22 Jan 2021
Last year market commentators saw how difficult both longer-term, and even shorter-term forecasting is. Our approach is to take a longer-term view of structural thematic change in the global economy and the investment implications. We have always believed that, despite market noise, and particularly in times of uncertainty, investment is a risk management exercise that requires analysis of markets in terms of the three risk drivers: economic fundamentals, valuation, and market sentiment.
Markets have front run the quickening recovery in global economic activity that became evident in the second half of 2020 and have remained strong despite a weakening of activity, especially in the non-Asia/Pacific service sector in the latter part of the fourth quarter as the Northern Hemisphere experienced a second or third wave of Covid-19. With further enforced lock downs and restrictions on activity, this slowdown will accelerate in the first quarter of the year with markets focused on prospects for recovery in the second half of 2021 and into 2022.
An important trend in the post GFC period is the discounting of both economic recovery and economic slowdown at an early stage. The latter occurred with the weakness in markets during the second half of 2018 as concern grew that monetary tightening by the US Federal Reserve would slow economic activity significantly. The rally in markets in 2019 was driven by the Fed pivot on interest rates and today, investors do not wait for hard economic data to price in these changes. This is demonstrated by the speed of market moves in 2020 with the fastest bear market selloff and then the shortest bear market period and rapid recovery. Investing is harder in this environment and unless an investor is an excellent short-term trader, taking a longer-term view on market prospects is often the most prudent course.
Today, equity markets look expensive on an absolute basis versus history under a variety of metrics, with both the forward PE and CAPE ratios in the top decile of historical data. The Shiller PE which looks at cyclically adjusted price earnings ratios, also known as the CAPE, averages earnings over a 10-year period to estimate if stocks are over or under valued. Shiller has now acknowledged that in a world of zero interest rates, higher CAPE ratios are justified, and he has developed a new measure, the excess CAPE yield (ECY), which considers both equity valuations and interest rates. This indicates that global equities are cheap and highly attractive relative to bonds, particularly in the UK, Europe, and Japan. The ECY estimates suggest inflation adjusted returns of about 5% for the next decade from the US stock market are plausible. As a result, Shiller acknowledges that stock market valuations are not as absurd as some people think.
In the very short-term, market sentiment is very bullish, and this can be a cautionary sign, especially if there is some unexpected negative news flow. This can be seen looking at some of the huge gains in individual stocks such as Tesla, not to mention the wild swings in the price of Bitcoin which are all indicative of speculative excess. The S&P 500 at 3768 is close to 15% above the 200-day moving average.
This might have investors heading for the door, but it is important to remember how the global economy and interest rate outlook are very different from even a decade ago. As Schiller has commented, equity markets are not expensive on a relative basis compared to fixed interest securities. A lower interest or discount rate applied to company earnings increases the present value of these, justifying a higher PE ratio. Empirically you can see that periods of low interest rates and inflation are accompanied by higher PE multiples and these high multiples will come down as long as the expected economic recovery comes through. In the S&P 500 Index, the high valuation reflects not only the concentrated nature of the market where the top five stocks account for nearly 25% of the index, but also the sector breakdown with its high weighting to the fast-growing technology sector. In contrast, the UK FTSE, which is often quoted as 'cheap', has a very different sector mix and arguably a much higher emphasis on sunset industries where top line, and even bottom line growth have been difficult to achieve over the last five years and where thematic trends suggest that this will continue. Even high sentiment readings do not necessarily mean a sharp market setback is on the horizon as these can often unwind by markets moving broadly sideways for a time.
The most important factor justifying the high rating of the market is that economic fundamentals are broadly positive over the medium term. Covid-19 has had a devastating impact on certain sectors in the global economy but overall, economic growth forecasts in the second half of last year were revised upwards and all the manufacturing PMI indices during December were not only above 50, but in most cases exceeded expectations. Manufacturing is easier to reboot than the service sector and within the service sector, those companies not reliant on a high level of personal service have not only seen market share and volume growth, but a re-rating by the stock market as investors have realised that the long-term trends favouring these businesses have accelerated and market share gains will not be given back to any large degree.
Markets are focusing on the continuance of easy monetary policy and on the 14th January Fed Chair, Jay Powell, sought to stamp out fears that the Federal Reserve would begin winding down its asset purchases later this year, stating that the central bank was far from considering an exit from its ultra-loose monetary policies. Mr. Powell was speaking at a virtual event hosted by Princeton University and acknowledged that the Fed had to be very careful in communication about asset purchases because of the sensitivity among investors to the potential withdrawal of central bank support. He added that a lesson from the Global Financial Crisis was to be careful not to exit too early and that, when the central bank had clear evidence of progress towards its goals and employment and inflation, it would let the world know about its assets purchase policies.
These assurances follow similar remarks from Richard Clarida, Vice Chairman, and Lael Brainard, another Fed Governor, and have underscored that the Fed is in no rush to pull back its support and wants to avoid a repeat of the ‘taper tantrum’ that rattled markets in 2013. The publication from January 14th discouraged data from the labour market, including net job losses in December and a surprise surge in first time jobless claims have underlined a huge slack in the labour market. It is also likely that the US Federal Reserve and Treasury will work closer with the appointment of previous Fed Chair Janet Yellen as US Treasury Secretary. Mr. Powell also emphasised that the Fed would not overreact to a sudden jump in consumer prices this year as the economy rebounded from the pandemic as long as the view remained that these would only be temporary. He concluded by saying ‘when the time comes to raise interest rates, we will certainly do that and that time by the way is no time soon.’
With the last two Senate seats in Georgia falling to the Democrats, the so-called ‘blue wave’ has now occurred to a greater degree than markets had assumed immediately post the election. Joe Biden has now proposed a new $1.9tn economic rescue plan which includes direct payments to Americans, aid for state and local governments, and more funding for the coronavirus pandemic response. The sad events on Capitol Hill will only make Republican opposition to these measures more difficult and a larger stimulus package than looked likely at the end of the year now seems possible. The second stage of Biden’s economic agenda is yet to be revealed but is likely to call for longer-term spending on infrastructure, green energy, and education which will be funded at least partially by higher taxes on both the wealthy and corporations. It is the latter which has the potential to cause at least some stock market concern.
Coronavirus case numbers, hospitalisations and deaths have increased significantly this year but markets, as discussed, continue to look further forward and the vaccine news overall remains positive. New approvals are expected from Johnson & Johnson over the next quarter (importantly a one shot vaccine) halving patient delivery time, together with Novavax, both of which have seen strong results from stage 2 trials and are in stage 3 assessments today.
These measures all point to a supportive background for equities. The speed of economic normalisation will be an important factor, looking at the dichotomy and performance between value stocks and growth names with technology significantly outperforming energy and financials over the last 12 months. Even within this, there are likely to be further distinctions between defensive and cyclical names and certainly in Q4, and especially November, growth defensives significantly lagged the market, with cyclical recovery doing well, as was to be expected, but also many high growth names performed well in Q4, both in the technology and innovative healthcare sectors.
One point to note is that with extended valuations at present and extreme sentiment readings, any short-term disappointments to vaccine efficacy or roll-out could trigger a short but sharp stock market pullback, and whilst this is not the central case, it needs to be borne in mind by investors. Historically, extended valuations and extreme sentiment readings have needed a catalyst to correct, but in today’s world of quant driven markets, if this did occur, it would likely be too fast for most investors to react after the event. The relative attractiveness of equities versus other asset classes continues to hinge on a continuation of low interest rates and inflation.
There were two factors behind the naming of this piece ‘The year of living dangerously’. The first is that, despite the positive news on vaccines, the emergence of second/third waves with increased levels of transmissibility means that, on the personal level, everyone needs to stay ‘on guard’, no one wants to emulate the soldiers who died just before the announcement of the First World War Armistice. The second concerns stock markets as the November vaccine news was rapidly priced in by markets to assume a strong economic rebound in 2021. New lockdowns and restrictions on movements, which are particularly concentrated in the Northern Hemisphere, will reduce Q1 economic growth numbers and impact heavily on the already struggling service sector. Disruptions to supply chains could yet impact on manufacturing and there has already been a weakening in employment numbers in the States. The medical understanding of the biology of Covid-19 is increasing but is not yet complete. Clearly, if issues arose about the effectiveness of the vaccine, particularly if the virus mutated more significantly, or there was evidence of serious side effects from any of the vaccines in the coming months, this would be viewed very negatively by markets.
Vaccines could be tweaked to adapt to mutations and the mRNA technology is particularly flexible. Some whole of virus vaccine treatments are due to be approved this year, but any consequent delay to the roll out would not be well received by equity markets. The chief concern at the moment involves the South African variant, although initial laboratory tests by Pfizer suggests its vaccine remains effective, although these results have yet to be peer reviewed, and test results from Moderna and Oxford AstraZeneca are still awaited, although there are no indications that major problems are expected. The vaccines have been developed quickly but the stage 3 tests were conducted with vigour. Moderna even skewed its stage 3 trials to elements of the population deemed to be more vulnerable or less receptive to vaccines such as the elderly, those with underlying conditions and ethnic minorities. Due to the rigour of these testing regimes it seems unlikely that serious adverse side effects on a widespread basis will occur.
There is always an interplay and overlap between secular and cyclical forces in an economy and investors must contend with this. In the post GFC period, powerful secular forces (ageing demographics, high debt levels, technology innovation and excess global savings) kept both growth and inflation at low levels. So-called secular stagnation was a positive backdrop for equity markets, keeping interest rates at historically low levels and justifying the re-rating which has occurred of equities. Both growth and inflation have been kept at low levels, but some businesses have delivered strong revenue/profit growth and have, particularly over the last 12 months, seen their prospects re-appraised by markets. To date, inflation has remained low despite the cyclical impulse from both low rates and quantitative easing by central banks. The key question for markets is how the anticipated cyclical upturn will unfold. If it is accompanied by limited inflationary pressures which remain constrained by secular forces with the spare capacity (especially in the labour market) caused by the severity of the Covid-19 recession remaining in place, there will be a relatively positive backdrop. This, however, is the first time both monetary and fiscal stimulus have been applied in large doses to the global economy, and today there is a rejection of the austerity policies that followed the Financial Crisis.
In a dramatic change from policies adopted post GFC, fiscal orthodoxy has changed. Organisations such as the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) have told governments that with low interest rates seemingly here to stay, the cost of excessive borrowing is much lower for advanced economies than previously thought. This is especially important in an era where it is now generally accepted that the positive impact from lower interest rates is played out and further rate cuts in the developed world will either be counterproductive or have limited impact, so there was a need for governments to take some of the burden off central banks in supporting crisis hit economies. In contrast to the previous decade, there is now a consensus view that trying to balance the budget can at least temporarily be dropped. In some ways this is akin to adopting modern monetary theory. A paper from the Peterson Institute for International Economics, headed by Adam Posen, argues for fiscal policy suitable for all seasons.
Financial Times columnist Gillian Tett has argued that a rise in inflation could be a ‘black swan’ event, something with a low probability but the potential for impact on markets is high. Most investment portfolios today have been based on the belief that interest rates and inflation will stay low indefinitely and the Covid-19 pandemic has further reinforced the lower for longer interest rate mentality. If anything did rock this consensus, there would likely be a nasty market correction. There is a short-term inflation risk if fiscal stimulus, particularly in the US, hits the economy at the same time as the Covid-19 vaccines become more widely available. This has led some to forecast a surge in economic activity later this year with references to the ‘roaring twenties’. If this coincided with supply bottle necks, and there have been indications this year of some supply chain difficulties in manufacturing, there is a potential for prices to jump in some areas.
It is reassuring that Fed Chair J. Powell, in his recent Princeton University address, emphasised that the Fed would not be panicked by a short-term uptick in inflation. Some economists argue that factors that kept inflation low in recent decades, globalisation and digitisation, could shift adversely. The overwhelming evidence is that ageing demographics are disinflationary and while the number of workers in many countries, including China, could decline, there remains the potential for productivity gains and replacement of human labour through automation. Pandemics in medieval times had a significant impact on the availability of labour and sometimes resulted in upward pressure on average wages but today, the result is likely to be the opposite of this with many furloughed workers becoming unemployed, helping to keep a lid on wage inflation.
Central banks around the world might also extend the practice of yield curve control to 10-year government bonds in a similar way to what has occurred in Japan. This could mitigate against any rise in long-term interest rates and, if inflation had also risen, would result in nominal fixed interest securities offering a lower real (post inflation) return and some argue that lower real rates would justify a further decline in the discount rate applied to global equities.
Looking at economic fundamentals and the response to Covid-19 by central banks, but particularly by governments, it is clear that there are striking differences in terms of crisis policy responses with the abandonment by most governments of fiscal prudence and the adoption to an extent of the new orthodoxy of Modern Monetary Theory with a profound shift in conventional economic thinking re deficits and debt. The extent of the fiscal injection relative to the size of GDP has been of eye watering proportions. Bank of America estimate that the combined fiscal and monetary stimulus globally to date is US$22 trillion, nearly 25% of global GDP. The Biden administration is requesting a further injection of $1.9tn into the US economy alone and the bulk of this stimulus spending has yet to take effect in Europe and Japan.
When Lawrence Summers identified the central importance of ‘secular stagnation’ for the global economy in his speech at the IMF in 2013, the Harvard Professor put his finger on the most important driver for financial markets for the remainder of that decade. For those believers in an era of secular stagnation, the opportunities provided by high-quality growth companies benefitting from a lower discount rate on future rapid earnings growth in a low growth world have provided a meaningful and extremely profitable investment opportunity.
Summers’ interpretation of the term argued that excess savings relative to intended investment had driven the global equilibrium real rate of interest down to well below zero by the mid-2000s, making it difficult for monetary policy to provide the typical stimulus after a recession. As a result, inflation dropped below the 2% central bank targets in the US, Eurozone, UK, and Japan. It is these forces that explain many of the key trends in global markets over the past decade. Short-term interest rates were able to remain ‘lower for longer’, not because central banks wanted to promote a bubble in asset prices, but in response to the downward pressure on equilibrium real rates. This allowed a continuation of the bull market in bonds with nominal and real bond yields continuing to fall in advanced economies, below levels previously seen as the effective lower bound (zero). The demand for safe fixed income securities exceeded supply, resulting in a frenzied search for yield which spilled into corporate credit, including non-investment grade and emerging market debt, leading to a significant tightening of credit spreads.
As a result, equities have benefitted from the lower discount rate on future profits, especially for stocks able to grow earnings on a reliable and regular basis. Corporate profitability benefitted from low wage inflation, another possible symptom of secular stagnation. Even Robert Shiller of Yale University, who had earlier warned of equity bubbles, has more recently written that lower bond yields support the current high valuation of equities and there is no obvious equity bubble in the overall market at this moment. Equities that gained from technological and structural changes, in particular the US FAANGS (Facebook, Apple, Amazon, Google, and Netflix), have delivered outstanding returns as have many less well known but equally technology-enabled disruptive business models, all of which have benefitted the most from declining discount rates. Secular stagnation has also arguably allowed a change in fiscal policy during the pandemic to be received calmly by bond markets that had become accustomed to large scale central bank quantative easing and rising budget deficits. If in contrast global savings had been in short supply, high government bond issuance would have raised interest rates, dimming the prospects for economic recovery. The direction of secular stagnation after the pandemic passes into history will remain crucial for asset prices.
Fuelled by vaccine optimism, highly accommodative central bank policies and record fiscal stimulus, equity markets have now moved a long way to discounting the anticipated improvement in economic activity over the next 12-18 months. Valuations and investor sentiment are at cautionary levels and the pandemic catchphrase ‘stay safe’ is appropriate. Equity investors need to be very alert to potential threats as this could well be ‘a year of living dangerously’. Unfortunately, outside of equities there are few other asset classes that look attractive. Cash rates are zero, or in many countries negative, as are high quality government bonds and even investment grade debt has seen spreads contract to levels where absolute yields will not provide the required growth required by many investors for their longer-term financial planning. Property, in no small part due to the pandemic, has seen its attractiveness fall both in terms of retail and office space. Equities have become the TINA (There Is No Alternative) asset class, but as more investors have come to recognise this, potential for a short, sharp setback on any bad news increases.
The critical near-term economic variable is the virus, the effectiveness of the vaccine and the speed of roll out. There is solid ground for optimism, although the South African strain changes a key part of the spike protein that the virus uses to enter cells, which potentially could render the currently approved vaccines less effective. Tests are underway to examine this, with preliminary results from Pfizer appearing encouraging. At current levels, equity markets are vulnerable should the timing for the vaccine fuelled economic recovery be delayed.
Looking a little further ahead to the second half of the year, assuming success with the roll out of vaccines, there could be a sharper than expected upturn in global economic activity. This could see an increase in inflationary expectations, and it is important that central banks continue to adopt an accommodative stance. Structural disinflationary forces remain but some cyclical inflationary forces are likely to gain ground and gather momentum over the next 12-18 months. There is no reason to yet believe that the three D’s of Debt, Demographics and Devices (technological innovation) will result in a long-term breakout of inflation above central bank targets.
The best outcome for markets is that the same long-term forces that have dominated recent decades will re-emerge after the pandemic. A continuation of the global savings glut is likely to keep equilibrium interest rates very low during the 2020s. As a result, near zero bond yields should continue to support buoyant equity markets. This year, however, could see expansionary fiscal policy, especially in the United States, challenge in the short term the now more established or consensual view of low inflation and while this might be positive for the world economy in the short term, it would not necessarily be good for asset prices. The factor most likely to puncture the long running bull market in global equities would be a rise in the long-term discount rate applied to corporate earnings. Clearly, this battle will also determine, over the short-term, the relative performance of growth versus value investment strategies. Value stocks typically outperform when growth becomes more plentiful and would be the primary beneficiary of the reflation trade if it persisted. Over the medium term, successful growth investors should benefit from the continuation of a winner takes most investment environment, but 2021 is a period when ‘living dangerously’ is the price to pay for the likelihood of continued long-term investment success.
Graham O'Neill, Senior Investment Consultant, RSMR
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