Posted 21 September 2020
Home-grown pessimism needs to be put into perspective for investors
Having spent most of 2020 hoping things can get back to normal, Britain’s political news over the last couple of weeks has left us thinking ‘be careful what you wish for’. Stalling Brexit talks, political disarray and the potential for a full-blown constitutional crisis all created that familiar feeling of pre-pandemic times. The sense of being ‘back to square one’ comes with the reintroduction of wide-ranging coronavirus constraints and concerns over what this may mean for the economy and stock markets.
That said, it is worth taking a step back to reflect on where we are and how far we have come. The current ‘soft-lockdown’ measures are very different to the full lockdown of March and April, themselves a response to having previously underestimated the COVID-19 threat. However rational current measures are, they are still damaging to the economy and the government has to balance the recovery, increasing infections rates and declining levels of fear with every week that passes by without a repeat of April’s public health pressures. More importantly, every week also takes us closer towards the formal licensing of COVID-19 vaccines. Reports that the joint venture vaccine between BioNTech and Pfizer appears on course to gain its licence and a potential first roll-out by the end of October was the hidden highlight of last week. Starting from November, fears for those most at risk from COVID-19 could reduce materially, given their numbers are small compared to the entire population.
For investors, there is plenty to be positive about, not least the gradual sentiment shift within capital markets. Money is no longer piling into the ‘fear trade’ that saw investors flocking towards apparently virus-proof businesses of our new virtual, digital, stay-at-home existence. Instead, investors are buying into the return-to-normality trade of the more physical parts of the economy, like manufacturing. Moreover, several virus-related uncertainties are beginning to approach the end of their natural life. With their expiry, a significant volume of pent-up activity could add suddenly to every aspect of the economy, as consumers behave similarly ‘de-mob happy’ as they did following past periods of wartime constraints. While much of the normalisation expectation has already been priced into financial assets since March, we can see from China’s recent economic development that there is considerably more economic upside from a true COVID-19 recovery than may be priced in presently. This is particularly true for all those sectors and companies shunned as the ‘losers’ of the coronavirus crisis, and now present promising bounce-back potential.
From our perspective at Tatton, we will be focusing on realigning our investors’ portfolios to take advantage of the sector rotation dynamics that have historically followed severe recessionary periods. Beyond that, we will once again look at focusing on the previous uncertainties for investors. The US election and our own Brexit arrangements may well become the more important dynamics for us to assess in the last quarter of 2020.
Are UK equities undervalued?
With the world edging out of lockdown in recent months, the key question on the mind of most investors has been when the cyclical rally – backed by a recovering economy – will begin. Historically, UK equities (especially the FTSE 100) are extremely sensitive to cyclical forces – growing when global growth is strong and lagging when it is not. If growth – in its conventional ‘analogue’ rather than ‘digital’ shape – is indeed returning, it therefore bodes well for UK assets.
In valuation terms, UK stocks are currently trading at around 16.5x their expected future earnings on average, compared to around 19x for European stocks and well over 20x for US equities. That relative undervaluation is – to an extent – justified. The prospect of a hard Brexit as the UK is still reeling from a total economic shutdown is a significant economic risk. But for the past few years, anxious investors at home and abroad have been selling UK assets. As such, even in the worst-case scenario of a chaotic ‘no deal’ Brexit, the immediate downside is limited. There are just not as many investors left to sell. This can be seen from the performance of the FTSE 100, which has traded mostly sideways for months.
When you combine the prospect of a global cyclical recovery, UK assets look like a bargain. Indeed, even if global investors remain pessimistic on UK equities, a rebound in global activity – and subsequent increase in company earnings – would mean that equity prices could rise without much of a change in valuations. However, two things need to happen for this positive scenario. First, the cyclical rally has to materialise. While there are some emerging signs, it is still too early to tell. Second, some kind of resolution to the Brexit drama must be found. For now, the dark cloud of a hard Brexit looms large over UK markets, making many investors uninterested even at cheap valuation levels. Threats to unilaterally break components of an already-agreed treaty do little to help them.
Can the Fed revise its policies enough to prevent a ‘war’ between workers and savers?
With the US economy still reeling from a global economic shutdown, everyone expected interest rates to stay at zero and for monetary policymakers to keep pumping liquidity into the financial system, which is what last week’s Fed announcement seemed to confirm. Nonetheless, the underlying framework change is significant, because it formalises a development which had already been making itself felt since well before the COVID-19 crisis. Significant, because while the Fed’s mandate has been to formulate policy that works for both savers and workers, for several decades now there has been a sense that the Fed has a disinflationary bias, favouring savers’ interests over that of wage earners.
Lately, the balance of priorities has swung definitively toward workers, or more broadly towards income gained from employment rather than financial assets. Last month, the Fed announced a new framework for monetary policy, opting for a ‘symmetrical’ inflation target of 2% over the long term. Last week, the Federal Open Markets Committee (FOMC) announced that it does not expect interest rates to rise above current non-existent levels until 2023. By committing to a ‘lower for longer’ policy on interest rates, the Fed has effectively said it will tolerate the economy running hot if that is what it takes to ensure jobs. In other words, to improve income levels from employment, the Fed is willing to undermine the purchasing power of savings.
This shift to making monetary (and fiscal) policy work for wage earners should not scare investors. For yield seekers, rates can only rise on a sustained basis if the economy is strong enough, and financial asset markets can only thrive if there is a dynamic economy alongside them. After all, if one age group needs to sell its assets to fund their retirement, only to find no one in the younger generation has the money to buy them, those underlying assets will see a sharp and damaging price reversal. One way or another, imbalances will be corrected. But with a steady change of monetary framework and fiscal policy, that correction can be orderly and benign.
Here, we suspect, lies the deeper transition for the Fed. In the post-pandemic world, inflation may not only be a spur for growth, but also potentially a rebalancing tool between age groups. We are unlikely to see the effects of this framework take effect soon, but it seems the Fed has recognised the importance of wage earners feeling the benefit of its policies more strongly now than they have over the past four decades. Monetary stability may otherwise prove to be a fool’s errand if political and societal instability sewn by imbalances between the generations reaps destructive upheaval.
This material has been written by Tatton Investment Management and is for information purposes only and must not be considered as financial advice. We always recommend that investors seek financial advice before making any financial decisions. The value of investments can go down as well as up, and investors may get back less than originally invested. All calls to and from our landlines and mobiles are recorded to meet regulatory requirements.