Monday digest

Posted 9 August 2021

Overview: August begins in upbeat fashion
After an unexciting July in investment return terms, August has made a strong start, bolstered by surprisingly positive US job markets figures and corporate earnings reports that continue to support elevated stock market levels across the Western world. That said, the latest quarterly earnings season has not generated as strong an equity market as might have been expected. In fact, while markets have risen somewhat, they have also become a little cheaper, as yields have fallen while earnings have risen strongly. This is good news for investors, as it provides a bit of a buffer should yields rise again – a prospect that is still very much with us.

Given that central banks are edging towards a reduction of (yield supressing) monetary support on the back of expected sustained growth, this anticipation of gradually higher long yields seems quite justified. Provided earnings expectations continue to rise – as they should if growth becomes sustained – that is a recipe for generally stable equity prices rather than big moves either way. We would be happy to see valuation levels ease back further as they did over the past months, as this would provide to basis for more sustainable valuations, even when yields gradually normalise upwards.

Corporate reforms on the agenda for China and the US
August began with further indications that China is continuing its rapid pace of regulatory ‘reform’. Just as online education companies were targeted previously, last week’s actions centred on computer games and addressing monopolies in music rights. China’s tech giant Tencent felt some pain, although it ended the week only about 5% lower than the start.

The compression of Chinese tech giants like AliBaba and Tencent has been met in the US and UK with some cognitive dissonance. Many investors are wary of the impact of mega-techs like Amazon, believing that their behaviour has destroyed general profitability. Yet investors also find it difficult to think that the Chinese authorities’ behaviour is about ensuring a level and fair playing field for its domestic businesses. But similar efforts appear to be underway in the US, and President Biden has been pushing various US agencies to act. His 9 July Executive Order called for 72 new measures across more than a dozen federal agencies to curb excessive corporate consolidation. For tech firms, this means greater scrutiny of both past and future acquisitions (including nascent rivals), as well as new rules to prevent excessive data collection, surveillance and ‘unfair competition’ in online marketplaces.

The mega-techs of the US now face headwinds across the board. Their revenues and reach are big enough to mean that the secular excess growth of the past 20 years may already be difficult to sustain going forward. At the same time, the now-attained relative certainty of their profits in the future also mean that higher yields affect their valuations more than the cyclicals; tax policies will be targeted towards their profits; their acquisitive business models face significant pushback.

Rather than being just talk, policy change appears to be underway. Indeed, the new appointees to the various US agencies will be under pressure to act from both sides of the US political divide. The US mega-tech companies have enjoyed an incredibly supportive policy environment, and there is an increasing belief it will prove challenging to sustain shareholder expectations for future growth levels. We should not write them off just yet, but as always, a broadly diversified portfolio has a better chance of benefitting from growth opportunities, wherever they are.

UK: caught between policy support withdrawal and bounce-back upsurge
With ‘Freedom Day’ firmly in the rear-view mirror, the surprise drop-off in virus cases seems to have levelled off. But with the UK having vaccinated nearly all of its adult population, the pressures on public health are a fraction of what had been experienced during the first three waves. If this continues to hold, there is little to suggest a worsening in the months ahead. That is good news for the UK economy which, despite widespread complaints about the ‘pingdemic’, is recovering nicely.

There are major tests to come, but for now UK growth is bouncing back and the path ahead is promising. The Bank of England (BoE) underlined this view last Thursday with its Monetary Policy Committee voting 7-1 in favour of keeping interest rates where they are. In its accompanying report, Consumer Price Index (CPI) inflation is forecast to rise through this year to 4% before dropping quickly in 2022. Even so, the BoE seems in no hurry to change its rate policy and its £895 billion bond purchase target is expected to remain in place until the end of the year. However, the absolute limit on bond purchases effectively amounts to a tightening of policy.

Perhaps surprisingly, BoE governor Andrew Bailey indicated that should policy need to be eased, negative interest rates would be the preferred tool used – instead of further quantitative easing (QE) through buying up government debt. Of course, the BoE does not currently expect negative rates will be needed. Indeed, it expects rates to start moving up next year, although only towards 0.5% by 2024. Despite this all leading to the perception that monetary policy will become less supportive, the “reaction function” framework is really designed to make central bank policy more predictable. Whether it succeeds in doing that is another matter, but it at least lowers the chance of a policy shock. The same cannot be said about fiscal policy, where we believe the bigger danger lies.

Now that COVID legal restrictions have been lifted, Chancellor Rishi Sunak will be reluctant to extend furlough payments or emergency loans. Should these dry up before the economy has found its feet, growth will take a hit. Stamp Duty relief is already set to end, and the government is likely to try reducing the deficit unless restrictions come back. The Office for Budget Responsibility will provide updated forecasts to the Treasury at the end of October, and it is likely to report significant negative impacts on the government’s finances. The end of the Stamp Duty holiday is expected to impact housing activity substantially, but for consumers this is likely to be offset by the recent fall in mortgage rates. UK banks have seen £370 billion of net inflows in cash deposits since the start of 2020, with loans growing only by £100 billion over the same period. This has led to a substantial increase in excess deposits, which has pushed down mortgage pricing. That is bad news for banks, but should be a positive for house buyers as Stamp Duty returns.

Despite the challenges ahead, the British recovery is undeniably underway. This, together with a rapid vaccination programme, has been a key support for UK equities in recent weeks. But the solid performance of British stocks has been proportionally less than the improvement in analyst UK earnings expectations. The equity market has not kept pace with the improving earnings picture, nor have prices properly adjusted for the fall in bond yields (which make equities more attractive by comparison). This means UK equities have become cheaper in terms of price-to-earnings ratios.

By our calculation, British stocks offer a 2% extra risk premium compared to the US (that’s adjusting for the different sectoral compositions), with a smaller advantage over European equities. This suggests investors do not fully believe in the UK growth story, and are expecting the economy to disappoint in the coming months. The market may be pricing in a sharper fall in UK earnings than elsewhere in the world. That is certainly possible, with pandemic scarring and the after-effects of Brexit still weighing down the UK economy. The positive, though, is that this is effectively priced-in already, so the impact would be minimal. On the flip side, if markets are wrong and UK earnings improve, it would make UK assets look significantly cheaper than other major markets. That would be a boost for UK equities, which could deliver strong returns from here.