Monday digest

Posted 7 June 2021

Overview: Markets going up sideways
June has begun as May left off – in quietly confident fashion. It appears optimism following the successful vaccination programme and pent-up consumer demand continues to support equities and summer expectations. Investors have moved on from asking whether there will be growth to wondering just how strong it could be. This in turn has led to questions over what central banks will do as a result of that strength. Higher inflation could trigger interest rate increases and restrain the economic rebound prematurely. This certainly explains some of the market volatility in May. So far, central banks have stood firm and clearly indicated today’s price rises are temporary, and mostly caused by COVID-disrupted supply chains, so these pressures should moderate as supplies of goods and services adjust over time.

Corporate confidence remains elevated, as various Purchasing Manager Indices (PMIs) showed last week. Equities are positioned well against a backdrop of normalising inflation rates, and for businesses, stronger sales growth can help offset higher costs. Additionally, rising demand generally makes it easier to pass higher costs onto consumers, ensuring profit margins are not squeezed.

It is hard to deny that equity markets, especially those in the UK, have made a solid start to 2021. However, rising optimism should not lead to complacency, and we would not be entirely surprised if markets remain choppy in the near term. Overall, the path ahead looks brighter than it did last year, which should mean equity markets remaining positive for the medium term.

Conversation returns to fiscal deficits and ‘Keynesianism’
Over the last year, politicians all over the world have racked up massive bills for their emergency fiscal support. Most of this has been funded by debt, pushing debt-to-GDP ratios significantly higher across developed nations. Understandably, this has provoked fear over how it will be paid off, and  what it means for government budgets further down the line. Economists and capital markets seem unphased by this supposedly looming danger. As the world starts to recover from the pandemic, and restrictions are eased, emergency fiscal support will peter out over the coming quarters – even if governments are allowing substantial leeway – as in the European Union (EU), where budgetary rules have been suspended for 2022. Politicians remain wary of tapering support too quickly and risking a fiscal cliff-edge scenario. If households and companies fear things to be slower in the medium-term, they’ll save rather than invest and spend.

In the US, though, emergency support has been channelled through extraordinary and time-limited measures – meaning a shock could be on the cards if they stop too abruptly. The UK faces similar issues (although the scale of support was smaller than in the US) surrounding the run-off of furlough payments and rent holidays. In Europe, much of the pandemic support has come through established social security mechanisms which act in a more measured way. And even there, more generous tweaks of well-established schemes are set to phase out.

It is interesting that the current discussion about debt and fiscal support is framed as a return of Keynesianism by the media. The simplified version of Keynesian economics is that demand is the defining driver of the broad set-up. Governments can boost growth when savings are high and demand is low, and so fiscal policy should be countercyclical. But countercyclical policy usually means investing in the hard times and pulling back in the good times – with the latter of course proving much harder. Emergency COVID measures go a bit into this direction, but ultimately they are there to plug the income gap and avoid a disaster. Importantly, this past year has been a great example of why fiscal deficits are not necessarily about public investment.

A picture emerges of growth, rotation and momentum
With the world opening up and the global economy finding its feet again, equities are inching higher on gently improving earnings expectations. These are supported by stable – and historically low – interest rates and bond yields. In this scenario you would expect bond yields to gradually climb higher with economic growth, thereby making stocks less attractive by comparison. Nevertheless, stocks have clearly become ‘cheaper’ to some extent. Even though the MSCI Developed World index rallied to new all-time highs last week, the ratio of price-to-expected earnings (over the next 12 months) has fallen.

At the aggregate level, earnings expectations have continued to improve at a fast pace, but stock price gains have been keeping up – so why is the index getting cheaper? The cheapening of the tech giants does not explain all of the move in the index’s overall price-to-earnings valuation. The answer comes not from the stocks themselves as much as the way they are included in the index. With markets rotating out of growth into value, the latter stocks see a bigger representation in major indices. Those companies generally have much lower price-to-earnings ratios, meaning that the aggregate index valuation comes down despite individual valuations remaining around the same.

Whatever the case, the index’s rebalance last month makes it clear what a huge rotation we have seen in wider markets. There has been a cheapening among growth stocks, and value companies now look as attractive as their growth peers. If you don’t have to pin your hopes on growth some years into the future, why would you pay up-front for it? Tesla – its valuation dependent on profits which can only be achieved in the next decade – has been a prime example of this. The electric carmaker, which more than doubled in price from November to January, has fallen back over a third. Inevitably, its valuation is now (slightly less) stratospheric.

It is hard to say how long this trend will last. If this economic cycle is a brief one, momentum is unlikely to be a winning strategy – with growth stocks becoming more attractive again. At the same time, if confidence is high that the economy will keep expanding, momentum will be behind the more cyclical and value-oriented stocks. Thankfully, there is still plenty to be positive about.

Is phase two of globalisation about to begin?
As investors, one of the challenges we face is to identify trends in the global economy and then work out how to invest in the assets benefitting from those trends. One such trend could be a second phase of globalisation. The first phase was a big expansion of global trade into emerging nations. The second will be about those nations moving into a more developed framework. They will no longer need to rely on neo-colonial countries to gain some small part of the value chain. Rather, the people of that country will have the necessary skills and organisation to do it for themselves.

The exploitation of emerging market countries rich in raw materials has been going on for centuries. However, for modern food, oil, and mineral companies, the current global political climate looks especially challenging. The news over the weekend that the G7 group had reached agreement in principle on a 15% “global minimum corporation tax”, means all global companies face the prospect of paying more tax. While mostly targeted at the tech giants, such measures will impact older companies as well. However, the emerging markets’ rising confidence in their pricing power is a threat to their margins which may continue over a long period. Of course, that is in addition to the climate change pressures that are already coming to the fore.

To combat these pressures, companies will need to change their cultures radically and swiftly. Some are making efforts, but have a long way to go. For the emerging nations, the improving governance structures which lead to pricing power is an all-round positive. The general deepening of their economies should benefit all domestic asset classes. Of course, no country’s path can be smooth, but the focus on removal of corruption is an enormous gain. As in the 1990s, it may be that global growth will happen at the same time, but the reasons to be positive on emerging markets may prove more constant.

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