Monday Digest 12 October
12 October 2020
Overview: debt markets buoyed by the promise of QE
After September’s unsteadiness, capital markets have regained their composure and continue to drift upwards in October. This poise stands in stark contrast to the flow of bad news. In the US, the White House has become a COVID hotspot, similar to many regions across Europe and the UK. Meanwhile, the Brexit negotiation noises have been loud enough to make those worried about the economic impact of the pandemic feeling even more queasy.
But markets everywhere are behaving as if none of this really matters. Almost every indicator that we look at tells us investors are increasingly confident about an upward path for economic growth over the medium term. Investors seem convinced the pandemic will not end up as a new debt crisis (followed by another era of austerity). Long-dated government bond yields have gradually risen across the board, five basis points (bps) in Germany and France, 15 bps points in the UK and a substantial 20 bps in the US – usually a sure sign that things are looking up, not down.
These positive signals go beyond the auspicious government bond markets. Corporate credit spreads have declined, and cyclical stocks are also performing well, beating the more defensive large-cap growth stocks which did so well during the post-March stock market recovery phase. Globally, small- and mid-sized stocks have outperformed large caps, a trend which has been going strong for several weeks. Equity analysts have responded to the reasonable start of the third quarter earnings reporting season by raising sales and earnings expectations. In other words, the starting point for profits is stable and next year’s earnings growth visibility is improving. This may be more than enough to offset the downward pressure on valuations from a rise in long yields.
The fact that markets are currently not panicking over the beginning rise in medium-term yields tells us two things: first, that economic growth (and tax receipts) in the short-to-medium term will likely exceed the interest governments are required to pay on the COVID debt, and second, that markets are also taking the US Federal Reserve (Fed) Chairman Jerome Powell at his word. Here, the belief is that the Fed will continue to respond benevolently to more issuance of both government and corporate debt when these want to borrow to invest. This requires a long-term commitment to capping longer-term yields by means of – you guessed it – quantitative easing.
Some will criticise this as an irresponsible undermining of capital market freedom, and an erosion of the public trust in value of money through sustained financial repression, long beyond the pressures of the COVID‑19 crisis. Others will describe it as the only way to return the global economy to a sustained growth path, by dealing with the universally-raised debt levels around the world in the same way that western societies did with their war debts after World War II.
Fishing for positives in the Brexit negotiations.
We are now officially in Brexit ‘crunch time’. Britain’s official transition period of European Union (EU) membership still only lasts until the end of this year, and, according to Boris Johnson, any deal needs to be agreed this week if it is to take effect on 1 January. The government has repeatedly tried to beef up its negotiating position with the ‘credible threat’ of a no-deal scenario. But recent noises from Whitehall have been more conciliatory. Reports suggest there has been a breakthrough on state aid – an issue so emotive the government felt it may need to break international law over. Hot topics remain on areas like fisheries, an area of low economic impact (but a key Brexiteer talking point), and a relatively high emotional value in parts of the EU; and even here negotiators seem hopeful. Michael Gove has gone as far as to say he sees a 66% probability of a deal happening. Gove’s positivity seems to have fed through to currency markets. Sterling was able to stabilise its recovery from September lows, and the options market has been similarly optimistic.
All countries involved are still labouring under the economic pains of the global pandemic, which has frozen businesses and put individuals in desperate need of support. Ensuring stability of trade terms with our nearest and dearest trading partners, rather than opening a second ‘front’ for the wider economy, is therefore even more vital than it was before. This goes for politicians in both Westminster and Brussels. That said, the incentive is not quite equal on both sides of the Channel. Not only has the UK seen more cases, deaths and longer-lasting restrictions than most on the continent, its economy has been much harder hit. UK economic activity contracted 20% in the second quarter of 2020, significantly worse than the 12% fall in the Eurozone. Last week’s release of GDP figures for August revealed slowing month-on-month growth of just 2.1%, also below expectations.
However, there are some bright spots for the UK. Employment, the cornerstone of Britain’s consumption-led economy, is still holding up reasonably well, according to official statistics. September saw the strongest monthly increase in hiring in almost two years. In all regions except London – which is still languishing – hiring activity and intentions are looking positive. What is more, economic surprise indices for the UK are now performing better than most major economies. In the Eurozone, the initial recovery hopes have tailed off, with the strong bounce-back losing steam. The same is true for business sentiment surveys, which have tailed off in Europe but are holding strong here. With new restrictions coming into force, and a still greatly uncertain virus outlook, it is far too early to get excited about Britain’s recovery prospects. But if Brexit worries can be put to bed, after plaguing both business and investor sentiment for years, it would go some way to improving things. Posturing aside, the incentive to strike a deal is certainly there for both sides.
Big tech’s ‘big five’ faces a post-Election reckoning
This pandemic has done wonders for the stock prices of tech’s ‘big five’. People all over the world have relied on Amazon, Apple, Alphabet (Google), Microsoft and Facebook for shopping, communication, entertainment, business and social interaction. But controversies around Facebook’s electioneering, Amazon’s poor workplace standards and Apple’s monopolistic practices have dirtied big tech’s ‘do-no-harm’ public image. And, with these companies wielding huge amounts of power in their respective domains, the public backlash has increasingly spilt into the political sphere. The ‘wild west’ of unregulated tech markets feels ripe to be tamed by politicians, with tighter rules surely set to come.
By rapidly building scale, the big five have dominated and used their leverage to suppress competition. Part of the issue for regulators is that they need to rethink the concept of monopoly. Monopolies in the past have been hoarders and price-setters, hurting consumers. But Amazon are not hiking prices for consumers – far from it. Instead, while the online retailer has been able to lower prices for consumers, they have also pushed down prices paid to end-producers. Regulators are now perking up to the idea that this new style of monopoly is not as benevolent as it may have seemed. And, without its ability to exert price pressure in this way, big tech could lose some of its shine.
Judging by last week’s US House Judiciary Committee report, things could look very different for tech companies when that regulation arrives. The Democrats have offered detailed and extensive proposals to beef up antitrust law to force more competitive practices, including: requiring online marketplaces to be independently-run businesses or establishing rules for how these marketplaces can run; blocking online platforms from ‘playing favourites’ with content providers; requiring users to carry information from one platform to another; directing antitrust enforcers to assume tech acquisitions are anticompetitive; and allowing news publishers collective bargaining with online platforms.
The timing of this report – just before an election and after months of upheaval and hardship, but with record-breaking big tech profits – is crucial. But it also comes as the big four have started changing as well. Over the past two years (but even more so this year) Apple, Amazon, Google and Facebook have started generating a huge amount of free cash flow. That is, they have stopped focusing as much on reinvesting every $ for growth and are focusing instead more on generating profits. These are effectively the signs of businesses maturing. The fact that a more comprehensive regulatory environment is also set to come could change the way America’s tech superstars are seen. These companies still are – and will continue to be – huge winners. But if capital markets and the economy itself became less concentrated in them, that would surely be a positive.