Monday digest

Posted 21 February 2022

Overview: Investors anxious for storms to blow over
It was another turbulent week in global stock markets – on the back of little in terms of new news, but plenty of speculation of what may lie ahead. At the time of writing, with ceasefire violations escalating and border troops amassing, the odds on a Russian invasion of Ukraine appear to be increasing. It could therefore be another tense and volatile week. So far, the situation is not yet affecting consumers that much, either here or in the US, except for the extension to elevated energy prices. This comes despite an easing on the supply side which has manifested itself in even further declines in the forward prices of oil in the futures markets.

The extent of the geopolitical and post-pandemic ‘noise’ means it is unwise to have much conviction for the short to medium-term. Gauging underlying trends is still difficult, and economists are currently getting spring forecasts much more wrong than before. What we do know is that the monetary and fiscal policy support environment has tightened, even though the water is still choppy from the pandemic shock. It remains very important for the global economy, and for markets, that the US Federal Reserve (Fed) is not entrenched in a hawkish view, or even gone on ‘autopilot’ in terms of rate rises. In this context, the Federal Reserve’s Open Markets Committee (FOMC) meeting minutes from January were published last week, and provided more insight into current policy thinking. The minutes underlined how the Fed has become much more hawkish in the past three months, however, the details revealed signs of flexibility. The FOMC restated it felt the longer-term situation for interest rates was still biased towards low rates rather than high. It also indicated it remains flexible in the face of emerging data, an important restatement given that the noise level remains high.

Readers might well conclude that the distribution of likely outcomes is one-sided, or in other words that the downside is greater than the upside. However, when we look back across the last 70 years at some of the better-known conflicts, markets have tended to perform well immediately after the point of maximum stress. Whether this point of maximum stress has in fact arrived, remains the key question for this week.

Why UK stock markets are an unexpected ray of sunshine
It has been a difficult year so far for equity investors. Stock markets have fallen in most major economies, prompted by monetary tightening at the US Federal Reserve (Fed), geopolitical tensions in Ukraine and a cost-of-living crisis hitting consumers across the globe. The S&P 500 index is down 8% year-to-date, while the MSCI World index has fallen 7%. That is the global picture at least. At home, things look a little different. The FTSE 100 stands out as one of the few major indices to post a positive return so far this year. Granted, the 2% gain is not much, but it shows a rare bout of outperformance from Britain’s biggest companies.

It might be tempting to see this mini-revival (UK equities have underperformed the MSCI World index every year since 2011) as a positive indicator of Britain’s improved economic prospects, but this positive spin needs some tempering. Though no longer in the headlines much, Brexit is still making life difficult for many businesses – with the latest data showing a fall in British exports to Germany. Meanwhile, any Covid optimism is tempered by a cost-of-living crisis that will constrain demand and limit growth ahead. On the policy side, both the government and the Bank of England are tightening their belts. We can see this in currency moves. Unlike a year ago, when sterling rallied against the euro, it has been broadly flat this time around – albeit with a slight uptick.

If not economic optimism, then, what has pushed up UK equities this year? Well, Britain’s sectoral make-up is helping it now, but it was a hindrance for much of the last two years. The FTSE 100 has a large energy and materials component, both sectors that have been boosted by the recent commodity boom. Energy and commodity companies are cyclical in nature, doing well when global activity is strong and vice versa. The same is true for banks – which benefit from an environment of rising interest rates. These are precisely the companies that dominate Britain’s major indices – giving UK large cap investors a cyclical uptick. By the same token, the FTSE has a relatively small technology component. This is in stark contrast to the US, where the Silicon Valley mega-caps dominate. While the likes of Google and Amazon benefited handsomely during the pandemic, the changing tide of the global cycle has made life more difficult for platform companies recently. Those with a heavy growth focus are considered longer-term investments, and rising interest rates make such longer-duration assets less attractive. The UK, with a much smaller tech component, is, therefore, less susceptible to this shift.

Although UK equities still look very cheap compared to global peers, this has been the case for some time, with international investors reluctant to buy in. Brexit fears were likely a big part of this, via its currency impact, as was the general perception that the US had better growth potential. That perception seems to be changing. JPMorgan recently upgraded the UK to overweight in its portfolios. Global financial conditions are once again a big factor. With rates rising and growth slowing, investors are exiting high growth businesses and looking for bargains. At the moment, there are few bargains as big as the FTSE 100. How long this can continue is unclear. Cheap valuations can only take companies so far, as the higher the price the less cheap it becomes. As always, we are focused on achieving sustainable long-term portfolio growth rather than chasing short-term arbitrage. For that, globally well-diversified portfolios with tactical asset allocation management and thorough portfolio construction principles continue to present a more consistent investment approach.

‘Build back better’ bites the dust
US President Joe Biden’s ‘Build Back Better’ Act is dead, according to Democratic Senator Joe Manchin. He should know, since Manchin effectively killed it. Biden’s $1.75 trillion fiscal plan was the great hope for progressives in America’s ruling party – promising ‘soft’ infrastructure spending, environmental transition and strong growth in the years ahead. Many investors were equally excited, hoping a large and sustained fiscal injection would prolong the post-pandemic recovery. With an evenly divided US Senate, Biden needed all his troops onside to push the plan forward. When Manchin publicly retracted his support (even for his own watered-down version of Biden’s bill), there was little more the White House could do. Investment spending looked like the winning message for the last few years – accelerated by the pandemic – but it seems the tides are turning, and de facto austerity is once again in the ascendency.

This is a far cry from a year ago. In the midst of the pandemic, western governments unleashed huge amounts of fiscal support – without which lockdown recessions would likely have crippled economies for a generation. But not all the proposed spending was stopgap support. In the US, as well as in Britain and Europe, a political consensus seemed to emerge that heavy public investment was needed over the longer term, to address longstanding problems of climate change and stagnant living conditions. The ‘Build Back Better’ Act was a big part of that positive story. Everyone expected spending commitments to be watered down, but its wholesale rejection is surprising – and throws significant doubt on longer-term fiscal stimulus prospects in the US. Instead, old concerns over national debt are coming to the fore again.

There are two pieces of important context here. First, persistent inflation has warped perceptions of what is politically possible. It was hoped the global inflation shock would only be ‘transitory’, but continued supply disruption has embedded expectations of rising prices. The Fed is so concerned by this it has gone full steam ahead with its monetary tightening even as the US economy may be slowing. Politically, this has been a win for the fiscal conservatives; price rises hit home with American voters, and ‘inefficient’ public largesse is an easy scapegoat. Heading into the mid-terms, this will be a powerful weapon to wield against any perceived profligacy. Republicans are expected to make significant gains in mid-term elections in November, and largely suspect inflation and government debt could be a decisive vote-winner, meaning any future Democrat spending plans will require their approval. More likely, it will mean political gridlock.

Biden and the Democrats will continue to push the regulation and oversight agenda, an area that has potential to make the private sector work more for the general benefit of the US citizens, especially in respect of climate change. We should expect a lot more action in this area over the second half of Biden’s first term, and some of the largest US companies could be affected. Meanwhile, the Republicans will also continue their very effective strategy of blocking appointments to national agencies. From a longer-term investment perspective, this may mean growth disappointment. It comes as the Fed pushes forward with interest rate hikes and balance sheet reduction, and means that both monetary and fiscal policy will be less supportive of growth. On the other hand, if austerity does come through, we suspect the Fed will reverse its more hawkish stance. In any case, a tighter-than-expected US fiscal policy in the years ahead may well mean a less rosy outlook for US growth.

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