August 2021 - Monthly House Views
With global equities up +12.5% in GBP terms, the story of the year continues to be the stock market. Policy – for now – continues to be exceptionally supportive. The US Federal Reserve (Fed), the Bank of England (BoE), the European Central Bank (ECB) and the Bank of Japan (BoJ) continue to collectively pump hundreds of billions of dollars of liquidity into the financial system every month. This has cut short every equity market wobble thus far in 2021: as markets falter they are met with a surge of cash looking to be deployed, taking us back to all-time highs. On a related note, government spending remains extremely robust globally, with the US on the verge of approving a gigantic infrastructure bill with bipartisan support amidst ongoing pandemic-driven fiscal largesse in the G7.
In addition, genuine economic growth momentum has been helped on more recently by pent-up consumer spending. July nonfarm payrolls in the US showed an increase of 943,000, the largest monthly increase since August 2020. Of that, 380,000 jobs were in the leisure and hospitality sector (253,000 in restaurants and bars). In Europe, Manufacturing Purchasing Managers’ Indices remain buoyant (i.e. in the 60+ range). UK consumer spending last month was up 11.6% compared with July 2019. Notably, the first growth in the entertainment sector since prior to the pandemic was registered . This is all underpinned by rising vaccination rates with over 30% of the world population having received at least one COVID-19 jab. In the five biggest world economies, vaccination rates are significantly higher: US (59%); China (64% ); Japan (47%); Germany (62%); and the UK (69%).
This is translating into earnings. With 90% of S&P 500 companies having reported Q2 results, earnings growth is at an astounding 89%, up from expectations of c. 52% at the start of the quarter. Revenue growth is equally spectacular at just under 25%.
However, the bond market has been telling a different story, with a huge sell-off in the winter (implying investors are bullish on risk assets) having moderated into the spring, before partially reversing over the summer (implying bearishness). Ten-year US government bonds saw a peak above 1.7%, but now trade closer to 1.3%; UK gilts hit a high near 0.9% but are now yielding 0.6%; German bunds came as high as -0.1%, but have slumped closer to -0.5% now. This tells a darker tale of peak growth, peak profit, peak policy.
This concept of “peak” is worth visiting. Effectively, it means that the rates of economic growth, earnings growth and policy support – monetary in particularly – has hit a high point and will now start to decelerate, which is supposedly undesirable. We do not deny that we have reached peak growth purely from a “rate of acceleration” perspective. The IMF expects global growth in 2021 to be 6% with advanced economies growing about 5%. According to their forecast this will slow next year to 4.4% and 3.6%, respectively. However, this year’s stellar figures are a result of a base effect, as they follow a massive global and advanced economy contraction last year of -3.3% and -4.7%, respectively. Next year’s growth, which builds on the gains of this year, is understandably slower, but it is reflective of an economy which is getting ever larger.
Ultimately, growth is good, even if it is slower. Extensive in-house analysis shows that equity risk premium is positive and compelling when economies are in any of “recovery”, “expansion”, or “slowdown” regimes, which can last for years. The regime to avoid is “contraction”, which thankfully appears nowhere on the horizon. The same dynamic applies for earnings.
Most market observers generally accept that liquidity – meant originally to rehabilitate economic growth – has been a huge support for risk assets. How will those assets fare without it?
No one knows for sure. But to begin to answer the question, we must refresh ourselves on how liquidity works. In a normal world, central banks conduct open market operations (OMO) routinely. This involves both buying and selling government bonds. Buying bonds from the market increases liquidity as it replaces them with newly created cash, which then often gets recycled into financial assets such as equities. The mirror operation is selling bonds, which removes liquidity from the system. This is conducted to keep money supply growth at an ideal balance where it is contributing to loan growth, the lifeblood of an economy, without letting inflation get out of hand. In an abnormal market environment, such as now, this is effectively a one-way operation where central banks only buy bonds, which is more commonly known as “quantitative easing” (QE).
QE cannot go on forever. For one, it raises the risks of inflation – the theoretical result of liquidity being created out of thin air and added to the economy without commensurate goods or services being created. For another, it has caused huge demand for financial assets, which now has resulted in high valuations for almost everything. Therefore, it would be ideal for QE to be stopped before it fundamentally breaks something in the system. However, ending QE itself is tricky. History suggests it can be done benignly or disruptively:
- The benign outcome: Central banks buy bonds at a decreasing pace (tapering) and then stop buying them altogether. The Fed did this with aplomb from 2014 onwards (see chart below), at first simply stopping to buy new bonds and held the bonds they owned until maturity, thereby “running off” the balance sheet at a slow pace over time (i.e. flat Fed line from 2014 to 2016 in particular). When the economy was ready, they even resumed “normal” OMO with a bias to reducing the overall size of the balance sheet, actively selling more bonds back to the market than they buy (i.e. downward trend of Fed line from 2017 to 2019). As it was done in an environment of sufficient economic growth, the result was a “healthy deleveraging” which did not destabilise markets.
- The disruptive outcome: Central banks can go too fast from “run off” to “sell off”, as the ECB did in 2013 and 2014. This scuttled growth and deflation suddenly became the chief worry. The ECB is the cautionary tale which gives policymakers pause in being too quick to taper.
We believe that policymakers have been excellent at balancing the various risks and rewards of policy support thus far. Nonetheless, policy errors are possible.
We believe the case for risk-taking is well supported given a strengthening economic backdrop and strong momentum. Therefore, our portfolios are risk-on.
Nonetheless, we continue to hold a stable of safe-haven assets to offset risks, particularly those from equities – which are expensive and supported somewhat by heady sentiment. These include cash, government bonds, gold, and defensive alternatives (e.g. low-volatility hedge funds, Tail Risk Protection Note).
In accordance with the applicable regulation, we inform the reader that this material is qualified as a marketing document. NR84Apr2021