Monday Digest

Posted 6 April 2021

Overview: Q1 2020 review
It was turbulent at times, but the first quarter of 2021 brought genuine good news for UK-based investors with exposure to global stock markets. Equity markets generally resumed an upward trajectory, while low risk assets, especially long maturity bonds, sustained meaningful losses. Fixed income yields have risen on an increasingly positive medium-term outlook for the global economy. This improvement in outlook, and reversal of bond markets, also meant the turn of fortunes between the winners and losers of the pandemic year of 2020 that began last October has continued. Meanwhile, with economic growth rising, individual companies are finding profit opportunities. This is feeding through to specific stocks, helping stock-picking fund managers to again outperform index tracking funds.

We have grown accustomed to ‘the first 100 days’ as being the most active period in every US presidency and so far, the Biden administration seems determined to make every day count. On the last day of the quarter, it proposed $2.25 trillion of government-directed infrastructure spending spread over eight years, signposted as the first half of a ten-year $4 trillion investment programme. Funding the spending plan is the “Made In America Tax Plan”, with far-reaching tax proposals. Raising the headline rate of corporate tax from 21% to 28% is only part of the story. Importantly, for the long-term health of not just the economy but the planet, it removes fossil-fuel subsidies, while – recognising the globalised economy – the plan also proposes a “minimum tax” targeting overseas profits.

As the second quarter begins, we expect to see further economic improvements. The main unexpected element has been the delay to loosening restrictions, due to slower-than-expected progress of the vaccination campaign (most notably across Continental Europe) and the growing risk from virus mutations, even if this risk is not yet proven. We remain hopeful that the warmer weather is likely to reduce the spread of infections, and that the vaccination roll-out should significantly re-enforce this effect. We will, undoubtedly, continue to experience the disconcerting side-effects that monetary and fiscal stimulus medicine carries with them, and which played out during the first quarter. But as long as the economy remains on its expansion path, these should remain peripheral events.

Arch egos and greed bring down another firm
Springtime appears to be showering us with financial scandals. Just two weeks ago after the collapse of supply-chain financer Greensill, the demise of Archegos Capital Management could prove far more disruptive for equity markets and the institutions involved. The story is complicated in its detail, but simple at heart. Bill Hwang, a secretive but successful investor and the founder of Archegos, took out huge positions on a handful of stocks using borrowed money. But by spreading the borrowing across several banks, and using complex financial instruments, Hwang managed to hide the extent of his fund’s leverage, giving the banks a false sense of security.

The debacle is certainly significant, if only for what it symbolises. The banks involved are rightfully embarrassed about how they let such risk creep onto their balance sheets. Two big scandals in quick succession will be a considerable hit to the profitability of those banks involved, and potentially suggest considerable risk management issues. It seems highly likely this scandal will lead to increased regulation and transparency – particularly for the opaque total return swaps.

We wrote after Greensill that fraud and financial misconduct would inevitably rear its head again, given the system is awash with liquidity and investors are chasing slim returns. While we did not expect another example quite so soon, it only underlines our belief that derivatives will inevitably be misused by those that believe they can get away with it, while making outsized profits.

This does not mean markets would function better without derivatives – quite the contrary. But it is up to regulators, and banks, to contain the risks and utilise the ‘invisible hand’ of market forces by creating transparency, even if that means they no longer benefit from the gains that opaque trading is able to generate. It remains to be seen just how many warning shots across the bows the investment banks are prepared to take, before recognising that regular scandals do nobody any good.

The post-pandemic Emerging Markets picture looks increasingly complex
Markets are excited, and expectant, for the global economic recovery later this year. However, whereas emerging markets (EMs) are typically the classic global growth play, this time the story is more complicated. First, despite markets anticipating a strong recovery at the global level, growth expectations are concentrated on the US. While this in itself is a positive for EMs (as demand filters out) it has also led to a rise in the value of the US dollar in recent weeks – a negative for EM companies, as it raises the cost of their dollar-denominated debts. Second, and perhaps more importantly, there are a number of different stories unfolding in various EM countries that dampen their particular growth picture. China has disappointed lately, led by a deliberate tightening of policy. The health crisis in Brazil, meanwhile, is well-documented, and is placing severe pressure on its far-right government. Meanwhile, far-right Turkey continues to frustrate investors with its erratic policy decisions, after President Erdogan fired his third central bank governor in succession, prompting even more selling of the Turkish lira.

Even so, none of this is to suggest that the overall EM outlook is bad. A strong global economy combined with fiscal largesse in the US is inevitably a good thing for EMs. Rather, the point is that the ‘EM’ label is not so useful at the moment. The average correlation between EM equities fell substantially through the latter part of last year, and remains at a low level. In recent years, we have become accustomed to government-led stimulus creating huge Chinese growth and driving EMs, and the global economy, forward. This is not the case now. Authorities seem content to continue their deleveraging process and let China be a passenger in the global recovery. President Xi clearly wants China to return to relying more on its own savings and institutions – as it did for most of its history.

All of this is to say that China no longer behaves like an EM, and we should not even expect it to be strongly correlated with other EMs. Something similar can be said about neighbouring Taiwan and South Korea, which are extremely well developed and dominated by tech companies, and yet still count as ’emerging’ in many asset allocations (the two make up the second and third largest share of MSCI EM stocks, for example). As such, it is hard to draw any high-level outlook on EMs, without first splitting out China – and perhaps its surrounding Asian nations also.

When taking China out of the mix, the case for EMs still looks positive. But even here there are many idiosyncrasies. Turkey’s political turmoil has made it virtually un-investable, while Brazil’s struggles and Russia’s diplomatic scandals continue to weigh them down respectively. Overall, inflation and growth are certainly returning across many EMs. This is a positive, but may create difficulties for central banks down the line. How they respond could be the key differentiator. We are positive on EM-ex-China, but that does not mean we are negative about China or the wider EM market. It simply means the reasons to be positive on China are entirely different from the reasons to be positive about other EMs. After decades of rapid growth and development, there really is not much ’emerging’ left for China to do.

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