Monday Digest

Posted 30 November 2020

Overview: fiscal tensions and Brexit overshadow thoughts of a vaccine
While global stock markets continued their more gradual upwards trend last week, government policy was in full focus, but offered little in support. In the UK, Chancellor Rishi Sunak delivered his Autumn spending review in sombre style, backed up by the report from the Office for Budget Responsibility (OBR), which forecast a £30 billion hole in public finances by the middle of the decade. Sunak’s review hinted at tax rises or spending cuts over the medium and long-term, but gave no indication of which he would prefer. Nonetheless, the Institute for Fiscal Studies (IFS) is predicting more than £10 billion of cuts to departmental spending plans from 2021 and beyond. The IFS is also assuming that emergency pandemic spending will end next year, as well as the temporary increase in Universal Credit. However, all of that is also assuming that Brexit negotiations deliver a happy ending for the UK.

We still believe fiscal conservatism at this time would likely be disastrous for the economic recovery. With swathes of the population still unable to go about their business as usual, cutting off support would choke any semblance of a recovery, and undermine compliance with COVID restrictions out of sheer necessity to survive. And, with central banks pinning down bond yields at historic lows, the future costs of not spending enough now is much higher than the danger of spending too much. Indeed, capital markets have been conspicuously rewarding those countries committed to decisive fiscal support.

We suspect the fence-sitting is purely political. With the crisis dragging on, the Treasury must toe a fine line. On the one hand, it must convince the population it will offer unlimited support through the pandemic. On the other, it must convince capital markets and the money-trusting public that the government and the Bank of England are not running a money-printing scheme – or at least not one any bigger than comparable nations. If it fails on the first count, confidence will plummet, unemployment will spike and a full-blown ‘classical’ recession will ensue. If it fails on the second, it risks undermining confidence in its currency value – leading to financial instability which leads to a similar outcome.

The first risk is most certainly the more pressing. As such, we expect the government will borrow, the BoE will buy debt in similar proportions with money only they can create, and we can all just keep our fingers crossed that the recovery strategy works, and that our economic growth can outgrow the risen debt and burden it may bring much further down the line. In the meantime, government hints at fiscal restraint need to be seen as an expectation setting tool more than forward guidance.

Why this time, Brexit really does mean Brexit
Last week’s FT headline “Brexit talks remain deadlocked” could have been printed at any point in the last four and a half years. But having sailed past deadlines, crunch talks and other ‘last gasp’ moments, negotiations are now deep into extra time. A deal would need to be ratified by the European Parliament’s last session on 14 December. Given that MEPs need time to go over the details, this week is the real deadline, and that presents a massive challenge.

Even so, capital markets have been notably sanguine. Investors do not believe – even as we race toward the cliff edge – that a no-deal Brexit is possible. Exiting the European Union (EU) empty-handed after more than four years of negotiations would be – in Boris Johnson’s own words – a massive failure of statecraft. Despite some specific quibbles, every EU member state wants an agreement in principle, and a no-deal scenario would harm manufacturing and trade exposed areas most – an area the government would like to revive.

However, another reason UK markets look unphased is that the bad news has already been priced in. British equities have been unloved by international investors for years (even pre-Brexit vote) and there is only so much damage that Brexit uncertainties can do. British and European businesses have already been forced to make divorce plans, partly because governments have told them it is necessary, partly because the negotiating strategy of “credible threat” has, funnily enough, created a credible threat.

If businesses have already prepared for the worst, even a ‘skinny’ Brexit deal could be a small victory, a prospect that has given sterling some pep in recent weeks, but that doesn’t mean a positive outcome for the UK economy. In terms of overall economic activity, almost any deal will still see trade subject to regulatory conformity checks at the border. Even if an agreement is successfully concluded, some short-term disruption, especially to exports, remains a downside risk. The Bank of England’s latest forecast assumes disruption would reduce GDP by around 1 per cent in the first quarter of 2021, with the best hope being that the disruption will not last too long. Still, we could see higher import inflation over the short to medium-term.

The unpopularity of UK stocks over the past two years has been strongly linked to Brexit scares, but the FTSE 100 is dominated by old-industry energy companies and financials still struggling in a low-yield, COVID world. Washing away Brexit uncertainties should help – as it should the real economy. But whatever happens on 31 December, it will not be the end of market woes for the UK.

Tesla powers its way into the S&P 500 – and everyone has to adapt
Tesla’s stock performance this year has been – in an analogy that will no doubt please Elon Musk – a rocket in flight. At the time of writing, the electric car maker’s shares are up nearly eight-fold since the COVID sell-off in March, making it the most valuable car company in the world. And, on 21 December, Tesla will make its debut on the S&P 500 Index. Upon entry, Elon Musk’s company is set to become the fifth or sixth largest in the index – with a current market cap of nearly $550 billion.

For Tesla, joining the S&P 500 is so much more than a status play. As one of the world’s leading stock indices, there is around $11 trillion indexed or benchmarked to the S&P. When rebalances occur in the next few months, passive funds tracking the US stock market through the S&P500 will have to buy around $70 billion of Tesla stock. Moreover, it is not just index-based funds that will have to start buying Tesla. Once in the S&P, mutual funds benchmarked against the index that are not already holding Tesla will have to decide either to underweight the company or buy it. Goldman Sachs estimates that, if the large cap mutual funds they track moved to a neutral position on Tesla, it would mean a further $8 billion of buying pressure going toward the company. The anticipation of this buying pressure has put investors into a frenzy, with Tesla’s share price pushing up more than 40% since the announcement. The question, as ever, is whether the currently still small-scale producer can live up to its lofty stock valuation anytime soon. Despite 2020 being a great year for Tesla’s output, it will still generate less than 10% of Ford’s revenue and less than 5% of Volkswagen’s (according to Bloomberg aggregates of analysts’ forecasts).

On a deeper level, this episode also highlights that passive investing is not always so passive. If you hold a fund tracking the S&P 500, you will be a forced buyer of all the stocks the committee decides to list come 21 December. Active stock pickers are aware of this, and can therefore win big by gobbling up companies such as Tesla in advance. This added manoeuvrability in such situations is what justifies their higher fee charges, after all. It is, as ever, swings and roundabouts. One need not change an entire investment strategy because of a booming Tesla stock – but it pays to be aware of the downsides too, however you choose to put your money to work.

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