Monday Digest

Posted 11 January 2021

Outlook: endpoints and new beginnings

After last year’s annus horribilis, many people were hoping for a more prosaic start to the new year. But it soon became clear that 2021 had other ideas. Yet even though events of massive importance have taken place since we last reported, they are, in most instances, end points of the old phase. Since our last update we have seen four years of Brexit disputes come to an end, the four years of Trump’s tumultuous administration approaching its end (in the worst manner anybody could envisage), and the third national lockdown for the UK – but also with mass COVID-19 vaccinations of the elderly and vulnerable gaining speed and volume across the western world. 

For the UK, there has been a sobering realisation that ‘the deal’ that replaces European Union membership terms for its main trade relationships is relatively thin and, in particular, does not cover services exports, which matters more for the UK economy than trade in goods, even if it is less tangible than empty shelves in supermarkets and price rises on cars.

In the US, the outgoing president’s traditional ‘lame duck’ period is proving anything but. Even so, the shocking scenes of insurrection in the Capitol building left stock markets in New York largely unaffected. Indeed, markets rose overall on the day, with investors more cognisant of the news that the Democratic Party had managed to eke out wins in two Georgia Senate races that would give them control over the three branches of government by the slimmest margin possible. Incoming president Joe Biden should have far greater legislative power to execute much of his structural renewal plans around infrastructure and green agenda. The jury is still out on the increased probabilities of tax rises and anti-trust regulation bearing down on US tech giants. Judging by the initial market reaction, concerns over such headwinds remain very contained.

If Brexit uncertainty and Trump’s chaotic administration are both nearing their natural end points, bringing with them collective sighs of relief, then the return of tighter restrictions in the wake of exponentially rising rates of COVID infections shows that the pandemic – and its economic impact – is far from over. And yet, despite the economic hardship these will inevitable – and often arbitrarily – bring for different parts of the economy, the medium-term outlook of markets is far more driven by the ramping up of the vaccination campaigns than the short-term pressures on the economy.

This is beginning to find its reflection in capital markets, where we have experienced a significant increase in the longest-term government bonds’ yields. This “bear steepening” of the yield curve (rising  yields of long maturity bonds driving down bond prices) is driven by improving growth expectations. While this bodes well for the 2021 corporate earnings growth in particular, rising long-dated bond yields can also quickly become a headwind for stock market valuation levels. That said, we firmly expect that earnings will indeed improve for most of 2021 and – just as importantly – that when push comes to shove, central banks will keep a lid on bullish upward yield pressures through more quantitative easing.

Bye-bye ‘Brexit’, hello new ‘Special Relationship’
The last-gasp agreement with the European Union has been ratified and announced by British and European lawmakers, finally locking-in the UK’s regulatory break from the continent. At long last, ‘Brexit’ is consigned to history. In terms of Britain’s economy and asset markets, the fact that we have a deal rather than none is clearly a positive. But anything less than full membership of the customs union – which Johnson’s deal deliberately falls well short of – is likely to be less conducive to trade over the medium and long-term, thereby downgrading UK growth prospects.

The hope is that the skinny deal is only a starting point and will get plumper in time. But there are no guarantees, particularly for Britain’s financial sector. The key sticking point is whether the EU will grant London’s finance companies ‘equivalence’ – access to EU capital markets on the same basis as EU member states. Given the size and financial importance of the City of London on the global stage, the EU would certainly not want to cut off British financiers completely. But the European Commission is yet to make a decision on equivalence, awaiting clarifications from Johnson’s government. One key reason why the Commission could grant equivalence would be the amount of European share trading that goes on in London’s financial halls (or rather, mainframe computer systems), blockage of which could cause liquidity shortages on the continent. But this might well not be a problem for Europe. Over the last four and a half years, European share trading has increasingly moved to centres in Paris and Frankfurt, in anticipation of post-Brexit difficulties. Without the danger of liquidity issues, EU negotiators have little incentive to hand out access to their markets.

Putting the Brexit question to bed should help UK equities by simply clearing up lingering uncertainties. As we wrote in our UK outlook, Brexit has loomed so large over the UK for the last five years that its assets have been seriously unloved by international investors. This has left Britain’s stock market with cheap valuations relative to its global peers – a fact that should help as global investors rebalance for the upcoming cyclical rebound. The fact that political uncertainties are fading provides a notable catalyst for this.

There is another benefit to the skinny deal. Regardless of what one thinks of Johnson’s brinkmanship as a tactic, the constant threat of confrontation and a hard split created headaches for British and European businesses trying to plan ahead. But the latest deal was presented on both sides as a great achievement, and the start of a new, prosperous and friendly relationship between the UK and EU. Ill feeling has receded and, for now, the blame game has stopped. If this can continue, it bodes well for future negotiations on services, equivalence and all else. If it lasts, a calmer tone in negotiations could be the biggest thing to come out of this skinny deal.

The unintended consequences of interventionism
With the pandemic piling a hammer-blow on economic activity, stock performances are clearly based on expectations of a strong 2021 – as we get further down the road to normality. But this means that – once again – markets are starting the year at extremely high valuation levels. If central banks holding the world together was one of 2020’s most welcome main themes, in 2021, the same actions may begin to reveal some distinctly unwelcome side-effects.

As with previous episodes of extraordinary monetary support, the abundance of capital seems to have led to speculative rallies in certain asset classes and stocks which seem very hard to justify when applying historically proven valuation measures. In the aftermath of the 2008/2009 Global Financial Crisis, this was noticeable in the global commodity sector and, to a certain extent, property.

Today, we are not talking about the general valuation levels of equities around the world, even if valuation multiples are close in many instances to exceeding levels that proved unsustainably high during the 1998-2000 dotcom boom. But, as outlined above, recovering bond yields put pressure on such valuation metrics and interpretations, because unless earnings begin to underpin valuations to the same extent as rising yields undermine their sustainability, then there is the risk that valuations drift toward irrationality.

What may prove to be more bubble-like is the meteoric rise of certain technology companies like Tesla, and the renewed explosion of crypto-currency values. In both cases it is hard to identify long-term intrinsic value, an implied return which would justify both the expectations of holders of these assets and the inevitable risks which come from their lack of visibility. Both require belief rather than valuation, and that makes them vehicles for speculative trading rather than investment in the classic sense. We will naturally monitor such developments closely.

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