‘Play the music, light the lights’
Q4 2020 Report by Adam & Company’s Investment Management Team.
Amongst the most watched films over the holidays was, once again, The Muppet Christmas Carol. It takes the most famous Christmas story (apart from the original one obviously) and adds songs, jokes and puppets. The enduring popularity of this film and the book on which it is based is surely down to the message behind it. Scrooge treats people less fortunate than himself as if they don’t exist and if he doesn’t change his ways he is going to hell. He is shown the error of his ways and learns to understand the real meaning of Christmas. He changes and shows ‘a life can be made right’.
We may not have the widespread slums Dickens describes; however social injustice and homelessness remain a curse. But one aspect which is strange to modern eyes is the darkness and gloom which envelopes the characters and their surroundings, and the reluctance of Scrooge to light his candles: ‘Darkness is cheap, and Scrooge liked it’. To modern eyes, this is preposterous and shows his penny-pinching, but this would have been less noticeable to readers in Dickens’ time.
The Economist Tim Harford notes that the electric lightbulb is one of the ‘Fifty things which made the modern economy’ in his book of the same name. He describes how economists have studied the deflation in the price of illumination, as measured by the cost per lumen-hour. By this measure, the price has fallen by a factor of 500,000 over recent centuries. Too precious for Scrooge to use has become too cheap for us to notice.
At times during these past twelve months, it has felt like a blanket of gloom has been wrapped over the lives we used to lead. In many areas however, 2021 promises much brighter times.
With its means to replicate severely reduced, Trump 2017-21 should die away quickly, though mutations of the strain cannot be ruled out. A Brexit deal for goods is done and we move on to what happens next. And most of all, the speedy roll out of effective vaccines promises a return to normality at some point this year.
These vaccines potentially cast a bright radiance at the end of the Covid tunnel – but how long is the tunnel? It is unlikely that the strong economic recovery which stretches out ahead of us will be smooth and in a straight line. For example, we haven’t had to worry much about inflation for several decades as structural forces such as technology and globalisation have reduced prices for many consumer goods and services. However, it is likely that if vaccines are rolled out successfully demand for all those things we have been unable to do these past months will come roaring back. Can governments and central banks avoid policy errors such as cutting spending and tightening money supply which would hurt the recovery?
How will governments, companies and individuals react to the high levels of debt accumulated? And whilst many countries have access to vaccines, many do not. It seems likely that we will have to tolerate this virus for many years to come and accept a certain level of it, in the way we do with other diseases – this is a difficult message for politicians to give and may be difficult for voters to accept.
The recovery promises to be uneven, bumpy, unfair and still many months away. Indeed, the UK economy is not expected to return to 2019 levels until 2023. However, we continue to believe in looking forward and being guided by the light ahead of us.
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Economic activity rebounded strongly from the lows of the first and second quarter of 2020, however renewed lockdowns mean that the first quarter of 2021 will see another fall in output. After falling 5% in 2020, global GDP will likely jump by 6% this year, but this will vary depending on the path of the virus and vaccination programs underway around the world.
The UK did relatively badly in 2020 due to our exposure to areas such as retail, leisure and recreation all of which have been badly affected by the lockdowns. After a likely 11% fall in GDP in 2020, economists worry that the recovery will be slow as high levels of the virus remain in circulation. However, the UK was also the first to approve vaccines and the first to use them, and as a result could be well placed relative to other countries.
For the moment, uncertainty remains high around how long lockdowns will last and the race to vaccinate the population, and business and consumer confidence are low. However, consumers are generally cash-rich and desperate to get back to normal so we would expect an extremely strong rebound from the spring as people do all the things they have had to postpone in the previous 12 months.
Inflation has fallen sharply in the UK, Europe and the US in the past 9 months as economic demand fell sharply – the price of oil even turned negative as demand collapsed and storage facilities were full. Airlines could not give away flights at any price. There were however some other quirks on the side of higher inflation – the price of puppies has soared as demand from home workers met finite supply as did the price of yeast and flour as home baking boomed.
Looking forward, inflation overall will likely jump in the second half of 2021 as vaccines mean lockdowns ease and cash-rich consumers rush to spend on leisure activities.
It is likely that central banks around the world 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. Furthermore, 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.
Equities continued their rise in the fourth quarter of 2020 but looking underneath the continuing rise of the global stock market indices, in reality everything changed on 9th November, 2020 with the announcement that the Pfizer/BioNTech vaccine trial was a roaring success. This saw the biggest rotation out of previous winners into previous losers that there has ever been as investors dumped Technology and defensive names such as Healthcare companies to buy those sectors which had suffered from a collapse in demand such as Banks, Oil, and Leisure companies.
These names have continued to do relatively well, despite many areas of the world such as the UK and Europe going into more severe restrictions. Investors are willing to look forward, assuming that vaccination programs are a success and we return to a more normal life by the summer.
As we wrote in the past few quarters, we have been gently adding to names we think may benefit from a recovery. Equities may well be a bumpy ride for investors, but on an 18 month view strong companies can take advantage of their robust balance sheets and emerge better placed than their peers.
Our views on bonds is largely unchanged in recent months. In absolute terms, 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. Despite historically low interest rates, there is scope for them to be cut further. However, we would expect strong economic recoveries to start in the spring and rising inflation may make headlines. Corporate bonds are more interesting but really depend on the success of vaccination programs and government schemes to keep unemployment and bankruptcies down.
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.
UK equities staged a strong recovery in the final quarter of 2020 with the MSCI UK All Cap rising 12.4% over the period, leaving the index down 11.3% for the year as a whole. The announcement of several vaccines evidenced to be effective against Covid-19, and their subsequent approvals drove investor sentiment. Cyclical value stocks, those most beaten down in the Covid crisis (notably banking, energy and travel & leisure sectors) rallied strongest.
Investor sentiment was further boosted by a last-minute Brexit deal on the cusp of the Brexit transition arrangement deadline, also driving sterling up 5% over the period. Over four years has passed since the UK voted to leave the European Union, and the final agreement was paraded as offering tariff-free and quota-free access to the EU market. The final sticking points ironed out included the EU’s access to British fishing waters and a ‘level playing field’ agreement in relation to workers’ rights and state subsidies, whilst adhering to the new trade deal and regulations. Auspiciously, the deal averts a mutually damaging worst-case ‘no deal’ divorce.
Lockdown measures were tightened once again in the period, a further blow to businesses and the population across the UK. As we enter 2021, we are now in a race between vaccine distribution and the continued surge in coronavirus cases across the UK. With tough restrictions expected to remain in place over the coming months, we are hopeful that a successful roll-out of the vaccines across parts of the population over the coming months may ultimately allow us to return to some degree of normality later on in the year, supporting the economic recovery.
US equities broke new highs in Q4, the S&P 500 rising 12.1% in US dollar terms. The bitterly contested Presidential election race drew to a close with Joe Biden victorious over incumbent Donald Trump, albeit after a number of days of delay in finalising the vote count.
The market’s reaction was generally positive, as fears of a reversal of US corporate tax cuts passed by Trump were offset by hopes of more normalised international relations, particularly with China. Meanwhile, the economic impact of the coronavirus was felt in US corporate results, with earnings forecast to fall by around 15% in 2020. However, analysts are bullish for a rebound in earnings in 2021, with estimates implying 22% earnings growth in 2021.
With the sense that the “worst is over” in terms of Covid-19, investors shifted into more economically sensitive areas of the market, notably Energy, Materials, Industrials and Financials. Energy was the biggest sector winner in Q4, rising by 26%. However, looking across the year as a whole, the sector fell by 37%, marking the third consecutive year that Energy has been the worst performing sector. Looking below the largest US companies that make up the S&P 500 index, optimism of an economic rebound was more evident. The Russell 2000 index of small caps rose by an astonishing 31% during Q4.
Past performance should not be seen as an indication of future performance
European markets finished the year strongly with positive news on vaccines offsetting the emergence of second waves of infections across the major European economies. The MSCI Europe ex UK index rose 9.0% in the three months to 31st December 2020, with banks and travel & leisure companies being the largest beneficiaries of vaccine news. Sectors that had been stronger earlier in the year, like healthcare, lagged in the fourth quarter.
Economic recovery across the bloc continues to be asymmetric, with the German economy outperforming the likes of Spain and France. Whilst much of the Eurozone is experiencing second waves of Covid-19, the containment measures are more targeted this time around, which should mitigate the economic impact. That said, the recovery seen in the third quarter as economies started to reopen certainly reversed in the fourth quarter, and the longer this pandemic persists the more pressure it places on the balance sheets of corporates and individuals.
Vaccine deployment, crucial to economic recovery, has commenced in the Eurozone. Nevertheless, criticism has been levied at EU leaders for their choice of suppliers and delays in placing orders. The European purchase programme sought to purchase a moderate amount of doses from a large number of suppliers. However, many of these vaccine candidates have not yet come on stream or have been unsuccessful, meaning that the Eurozone lags countries like the UK and US in terms of access to effective vaccines which have been approved for administration, such as offerings from Pfizer/BioNTech and Astrazeneca.
The Japanese stock market had an excellent period of performance in the final quarter of 2020, helping the index to a positive return for the year. This was led by cyclical companies benefitting from the perception that 2021 would be a far better year for economic growth than the Covid-affected 2020. After the news of successful vaccine trials, there were strong rises in car makers such as Nissan Motor and semiconductor manufacturing equipment makers like Tokyo Electron which will benefit from more normal times ahead.
Whilst Japan had a relatively low level of deaths related to Covid-19 in the initial stages, the virus has returned at the end of 2020 and poses a major threat to the economy. The Prime Minister Suga must get on top of this before October’s General Election.
Emerging market stocks rose strongly to near all-time highs. From a regional perspective, emerging market equities and Asia ex-Japan rose by a similar amount, reflecting the hopes that the roll-out of vaccines across the world would continue to spark a cyclical recovery. Furthermore, they were helped by a falling dollar (which reduces the cost of company debt) and increasing global trade activity.
The importance of technology, especially semiconductor manufacturers, helped the South Korean stock market and economy – sentiment amongst exporters jumped to levels not seen since 2011. Medical supplies and tech products lifted Chinese exports to the highest monthly amount on record in November.
Past performance should not be seen as an indication of future performance
Government and corporate bonds made positive returns in the final quarter to end another good, if volatile, year. Steps taken by the central banks and growing optimism about the economic outlook have underpinned sentiment.
CENTRAL BANK INTERVENTION AND UNCERTAINTY CONTINUE
Uncertainty around Brexit trade talks, the US election and the path of Covid-19 have ensured that UK government bonds (‘gilts’) have remained firm. The yield on a 10-year gilt is now around 0.25%. The increased level of borrowing by the government to address the pandemic has been eased by the Bank of England. Around £485bn of government bonds were issued by the Debt Management Office last year. The Bank of England’s quantitative easing (‘QE’) programme of buying gilts in the open market has helped to ensure that this massive supply of new issuance has been absorbed. Despite an improved economic outlook for this year, the measures of the Bank of England, which owns more than 40% of outstanding gilts, mean that gilt yields, and so government borrowing costs, are and are expected to remain low.
Elsewhere, the central banks of the US, the ECB and Japan continue to provide support through low or negative rates and QE programmes. In 2020, the balance sheets of the four central banks increased by $8tr. Their policies are set to remain in place for the time being. The ECB increased and extended its package by €500bn to $1.35tr in December. All of these measures are designed to support economies by keeping interest rates low as well as seeking to raise inflation.
Past performance should not be seen as an indication of future performance
CONFIDENCE RETURNS IN HUNT FOR INCOME
The extreme volatility in corporate bond markets in March was addressed by the US Federal Reserve’s announcement that it would buy corporate bonds for the first time. Stability returned and investor confidence has grown ever since. Both investment grade and high yield bonds were strong in the final quarter and produced positive returns for the year. The nature of the recovery from the pandemic is becoming clearer as vaccines are rolled out. At a time when the amount of bonds with a negative yield has reached a record level of over $18tr, the hunt for income has seen investors willing to take ever more risk by directing funds into high yield and emerging market bonds.
The result is that spreads – the difference between the yields of government and corporate bonds – have returned to levels seen at the start of last year. Companies have taken advantage of the favourable backdrop of strong investor demand and low borrowing costs through a record issuance of bonds (over $5tr last year).
Government bonds look set to be underpinned by central bank action for now. However, concerns about the continued supply of bonds, the possibility of a sustained rise in inflation and current valuations mean a cautious approach remains appropriate. 2020 highlighted that diversification is needed to counter the risks of liquidity and volatility in the fixed interest section of portfolios.
The source data for each graph is supplied by Thomson Reuters DataStream, as at 31 December 2020 total return, local currency unless otherwise stated.
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