Report by Adam & Company’s Investment Management Team.
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Investment Outlook 2021 | Adam & Company
Victor Frankenstein never reveals the secret of how he was able to bring the dead back to life. In the films – from Boris Karloff’s ‘Frankenstein’ to ‘Carry on Screaming’ – electricity is the key.
This is presumably as the novel refers to him infusing ‘a spark of being into the lifeless thing’, and indeed around Shelley’s time the Italian scientist Luigi Galvani achieved huge fame by appearing to revive dead animals by applying a charge to their limbs.
There have been plenty of things in markets which have burst back into life, having been written off for dead. Sterling has jumped, as have the values of industrial companies. The FTSE-100 index is closing in on 7,000, whilst UK small company indices hit all-time highs. The oil price is back above $60 a barrel. And economists are expecting a surge in the rate of inflation, as consumers’ excess savings from the past 15 months are deployed on having fun rather than ensuring a steady supply of bread making yeast and loo rolls.
Unlike the birth of Frankenstein’s ‘abhorred devil’, the cause of this monster rally in shares and economic data is clear. On the 9th of November 2020 Pfizer & BioNTech released the results of their Covid-19 vaccine trial and the direction of the world changed. Low interest rates and huge government spending were the electricity which jump-started the global economy, but the hope offered by vaccines showed consumers and businesses a world beyond the virus.
As a result, the fastest ever fall in shares in March last year became the biggest ever 12-month rally, and economists are scouring historical texts to get comparisons for the hugely positive year-on-year jumps in economic data – from business confidence surveys to job creation.
Unusual creatures have also emerged amidst all this optimism and hope, seemingly borne by free money and bored millennials. Intangible assets such as Bitcoin and ‘Non-Fungible Tokens’ (digital art) have surged in value. A few individual American shares have risen hundreds of percent on the back of individual investors coordinating buying in internet forums as they struggle to spend their government stimulus cheques on anything useful. And the market values a single electric car maker, Tesla, more than all other listed carmakers added together.
What do these examples of excess mean and where are the risks for investors in such assets and other more traditional ones? The main risk at this stage is policy error, both in the early tightening of spending and raising interest rates too quickly. Fiscal prudence and austerity are horrors of the past, set for the history books it seems, and the big central banks show no interest in changing policy at this stage.
In the story, Victor’s irresponsibility costs him everything. Could economies actually run too hot in coming months, and as a result see a surge in inflation and excess risk taking, the creature killing its creator? For now, we do not know but let’s enjoy the recovery whilst remaining alert to potential troubles ahead.
In trying to protect clients’ investments from the demon of inflation and beastly bubbles in certain assets, our philosophy remains the same: we continue to pursue good quality holdings, to try not to pay too much for them, and to hold them for a long time to get the benefits of compounding growth over the long term.
PLEASE REMEMBER THAT THE VALUE OF INVESTMENTS AND THE INCOME FROM THEM MAY GO DOWN AS WELL AS UP AND THAT YOU MAY NOT GET BACK THE AMOUNT ORIGINALLY INVESTED. PAST PERFORMANCE SHOULD NOT BE SEEN AS AN INDICATION OF FUTURE PERFORMANCE. WHERE AN INVESTMENT INVOLVES EXPOSURE TO A FOREIGN CURRENCY, CHANGES IN RATES OF EXCHANGE MAY CAUSE THE VALUE OF THE INVESTMENT, AND THE INCOME FROM IT, TO GO UP OR DOWN.
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Market
Spotlights
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The first quarter was dominated by hopes for economic normalisation in the second half of the year. Whilst the UK and European economies continued to be badly affected by lockdowns, by the end of the quarter data started to pick up in many countries, with job creation coming back strongly and business and consumer confidence seeing record bounces. This was largely as a result of the successful vaccination programs in the US and the UK leading to the belief that we really could get back to normal by the summer,
however the EU is seeing cuts to growth estimates as it stumbles and falls in the task of vaccinating its people.Another significant development in the first 3 months of the year was the Democrats securing an effective majority in the US Senate. This paves the way for more government spending on job creation and infrastructure in what is still the world’s most important economy. The numbers being talked about currently equate to around 9% of US GDP on a huge variety of schemes from broadband to energy infrastructure. Similar programmes are coming to the UK and EU later this year, and governments are keen to press the accelerator on economic growth to get recoveries firmly entrenched. How to pay for it all is for another day.
After falling 3.3% in 2020, the global economy should rebound by well over 5% in 2021. The UK did relatively badly in 2020 due to our exposure to areas such as retail, leisure and recreation, however we will have a huge economic bounce in the second half of the year as the accumulated savings of consumers – estimated to be over 6% of GDP – are spent on finally having some fun.
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Inflation has fallen sharply in the UK, Europe and the US in the past 12 months as economic demand fell sharply – the service sector from travel to retail and education simply closed. This is likely to reverse sharply in the next 12 months, partly due to ‘base effects’ – easy year on year comparisons – and partly as consumers will be spending accumulated savings like never before. This wall of demand will likely meet supply constraints and prices will rise.
As we said last quarter, it remains likely that most major central banks will look through this jump in inflation and not raise interest rates. Firstly, they realise it is temporary and caused by easy comparisons from last year. Secondly, they are far more tolerant of inflation as deflationary trends such as technology will keep numbers in check. Finally, with government and corporate debts jumping as a result of Covid-19, higher inflation is one way of reducing these in real terms over the long term.
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Equities continued their rise in the first few months of the year. Those stocks which benefit from economic reopening continued to do well in the UK and US, and defensives such as healthcare did poorly. Some of the ‘Stay at Home’ beneficiaries, such as the ecommerce
and food delivery companies, saw profit taking, however the feeling that their business models were now deeply entrenched meant that this was modest.
As we wrote in the past few quarters, we have been gently adding to names we think may benefit from a recovery, especially in the UK. Share prices will continue to be volatile, as ever, but on an 18 month view strong companies can take advantage of their robust balance sheets and emerge better placed than their peers.
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Our view on bonds has changed little. Even after bond values fell in the first quarter of 2021, the income offered by government bonds is extremely low and fundamentally unattractive, but for now they continue to provide a ‘shock absorber’ for bumpy equities. They have done poorly as safe assets such as gilts have been swapped for riskier ‘recovery plays’ by investors chasing the economic jump ahead. The rise in inflation to well above central bank targets of 2% is bad news for government bonds, paying as they do a fixed income which tends to be less than the rate of inflation. Overall, bonds may be vulnerable to policy mistakes by central banks and governments such as withdrawing stimulus too soon. For now, central bank actions should continue to support bond prices.
Asset Class
Review
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It has been a positive start to the year for UK equities, with the MSCI UK All Cap up 5.5% over the period.
The UK continues to progress well with its vaccination programme, which has helped build confidence over our roadmap out of lockdown and eventual return to a degree of normality later in the year. Economic growth forecasts for the UK continue to be revised upwards, with the IMF now forecasting growth of 5.3% in 2021, the economy having shrunk a record 9.8% in 2020.
As such, the market rotation towards the more economically sensitive areas of the market that we witnessed towards the end of 2020 has continued. We have seen a welcome recovery in the energy sector and the continued strong performance from the materials sector, supported by rising commodity prices. Other areas such as financials and travel and leisure have also had a strong quarter, reflective of the improving economic outlook for the UK. The laggards of the quarter have been largely defensive areas whose prospects are less tied to the economic recovery (utilities, healthcare, consumer staples) as well as the ‘winners’ of 2020, which have continued their underperformance since the initial vaccine breakthrough news in November.
Whilst dividend payments suffered significantly in 2020, payments have now largely resumed, with Q1 proving to be a good quarter for income – welcome news for UK investors. There has also been a strong level of capital markets activity in the quarter, with notable flotations on the London Stock Exchange including that of Dr Martens, Moonpig, Trustpilot and the highly publicised listing of Deliveroo.
Past performance should not be seen as an indication of future performance
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US equities registered their 4th consecutive quarterly gain with the S&P 500 rising by 6.2% in US dollar terms. Investors were buoyed by the successful passage of a $1.9tn coronavirus relief package through Congress and the prospect of a further $2.2tn in infrastructure spending by the Biden administration. This helped offset growing concerns of rising inflation. Federal Reserve Chairman Jay Powell sought to allay fears of interest rate increases in March saying that the current monetary policy stance was “appropriate”. Equities also appeared to shrug off supply chain worries. US imports have been hampered by port congestion and carmakers Ford and General Motors have warned of production halts from the global shortage in some microchips.
The energy sector rose an astonishing 29% supported by a further recovery in crude oil which finished the quarter at $60 per barrel (using the WTI measure) – its highest level since 2019. Among other sectors, the largest gains were seen in cyclical areas, seen as most exposed to a continuing economic recovery, including financials, industrials and materials. Conversely, the laggards were the traditionally defensive sectors of consumer staples, utilities and healthcare.
So far this year, new equity issuance has been dominated by SPACs (Special Purpose Acquisition Companies). SPACs are non-operating companies set up with the objective of purchasing private companies. Once they have purchased their target, the private company adopts the listing. Their current popularity among investors stems from the limited access to shares in private companies before their listing, particularly for retail investors, and also the costly and timeconsuming listing process for private companies. But this comes with high risk, which investors currently appear willing to take.
Past performance should not be seen as an indication of future performance
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European equity markets enjoyed a buoyant first quarter, with the pan-European Stoxx 600 index rising 7.7% during the period. Cyclical stocks led the rally, with some of the hardest hit sectors of 2020 (banking, travel & leisure, and automotive stocks) experiencing the strongest resurgence in 2021. On the flip side, there has been a rotation out of stocks that proved resilient during 2020, with healthcare and utilities being some of the weakest performing stocks this year.
European equity markets are returning to pre-pandemic levels on optimism about economies reopening, as well as large economic stimulus on the global stage helping general sentiment. This market strength comes despite the pandemic still ravaging through most large European economies, with stringent lockdown measures being reintroduced to control rising infections and hospitalisations.
Europe’s reopening opportunity appears to be further off than that of the UK or US. Vaccination progress in the Eurozone has been slow due to a range of issues including procurement, supply and general sentiment towards vaccines. The situation looks set to improve, with the European Commission anticipating delivery of 360m vaccine doses in the second quarter, up from 106m in the first quarter, supporting ambitions to vaccinate the majority of European citizens by the end of June.
2021 looks set to be an interesting year for European politics, which may translate over into markets. Former European Central Bank President, Mario Draghi, has recently been elected Prime Minister of Italy whilst, later this year, Angela Merkel will step down as Chancellor of Germany. Furthermore, as we look ahead to the French Presidential elections in 2022, support for far-right candidate Marine Le Pen has increased notably in recent months.
Past performance should not be seen as an indication of future performance
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The Japanese stock market continued its good run up, once again led by cyclical companies benefitting from the strong global economic rebound expected throughout 2021. Industrial companies involved in steel, shipping, and tyre manufacturing surged. Defensive sectors including healthcare were relatively weak, however these are a small part of the Japanese stock market.
Prime Minister Yoshihide Suga continued his predecessor Abe’s reforms, with proposals to form a new government department, the Children’s Agency, to boost support for children and parents, at least partially to help reverse the moribund birth rate which threatens Japan’s long-term future. Perhaps the biggest news came in recent days, however, with a British private equity company trying to buy out industrial giant Toshiba. Hostile takeovers are unheard of in Japan so if successful, it could herald a big change.
Emerging market stocks rose strongly to near all-time highs, however they have pulled back in recent weeks. Chinese authorities are talking about tightening policy – having loosened it considerably in the wake of the coronavirus outbreak in early 2020 – with domestic banks being instructed to maintain new loans at the same level as last year rather than grow them. As a result, Chinese shares have fallen back from record highs.
The virus continues to play a major role in the economic outlook and share prices. Latin America’s largest country Brazil, has been severely affected and the roll out of vaccinations is currently poor in many emerging economies, delaying recovery.
Past performance should not be seen as an indication of future performance
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Government bonds (‘gilts’) were weak in the first quarter as confidence grew about economic revival with the rollout of vaccines and an easing in lockdowns. While uncertainty about the pandemic has receded, concerns now focus on the nature and pace of recovery.
SAFE HAVEN BREACHED
The safe haven status of gilts was demonstrated clearly in the first quarter of 2020 with a total return of nearly 7% as the outbreak of Covid-19 and fear took hold. By contrast, in the first 3 months of 2021, gilts recorded their worst quarterly performance for more than 20 years with a negative return of over 7%. Growing economic optimism has unsettled sovereign bond investors. Central banks are providing support through their policies of low or negative interest rates, and quantitative easing (‘QE’ or bond buying) programmes. Governments remain committed to expansionary fiscal policies by increasing their levels of borrowing or raising taxes. This is reflected by President Biden’s huge $1.9tr spending package and his plans for infrastructure investment of $2.2tn.
With concerns about high levels of government borrowing, rising inflation expectations and fears that central banks may have to raise interest rates earlier than flagged, government bond prices fell (with yields rising) during the quarter. In the UK and the US, 10-year yields rose sharply to around 0.8% and 1.75% respectively by the quarter end. Longer dated bonds (with over 15 years to maturity) are particularly sensitive to changing interest rate expectations. Their return was -12.5% in the UK.
CORPORATE BONDS SHOW RELATIVE RESILIENCE
The improving outlook has been favourable for companies looking to raise funds. New issuance of bonds this year has remained strong as companies lock in lower borrowing costs or raise funds for mergers and acquisitions. Investor confidence is reflected by the spreads – the difference between government and corporate bond yields – remaining at levels last seen just before the pandemic started. However, while the spreads have remained narrow, the weakness of government bonds (with yields rising) has seen investment grade bonds also deliver negative returns this quarter.
High yield (or ‘junk’) bonds have been underpinned by investors’ search for income. For example, in the UK there was strong demand for the record £2.75bn sterling high yield bond issued to part finance the takeover of Asda. With default rates set to peak well below levels seen in previous economic cycles, companies operating in challenging sectors, such as oil, travel and leisure, have successfully raised funds. Emerging market bonds as an asset class delivered negative returns, with a stronger dollar and rising interest rates in Turkey, Brazil and Russia affecting sentiment.
OUTLOOK
Concerns about the impact of the pandemic on employment mean central banks and governments will pursue economic growth. However, uncertainty prevails about whether the current rise in inflation will be transient or a structural shift higher, requiring changes in central bank policies. Given the uncertain outlook and current valuations in bond markets, a cautious and diversified approach in fixed interest remains appropriate.
Past performance should not be seen as an indication of future performance
Note
The source data for each graph is supplied by Thomson Reuters DataStream, as at 31 March 2021 total return, local currency unless otherwise stated.
Important Information
Issued by Adam & Company Investment Management Limited (Adam), which is authorised and regulated by the Financial Conduct Authority. Adam is registered in Scotland number SC102144. Financial Services Firm Reference Number 141831. Registered Office: 6-8 George Street, Edinburgh, EH2 2PF.
This document is produced by Adam & Company Investment Management Limited (Adam) for information purposes only and for the sole use of the recipient and may not be reproduced in part or full without the prior permission of Adam, and Adam accepts no liability whatsoever for the actions of third parties in this respect. This document may be modified without notice and Adam may, but shall not be obliged to, update or otherwise revise this document.
The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment. Past performance should not be taken as a guide to future performance. Where an investment involves exposure to a foreign currency, changes in rates of exchange may cause the value of the investment, and the income from it, to go up or down.
The information in this document is not intended as an offer or solicitation to buy or sell securities or any other investment or banking product, nor does it constitute a personal recommendation. The information is believed to be correct but cannot be guaranteed. Any opinion or forecast constitutes our judgement as at the date of issue and is subject to change without notice. Nothing in this material constitutes investment, legal, credit, accounting or tax advice, or a representation that any investment or strategy is suitable for or appropriate to your individual circumstances. The analysis contained within this document has been procured, and may have been acted upon, by Adam and connected companies for their own purposes, and the results are being made available to you on this understanding. To the extent permitted by law and without being inconsistent with any applicable regulation, neither Adam nor any connected company accepts responsibility for any direct or indirect or consequential loss suffered by you or any other person as a result of your acting, or deciding not to act, in reliance upon such analysis.
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‘Play the music, light the lights’
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Investment Outlook 2021 | Adam & Company
