ECONOMIC AND MARKET BACKGROUND
As 2020 drew to a close, new-year fireworks celebrations around the world were cancelled or scaled back as many countries struggled to contain spikes in coronavirus cases. However, there were some pyrotechnics in equity markets during the fourth quarter as a series of events boosted sentiment and enabled market participants to look beyond the near-term economic impact of continued virus-related restrictions and lockdowns.
At the start of the quarter, markets were beset with heightened volatility as investors became increasingly concerned about the rising rate of Covid-19 cases in Europe and the US, while fears grew that a close US presidential election result could be contested, offering the prospect of continued uncertainty and even the potential for civil unrest. Against this backdrop, the final week of October was the worst for global equities since March, when worries over the emerging pandemic had gripped markets.
However, two key developments in early November served to reignite the flames under global stock markets, leading the MSCI All Countries World index of developed and emerging-market equities to experience its best month on record with a return of +12.2% in US-dollar terms.1
First, the outcome of the US election was widely viewed as benign for financial markets. Democrat Joe Biden, named as president-elect on 7 November, is expected to return the US to the more global, multilateral approach to which investors had been accustomed prior to 2016. Furthermore, the projection that Republicans would maintain control of the Senate (subsequently proven wrong after run-off elections in early January) led to an assumption that Biden would be unable to deliver what were seen as some of the less market-friendly aspects of his manifesto, such as corporate tax hikes.
Second, while investors were still digesting the US election fallout, it was announced that one of the Covid-19 vaccines under development had been found to be more than 90% effective in clinical trials, and could be available for use by the end of the year, thereby opening the door to normalisation of social and economic activity in 2021. As positive news on other leading vaccine contenders soon followed, the scene was set for a sharp rotation into more economically sensitive industries – such as banks, energy businesses and airlines – as the outlook for those sectors that have suffered the most under the virus restrictions appeared to improve materially.
While further lockdowns in Europe and the UK, where a more transmissible variant of the coronavirus was discovered, tempered the market rally in December, investors’ nerves were calmed by the US Federal Reserve’s (Fed) decision to continue its debt- purchase programme, while the European Central Bank (ECB) also launched a fresh wave of monetary stimulus. Finally, in the closing days of the year, markets were buoyed by the eleventh-hour agreement of a Brexit trade deal between the UK and European Union (EU), and the signing into law of a US$900 billion emergency Covid-19 fiscal stimulus package in the US.
In fixed income markets, government bonds avoided a significant sell-off in spite of the strong performance from risk assets, as uncertainties over the threats from the latest virus waves helped to maintain support for the ‘safe-haven’ qualities of the asset class. In the UK, the FTA Government All Stocks Index (gilts) delivered a return of +0.6% over the quarter (+8.3% over the 12 months to 31 December). Meanwhile, the relative strength of sterling meant that the JPM Global Government Bond Index (excluding the UK) delivered a negative return of -3.6% in sterling terms for the quarter, with a calendar-year return of +6.1%. Corporate bonds, as represented by the BofA ML Sterling Non-Gilts Index, returned +3.2% for the quarter (+8.0% over 12 months).2
Total returns (£), rebased to 100 at 31.12.19
Note: all indices are FTSE series.
Source: Factset, January 2021.
All major equity markets delivered strong positive returns. Asia Pacific ex Japan equities produced a return of +18.3% in sterling terms over the quarter (+17.6% over the 12-month period), while emerging-market equities returned +11.2% (+11.9% over 12 months). UK equities delivered a strong quarterly return of +12.6%, although the market was still the clear laggard over the year as a whole with a negative return of -9.8%. Meanwhile, Europe ex UK stocks returned +9.2% in sterling terms over the quarter (+8.6% over 12 months), Japanese equities returned +8.5% (+11.1%), while North American equities returned +6.8% to UK-based investors over the quarter (+16.4% over 2020 as a whole).3
Gold produced a modest quarterly return of +0.7% in US-dollar terms, taking its 12-month return to +25.1%. In sterling terms the precious metal delivered -4.8% (+21.4% over the calendar year).4
While the US economy rebounded at a record pace in the third quarter – with gross domestic product (GDP) jumping 33.1% on an annualised basis5 – it has not yet returned to pre-pandemic levels. Based on December projections from Federal Open Market Committee (FOMC) members, the economy is expected to have shrunk by 2.4% in 2020, while growth of 4.2% is predicted for 2021.6
US real gross domestic product (US$ trillion)
Source: US Bureau of Economic Analysis, October 2020.
The Fed has committed to keep purchasing at least US$120 billion of debt per month until “substantial further progress” has been made on the economic recovery, while pledging to keep interest rates near zero until maximum employment is reached and inflation is on track to exceed its 2% target for some time.7 Chair Jay Powell said that the Fed’s latest guidance sent a “powerful message” about the central bank’s resolve to keep supporting the recovery.8
Powell also highlighted the importance of fiscal policy in tackling the economic downturn. The US$900 billion coronavirus stimulus package, which received bipartisan support and was finally signed off by President Trump on 27 December, will provide assistance for Americans who have lost their jobs, as well as providing funds for struggling industries such as airlines. President- elect Biden has indicated that his new administration will need to take further action to revive the economy. With the Democrats gaining control of the Senate following the Georgia run-off elections in early January, he will have more room to pursue the Democratic agenda of infrastructure spending and greater fiscal largesse.
With the UK becoming the first country to administer Covid-19 vaccines outside clinical trials, the second person to receive a jab was an 81-year-old man named William Shakespeare.9 As the country finally sealed a trade agreement with the EU on 24 December after years of tortuous negotiations and acrimony, his playwright namesake might have declared that “all’s well that ends well”. Certainly the deal, which guarantees tariff-free trade on most goods, was welcomed by business groups, and sterling reached its highest level of the year against the US dollar on the final day of 2020.10 However, it is estimated that the additional burden of customs declarations could cost British companies trading with the EU an additional £7 billion a year,11 while the lack of focus on services – which form around 80% of Britain’s economy and nearly half its exports – is likely to have an immediate impact on many businesses, particularly in the financial sector.
With coronavirus-related restrictions being reinstated during the quarter, the UK’s economic recovery has stalled, and the Office for Budget Responsibility does not expect GDP to reach its pre-pandemic level until the end of 2022.12 Nevertheless, with UK equities having underperformed global equities since the 2016 Brexit referendum, opportunities could arise for investors in domestic assets, whose prices arguably reflect a great deal of pessimism already.
As with other major economies, the prospect of continued economic lockdowns has hampered the recovery in Europe. ECB President Christine Lagarde predicted that the eurozone economy would contract by 2.2% in the fourth quarter and that the downturn would continue into early 2021. On a more positive note, she suggested that the economy should “begin to function under more normal circumstances” once vaccines have been rolled out by the end of 2021.13
Recognising the need for significant monetary stimulus to be maintained, in December the ECB announced an increase in the size of its pandemic emergency purchase programme (PEPP) from €1.35 trillion to €1.85 trillion, while extending its bank financing programme, which aims to preserve favourable bank lending conditions by, in effect, paying banks to borrow money.
The ECB has also maintained a tough stance on bank dividends. Having asked banks to refrain from paying dividends when the pandemic first hit in the spring of 2020, in order to preserve capital, the ECB will permit dividends to be distributed again in 2021, but with limits of 15% of the last two years of profits and 0.2% of common equity tier-one capital ratio.14 This contrasts with the UK, where the Bank of England has imposed less stringent criteria.
While Japan has so far been able to contain the spread of Covid-19 better than many of its counterparts, it has not escaped the economic impact, and a major ¥30.6 trillion (US$294 billion) fiscal stimulus package announced in December – the third of this year – aims to support the post- pandemic recovery by investing in green and digital technologies.15 Following similar pledges from the EU and China, Japan’s new Prime Minister Yoshihide Suga has stated that the country will be carbon neutral by 2050, in a bid to tackle climate change. This could prove challenging for a country that relies on fossil fuels for 87% of its primary energy supply, but Suga believes initiatives such as next-generation solar panels and carbon recycling can be a major source of growth.16
China imports and exports
Source: China Customs, December 2020.
Meanwhile, the Bank of Japan has been forced to launch a review of its monetary policy for the first time since 2016, and is considering the possibility of further monetary easing after the pandemic-induced downturn quashed hopes of achieving its 2% inflation target.
With industrial production increasing 7% year on year in November, and retail sales growing by 5%,17 China‘s economy appears to be returning to levels of growth seen in late 2019 before the pandemic took hold, and the country is likely to be the only major economy to deliver positive GDP growth in 2020. Despite being the original epicentre of the pandemic, China has succeeded in suppressing further virus outbreaks, while growth in industrial production and property investment has been driving the country’s recovery, and has led to huge demand for commodities.
China’s recovery has been boosted by the growth in exports, which rose by 21.1% in US-dollar terms in November compared to the previous year.18 This large increase may partly be explained by demand for products resulting from the pandemic and lockdowns such as personal protective equipment (PPE) and electronics items, but it also likely to be indicative of a global restocking cycle in action.
With the US election out of the way, and Covid-19 vaccines now being approved for use across the world, investors’ attention has turned to focus on the potential for continued economic recovery. As the pandemic is still wreaking havoc around the world, this recovery will take time, and will be hampered by periodic lockdowns. That being said, there has been an immense amount of firepower applied through continued use of loose monetary policy and increasing deployment of fiscal policy. This combination is new, and represents a different sort of regime.
For now, government bond yields have been held in check because of the extraordinary central-bank activity as well as the fragmented nature of the economic recovery caused by the pandemic. Loose monetary policy and the potential for fiscal stimulus are also helping risk assets.
Covid-19 has delivered a huge deflationary shock to some parts of the economy which will take time to adjust. The unification of both monetary policy and fiscal policy will be slow to unwind and could still be in place long after economies have recovered; central banks tend to make policy changes faster than governments.
As we have said before, there are a number of other longer- term factors that have started to change the inflation outlook. We expect the move towards de-globalisation, for example, to gradually push up domestic prices over the next couple of years. In this context, while it appears likely that Joe Biden’s new US administration will look to reverse some of the ‘America first’ foreign policies pursued by President Trump, it is by no means certain that it will jettison all of these policies, not least because anti-China sentiment appears to have a strong groundswell of support in the US. The rhetoric employed towards China may not be as harsh, but the direction of policy is likely to be similar.
The rollout of vaccines, combined with continuing fiscal and monetary stimulus, should provide a supportive backdrop for credit risk, and opportunities are likely to present themselves to add exposure to cyclical investment-grade assets. However, as investors continue to hunt for yield, high-yield corporate bonds and emerging-market sovereign bonds are likely to be the biggest beneficiaries. In these areas it remains important to be selective, as certain industries still remain challenged and face the prospect of defaults, while some sovereign issuers may struggle to service their debt.
As waves of Covid-19 continue to scar economies, government bonds can provide a useful hedge, even if their return potential appears limited at present. With inflation expectations set to increase over the coming months, and yields gradually begin to rise, inflation-linked bonds seem likely to outperform.
10-year government bond yields
Source: FactSet, January 2021.
The rotation into more cyclical areas of global equity markets, following positive vaccine developments, is similar to action seen in mid-2020 when an unforeseen push to reopen economies prompted a sharp rotation, albeit on that occasion cut short by the resurgence of the virus. This time, the vaccine news makes it possible that the rotation can be stronger and more durable. Clearly the remainder of the northern hemisphere winter will still be difficult as vaccines will not be distributed in time for many restrictions to be lifted before spring; however, markets appear inclined to look beyond the near term.
We believe this market dynamic is influenced by other factors, beyond news of the vaccines. Crucially, the valuation discrepancy between cyclical and secular growth sectors had become startling. Furthermore, concurrent looseness of fiscal and monetary policy has tended historically to induce a reflationary environment, which would typically support the outperformance of more economically sensitive businesses.
Nevertheless, headwinds for cyclical sectors may present themselves once the current enthusiasm dies out. When government support programmes are eventually lifted, investors may conclude that those cyclical stocks that rallied may not be rewarded with higher earnings, especially if the pandemic leads to permanent lifestyle changes such as less plane travel or commuting.
Because of this, maintaining some exposure to more defensive names may be warranted.
Performance from technology businesses, for example, is likely to remain strong, particularly as corporate spending on technology is accelerating. The basis for many hardware businesses is rooted in secular growth through the increase in digitalisation, but these companies also tend to be more cyclical so can participate in value rotations. There are also companies within health care, notably in the pharmaceutical industry, which have exposure to long- term growth drivers but are now priced more attractively, thanks in part to the recent rotation.
While significant headwinds for the real economy will persist for some time given continuing concerns over further waves of the virus and restrictions on social mobility, the start of vaccine rollout, following successful clinical trials, has reinforced the already improving global trade momentum and abundant liquidity conditions that represent a favourable backdrop for risk assets. Recent geopolitical developments, including the US election outcome and UK-EU trade agreement, have also bolstered investor sentiment.
Although the pandemic has delivered a profoundly deflationary shock, the scale of the response from policymakers – which has resulted in the unification of fiscal and monetary policy – is unprecedented in peacetime. It is conceivable that, over the medium term, this could finally be the catalyst that causes inflation to return, which would have profound implications for investors.
Investors must also contend with a number of other challenges: US-China tensions appear likely to continue, populations are ageing globally, while economies face high and rising debt levels. At the same time, the pandemic has caused a number of key structural trends that were already in place to accelerate. For example, international business travel is likely to be reduced in favour of technology-driven alternative methods of communication, and a number of major oil companies have hastened their transition to renewable rather than hydrocarbon- based sources of energy.
In navigating this changing backdrop, and with volatility likely to remain elevated for some time, we believe an active and disciplined approach is crucial. In this context it will be critical to maintain a focus on the underlying characteristics of individual securities, including their long-term prospects, valuations, and environmental, social and governance (ESG) credentials.
2 Bond market returns sourced from FactSet, 01.01.21
3 Equity market returns sourced from FactSet, 01.01.21 (All sterling total returns, FTSE World Index)
4 Gold bullion returns sourced from FactSet, 01.01.21
All data is sourced from FactSet unless otherwise stated. All references to dollars are US dollars unless otherwise stated.
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