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Market sentiment: We have seen a strong start to the year for risk assets, as investors continue to look beyond the ‘second wave’ of the Covid-19 pandemic and to a strong global economic recovery later this year.
An extra kick to investor confidence has come from the U.S. President Biden has promised U.S re-engagement with the world, and will press Congress for a $1.9tr stimulus package. This has contributed to new highs in the week for the MSCI World and the MSCI Emerging Markets stock market indices. Strong retail demand continues to support big U.S tech and Bitcoin, while the global recovery theme has helped global value and small-cap stocks to outperform growth and large-cap globally. Indeed, the strong performance of the U.K main market in January reflects the growing optimism surrounding economically-sensitive sectors.
Unease coming from the bond market. There is, though, nervousness coming from the bond market. U.S Treasury yields are rising, thanks to a complex mix of inflation fears, fear of oversupply and expectations of further dollar weakness (all of which inter-react). Higher risk-free returns from U.S Treasuries offer investors an alternative to equities, and also raise the discount rate by which companies are valued (ie, raising the hurdle that makes a long term investment in a company worthwhile).
But these fears are exaggerated: first, inflation. While supply blockages and higher energy prices will contribute to higher prices, they are expected to be one-off in nature. Demand-led inflation is non-existent at present in the industrialised world, with pay growth minimal and precautionary savings likely to remain high well into the recovery cycle (since bankruptcies and unemployment are lagging features of the cycle). U.S long-term inflation expectations remain modest at 2%, exactly on the Fed’s target inflation rate*.
It could be added that should inflation take off, equities offer some protection from companies’ ability to pass on rising input prices to consumers, even has higher bond yields will erode their relative attractiveness.
Second, the U.S Fed and other major central banks remain committed to keeping yields low through bond purchase programs and ultra-low, and negative, interest rates. This policy is unlikely to be reversed in 2021, with central banks everywhere nervous of premature tightening of monetary policy. This creates an artificial scarcity of bonds relative to demand, keeping prices high (and yields low), and arguably contributes to a mispricing of risk. But no one is going to be upsetting this apple cart in the near term.
Cyclical stocks. Ongoing loose monetary policy in the west is one of the three legs supporting equities, and in particular recovery plays amongst cyclical sectors. The second leg is loose fiscal policy, as demonstrated by the Georgia senate election on 5th January, when U.S and global cyclical stocks jumped as control of the upper house went to the Democrats. The Democrats will now find it much easier to pass a large fiscal stimulus package, and the outlook is good for an infrastructure spending bill. Both will boost domestic demand, adding stimulus to the U.S economy and to global trading partners.
The third leg of the cyclical story is China. Last year the country’s GDP grew at 2.3%, while the rest of the world economy shrunk by approximately 4%. China demand was an important contributor to the recovery seen in global demand in the summer and autumn of last year, and it is hoped that strong and stable demand growth will continue this year.
As a result of investor interest in economically-sensitive stocks, U.S and global industrial cyclicals, commodity-related areas, banks and those stock markets with a high a proportion of such stocks, such as the Japanese and U.K markets, may outperform in 2021.
U.S presidential elections fox the forecasters. In 2016, the consensus amongst financial commentators was that a Trump victory in the November election would lead to a sell-off on Wall Street. Instead, after a brief wobble, the U.S stock market began a rally that lasted well into 2017.
Last year, consensus was that a Biden presidential victory would lead to a stock market sell-off, on fear of higher business taxes and increased regulation. Instead, stocks rallied, apparently because investors liked the gridlock in Washington that a Republican-controlled Senate offered. Now that the Senate is controlled (just) by the Democrats, stocks are rallying apparently because investors like the promise of further U.S fiscal stimulus, and a commitment to multilateralism on the world stage!
Remain diversified. Investors can, therefore, be forgiven for being sceptical of financial analysts’ political antennae. Indeed, we are as guilty as anyone else of group-think, and of miscalculating investor sentiment and the impact on it of political and economic events. What it does do, however, is to emphasis the unpredictability of financial markets and consequently the need to remain diversified.
Sterling and Brexit. The sterling/dollar FX market is one area where political analysis has provided reasonably accurate forecasts since the 2016 Brexit vote. Since then, sterling would fall when fear of a no deal rose, and visa-versa. We are currently at $1.37, slightly up on the year. Many FX analysts believe further sterling appreciation is likely, given anticipated weakness in the dollar (a common feature when the global economy is in recovery mode).
However, Brexit is not yet over and another lurch downwards for sterling cannot be ruled out as the implications of leaving the E.U play out.
To take some examples: first, as the weeks pass it is becoming increasingly clear that the December U.K/ E.U trade agreement represents a very ‘hard’ Brexit indeed. ‘Rules of origin’ laws are stricter than those that apply to the Canada/E.U trade deal, and are resulting in tariffs being applied to U.K exports in far greater quantities than envisaged.
Secondly, negotiations for the services sector -which accounts for the majority of U.K GDP- continue. Of particular interest to the City’s future is the granting of ‘equivalence’ status, by which banks, insurance companies etc can sell across the E.U without setting up local registered companies. The U.K has a large surplus in this sector, which several E.U states want to see reduced and are actively lobbying Brussels to tailor legislation accordingly. Of particular interest to France is re-locating London’s euro-related into the E.U.
Third, it appears that that the U.K population may have lost around a million E.U workers over the last few years, due to Brexit uncertainty and the pandemic, which will result in lower demand and output in the economy in future, than has been built into economic forecasts.
*As measured by the 5 year- 5 year inflation expectation rate, which is the market’s expectation of the average CPI inflation between five and ten years ahead. For bond and inflation aficionados, the 5-year TIPS/Treasury breakeven is in a similar ballpark, at 1.8%.