February 2021 - Monthly House Views
Crosscurrents, but a favourable wind
This year was supposed to herald a new dawn, but successive waves of COVID-19 infections and the emergence of new, more virulent strains has put renewed pressure on healthcare systems, forcing governments to tighten and extend lockdown restrictions. In turn, this has pushed economic activity back, particularly in services businesses dependent on people interacting in close quarters or in activities not deemed “essential”. The UK provides an apt example: services Purchasing Managers’ Index (PMI) surveys for January registered at 39.5, plunging from 49.4 in December (50.0 marks the dividing line between expansion and contraction in activity). This is the sharpest contraction in the sector since May 2020, obviously reflecting the latest national lockdown. Manufacturers, while better off, are not immune, particularly as the first post-Brexit disruptions begin to bite. Indeed, the UK manufacturing PMI for January was recorded at 54.1, below 57.5 in December, driven lower not only on pandemic-related factors, but also by Brexit-linked delays at ports.
Nonetheless, considering the disastrous economic picture which unfolded following last year’s lockdowns, this time is materially different. Once again, the UK is a case in point. Despite the painful strictures on economic activity and the horrific human toll of the virus which continues, PMI data also shows the third consecutive month of improved business optimism – the strongest since May of 2014 – as the UK’s vaccine rollout so far in 2021 has been a success, fuelling hope of a strong economic rebound later this year.
The US has taken a much less stringent approach, leaving individual state governors to decide on restrictions. As a result, mobility data for retail and recreation activities show a relatively modest 25% decline from pre-pandemic levels whereas the falls in Europe range from 45% to 65%. Unsurprisingly therefore, business confidence in the US has remained buoyant in both manufacturing and services according to January’s PMI.
While optimism in the face of a still virulent pandemic is well-grounded, much will depend on the speed with which countries can ramp up their inoculation programmes. The first movers in vaccination – notably the UK and the US – have made great strides, with about 19% and 12% of their respective populations already inoculated1 (only Israel and the UAE are ahead, both with much smaller populations). Vaccine approval came much later in the EU partially due to slow EU-internal procurement coordination – the UK just evaded this by Brexiting. This meant Continental programmes only really got underway in late December, three weeks after the UK. Provided that supply delays can be reversed quickly, one can reasonably surmise that countries will be able to begin to lift restrictions by the spring, with the UK and the US leading the EU by a month or so.
Recovery in Asia is much less dependent on vaccines. China – a critical source of global aggregate demand – actually saw its economy grow 2.3% last year and will likely see growth accelerate to over 8% in 2021, a level that hasn’t been seen since 2011. Moreover, China has not had to resort to the type of monetary easing employed by the US Federal Reserve and the European Central Bank (ECB) – while key 3-month rates were cut by 160 basis points to their lows in March last year, they then rose steadily to their 2020 high in late November. Nor has fiscal stimulus been necessary for China’s recovery at the scale seen in the West. According to the Institute for International Finance, Beijing’s government debt to GDP ratio rose by 10.1 percentage points (pp) to 63.0% between Q3 2019 and Q3 2020 whereas the US piled on 25.5pp over the same period, taking its ratio to 127.2%, the highest level ever recorded in peacetime.
More is to come in Washington. President Trump signed a $900 billion support bill in late December and his successor has proposed a supplementary $1,900 billion package, together representing some 13.4% of GDP. Some worry about the potential market distortions caused by all this stimulus, but it has prevented the world’s largest economy from falling into a deep abyss, having regained roughly three-quarters of the output lost during the first half of last year, and over half of the jobs.
While there are worries about the inflationary impact of all this stimulus, we don’t consider sustained, structural inflation a serious risk at present for a variety of reasons, including large output gaps and low money velocity. This is not to say headline inflation may not jump in the short term given rising food and fuel prices – but it is probably wise to look through such transitory factors.
On balance, we believe risk assets – particularly equities – remain compelling, supported by strong momentum and a recovering global economy.
As always, we are guided by the four pillars of our investment process:
- Economic regime: Our Leading Economic Macro Indicator (LEMI) suggests the global economy is in expansion, which is clearly favourable for risk-taking.
- Valuations: Valuations for equities – the largest source of risk and return in most strategies – remain challenging in absolute terms. However, with global interest rates near zero, there is a case for a higher than usual tolerance to valuations (i.e. future cash flows are discounted by less). Moreover, companies are reporting stronger than expected earnings, which should help lower rich valuations, all else being equal. For example, over halfway through earnings seasons, the US equity market (i.e. S&P 500) is reporting year-over-year growth in earnings of 1.7% for the fourth quarter, compared to expectations of a 9.3% decline on 31 December 2020. Should the final figure be positive, as expected now, it will be the first time the index has reported annual growth since Q4 2019.
- Momentum: Global equities remain in positive momentum on the ten-month moving average metric that we favour. This is clearly supportive of increasing exposure to the asset class.
- Sentiment: There are numerous recent anecdotes of heady sentiment: an army of retail investors infamously fueled speculative excesses in GameStop to thwart hedge funds which had bet heavily against it; Tesla is up about 20% thus far in 2021 on top of the near 700% return last year; Bitcoin is up about 60% this year following on from its 300% gains in 2020. Other anecdotes suggest increased pessimism, such as record high cash balances in the US (i.e. $4.4 trillion) or a near-record household savings rate in the UK (i.e. 16.9%). Of the indictors we follow, the market in the aggregate does not appear to be overbought.
On balance, we remain comfortable with our risk-on stance given a strengthening economic backdrop, strong momentum and tolerable valuations, especially given stronger than expected earnings. However, we are cognisant of downside catalysts. These include vaccine-resistant coronavirus mutations, logistical setbacks in mass inoculations or a less supportive monetary and fiscal policy backdrop than expected – higher inflation, should it come, may cause rates to rise faster than expected, challenging risk assets. Therefore, we continue to hold significant safety assets as a form of risk mitigation including gold and low-volatility, defensive alternatives (e.g. hedge funds).
As ever, we are constantly monitoring markets. Should conditions change, particularly with the economic regime, or signals from our valuation, momentum or sentiment framework, we will adjust our asset allocation accordingly.
1 As of 9-February-2021 (https://ourworldindata.org/covid-vaccinations). Counted as a single dose and may not equal the total number of people vaccinated, depending on the specific dose regime (e.g. people receive multiple doses).