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From uncertainty to euphoria in seven days

16 November 2020

Overview: from uncertainty to euphoria in seven days
Investors have found it almost impossible to hide their elation from news that an effective coronavirus vaccine is possible and could be with us before the end of the year. Stock markets around the western world jolted upwards by 5-8% on the day of the announcement, not only erasing the declines of late October, but in most cases returning to previous summer highs. Those sectors and companies hardest hit over 2020 rallied most, while the ‘virus victors’ – especially the US tech giants – lost ground on the news. This stock market rotation towards the hitherto ‘lockdown losers’ seems imminently rational if the arrival of vaccines – of which the western world appears to have secured plenty to go around – offers the prospect that we will be able to return to our pre-pandemic lives relatively quickly.
But beyond these more obvious moves, we also observed the significant outperformance of value stocks over their growth counterparts. Given that value stocks have underperformed by close to 40% over ten years, last week’s bounce was a tiny retracement overall, but could prove the beginning of a shift away from the over-reliance on a handful of mega-cap tech names. Change is definitely in the air at present, and at times like these, diversification is the watchword.

Clearly, none of us are out of the pandemic woods yet, and record infection and fatality numbers provide a dire warning that things still might get worse before getting better. Nevertheless, capital markets tend to experience paradigm shifts well before the broader economy does. Indeed, what they require is a reasonable perspective that the worst-case scenario has been averted and that light at the end of the tunnel has become a distinct possibility. With the US Presidential election now effectively all over bar the shouting, and a coronavirus vaccine by the year-end looking a near certainty, markets are feeling positive about the prospects for 2021. A year from now, November 2020 may well be recognised as the turning point, when capital markets were no longer driven by the relief provided by emergency policy measures, but instead by the real prospect of a sustained economic recovery.

Can we expect a gangbusters 2021?
Much of the growth story for next year still hinges on additional demand generated by a step up of investment activity across the global economy. The backdrop for this is looking good. Central banks have committed to ‘looser for longer’ interest rates and yield levels, through continued asset purchases (our old friend quantitative easing), flooding the financial system with liquidity, while making the cost of investing cheaper than ever. This is allowing governments in the developed world to expand their fiscal support to ensure economies can bridge the gap between now and normality. This should protect the integrity of most businesses’ productive capacity by avoiding ‘economic scarring’ from this year’s activity constraints. Importantly, it should also facilitate scaling up of fiscal stimulus investment programmes to boost growth once the pandemic is behind us.

There are dangers in relying on fiscal investment, however, and we have already heard politicians in the UK, Europe and the US sound austerity alarm bells. UK Chancellor Rishi Sunak was urging spending restraint before the latest lockdown measures hit and Republicans in the US Senate remain intent on blocking fiscal largesse. More importantly, even if much-needed public spending measures find their way past political blockades, private sector investment will still be crucial for a sustainable recovery next year and beyond. Governments and central banks can provide liquidity and pump priming investment, but it is the private sector economy that drives perpetual re‑investment cycles.

Why the housing market is enjoying a mini boom
While the pandemic has undoubtedly taken a toll on many (younger) people’s financial positions, those with secure employment have been able to grow their savings during the crisis – and are looking like a much better borrowing bet for banks. There appear to be two main factors underlying this trend. First, the pegging of interest rates and bond yields to the floor has made larger mortgages more affordable for consumers. Second, widespread work-from-home policies have shifted people’s focus on their living conditions and attitudes towards commuting. This in turn shifted the type of housing stock most in demand. In the UK, you can add the suspension of Stamp Duty to the list of positive factors. House prices and sales have been trending up in recent months, despite the huge downturn in wider economic activity. According to the latest Royal Institute of Chartered Surveyors (RICS) survey, October was another strong month, with a net balance of +46% respondents reporting an increase in demand. With house sales continuing throughout the second lockdown, estate agents expect this upturn to continue.

This generates positive feedback on the economy itself. In the UK, rising house prices have an outsized effect on consumer confidence through the ‘balance sheet effect’. But beyond this, new housebuilding creates jobs and boosts incomes, while increased mortgage activity – even if only for house moves – is a good sign for the demand for durable goods further down the line. This is something governments will likely want to encourage – particularly if they remain squeamish about stimulating demand through fiscal investment programmes themselves. Higher growth will in turn be crucial in reducing the potential drag – and anxiety – caused by increased public debt levels. Of course, higher growth would mean higher tax receipts from the same tax rates – and with GDP rising at a faster pace than the costs of servicing the debt, the debt mountain that COVID has settled us with becomes less daunting. We suspect this is why central bankers have been willing to ditch past rhetoric and encourage politicians to borrow more to stimulate the economy. In other words, getting out of this recession decisively now should ensure higher debt levels are far less of a worry later.

Why investors still see China as an exercise in risk management
Last week, China’s tech giants saw substantial falls in their share prices. Alibaba, the “Chinese Amazon” which has nearly 60% of the ecommerce market in the world’s second largest economy, tumbled 10% last Wednesday. But this was just the latest round in a fight that began in October, with the China Banking and Insurance Regulatory Commission (CBIRC) taking the fight to China’s biggest tech names and their entrepreneur founders. We have already seen the scrapping of potentially the world’s largest stock market floatation (Ant Financial), and more recently Beijing proposed new rules attempting to define anti-competitive behaviour in the internet sector. Clearly, this is a negative for Alibaba and other China tech superstars such as Tencent and Meituan. No matter what the substance of the monopolistic charges, targeted regulation specifically designed to change their business practices will hurt their revenues. International investors may worry that this might not be just about powerful tech companies; it might be a Communist Party crackdown on private sector freedoms; or it might even be an attempt to steal the success of entrepreneurship.

If China’s government succeeds in putting together a framework which is applied reasonably consistently – and really achieves more competition, allows smaller companies to be profitable and to become largish companies – it would be a positive for the investment community over the long run – if only for an expansion of choice and thereby risk reduction through diversification. From our perspective, the tech story is not the real issue with China. We have maintained our view that all the ingredients for a positive Chinese investment story are there. It is the only major economy on course for positive GDP growth this year, it is well into its domestic-led transition, it offers higher yields and greater stability than most other developed nations, and is increasingly open to foreign capital. Indeed, we suspect strong investment inflows to China are all but inevitable over the next few years. But international relations and a growing global consumer distaste for anything Chinese – rather than domestic political crackdowns – could spoil the party in the short and medium term.

The delicate political situation is why we have stayed neutral on China up to this point, despite the obvious economic positives. In a week where vaccine positivity gripped Western stock markets, the relative advantage of China having been able to live under COVID-19 without a vaccine has lost much of its shine. This, together with the relatively downbeat Chinese news has prompted an underperformance in Chinese equities. Looking forward, China presents a curious case of immense potential tinged with significant unknown risks. We will continue therefore to monitor and assess these risks closely.

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Bond rally musings

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15 February 2019

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25 January 2019

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No Surprises

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4 May 2018

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Constructive tones amongst much noise

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Remarkable market resilience

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Returning themes

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Bear markets without recession tend to be brief

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