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The rally continues, with all major stock markets making good gains in August. Stocks continue to benefit from very low ‘risk-free’ rates around the world, which means that there is little to be gained by switching out of stocks and into bank account cash or government bonds. Meanwhile, we expect to see a recovery in corporate earnings as lockdowns ease, though some sectors will remain subdued.
Continued investor interest in U.S tech stocks have pushed the NASDAQ and the S&P 500 to new highs and created the first-ever non-state controlled $2 trillion company (Apple). Meanwhile, investor interest in cyclically-sensitive industrials has contributed to similar gains for the German and Japanese main markets. Emerging markets have shared in recent gains, with India and China leading the way in August…
Given the improving global economic data and the continued re-assurances by central bankers of plentiful cheap money policies to continue, risk assets seem well supported. Perhaps the single biggest risk to investors is a delay in the development of a Covid-19 vaccine. Many analysts expect mass-availability of one by spring 2021. But failure on this could test the resolve, and the ability, of governments to avoid a wave of bankruptcies leading to higher unemployment.
Fed chairman Jay Powell’s speech yesterday, at the Jackson Hole symposium, offered investors reassurance that interest rates will remain very low even as the economy recovers. In announcing changes to the way that the Fed will look to use its tools, he formalised what we have been seeing this year. The Fed has more or less abandoned using changes in the unemployment rate as a predictor (a ‘lead indicator’) of inflation. The relationship between the two has become very weak in recent decades. Furthermore, it will stop using other leading indicators of inflation as reasons to pre-emptively raise interest rates. Instead, it will allow inflation to go above the 2% target if that makes up for a prior period when it was below 2%, or the rise in inflation is expected to be temporary. The 2% inflation target remains in name, but has become a fuzzy ‘average of 2%’ over an unspecified time period – monetarists of another generation would recoil in horror at such apparently lax rules.
Indeed, some commentators suggest the Fed is going easy on inflation by this change in policy, and of doing Trump’s bidding. This is unfair. A moderate amount of inflation helps demand recover from sharp falls. Money becomes a hot potato, that people spend because it is steadily losing value. This supports consumption and also the value of real assets, such as homes, that form the bulk of many people’s wealth. Of course, history shows that once inflation is stimulated that it can be a problem to control it. This is one reason why there has been so much interest in gold this summer, as a hedge against inflation.
Politicians and investors both have ‘K’ shaped problems on their hands. Assume, for this discussion, a sheet of graph paper and the upright of the letter K is the vertical margin of a graph, and the intersection of the two arms halfway down is starting point set this spring.
The first K, which is political, is the discrepancy in the labour markets around the world since the Covid-19 pandemic emerged. Professionals who can work from home have seen little drop in income. They tend to be amongst the richer, older, better-educated sections of society. Meanwhile, their savings are going up in value thanks to a strong stock market. In our K analogy, they are the arm moving upwards.
The arm moving downwards represents the household incomes of those less well-off workers who are seeing reductions in unemployment benefits (eg, the U.S), or who are on furlough schemes that have a limited time period (eg, the U.K). The sectors most affected by Covid-19 are hospitality, high street retail and travel. These disproportionately employ the young, part-time workers, the less well educated and minorities. People who have not, by and large, got stock market investments and whose savings and stock market investments are modest if they have any.
Should unemployment become a significant problem in western countries, social divisions may become greater. In the U.S especially, tensions may grow along racial lines. But everywhere might see poorer communities resentful, tensions rise between the old and the young, with unpredictable consequences for politics.
The second K is of the different performance of sectors on global stock markets since the crisis began in February. It has been sectors, not country-specific factors, that have driven global stock markets since the rally began in late March. I.T. healthcare, consumer discretionary (ie, Amazon, which dominates the sector), have had a ‘good’ crisis. This is reflected not only in the ever-greater weighting of these sectors in the S&P500 index, but we have seen the same sectors outperform in other markets. Their gains since the outbreak began are illustrated by the top arm of the letter K.
Meanwhile, financials, energy, utilities and real estate sectors continue to trade well below their pre-crisis levels – everywhere. Banks are hit by loan loss provisions having to be made, and by shrinking net interest margins. Energy and utilities are hit by reduced demand, real estate as investors worry (probably overly so) on the long-term viability of high street retail and office space. Their losses since the outbreak started are illustrated by the bottom arm of the letter K.
Amongst the more stricken sectors, there will be some bargains to be had, when the global economy returns to normal. But value hunting is a dangerous business today, with no certainty as to when a vaccine will be available to allow normality to return. In the meantime, continued outperformance of the year’s winners seems a more likely scenario.
No one, including myself, expected to see a summer rally in sterling against the dollar. But that is what we have seen, from a level of $1.24 in mid-June to $1.31 today (the March 19th low was at $1.15). Sterling has also risen slightly against the euro an the yen. Does this mean that investors and FX traders are simply ignoring the issues that sterling’s critics have been discussing for months now? These include the U.K economy being much worse affected by Covid-19 than the American economy (judging by second-quarter GDP data), a relatively large U.K current account deficit, and the failure to negotiate any new trade deals.
Explanations for sterling’s strength are in short supply. Some point to the Bank of England’s repeated commitment not to cut interest rates below zero. Perhaps the bank’s chief economist, Andy Haldane, is helping to lift sentiment, with promises of a V-shaped economic recovery taking place (which more jaundiced commentators are not seeing).
But it is clear that dollar weakness is as much a factor as sterling strength in the GBP/USD exchange rate. The dollar is weakening against all major currencies as global growth picks up, and the safe-haven attraction of the dollar diminishes. It is also weakening in response to the Fed’s commitments to keep interest rates low even as economic recovery takes place, and on increased political risk as the November presidential election approaches. The nightmare political risk, for the dollar and other U.S assets, is Trump refusing to accept defeat and producing a constitutional crisis in an already sharply divided America.