factors:
Past performance is not a guide to future performance and investment markets and conditions can change rapidly. Investments in equity markets will be more volatile than an investment in cash or fixed deposits. The value of your investment may go down as well as up. There is no guarantee you will get back the amount invested. If your fund invests in overseas markets, currents movements may affect both the income received and the capital value of your investment. If it invests in the shares of small companies, in emerging markets, or in a single country or sector, it may be less liquid and more volatile than a broadly diversified fund investing in developed equity markets.
The views expressed herein should not be relied upon when making investment decisions. The article is not intended as individual advice and if you require advice or further information you should contact us.