This January/February 2021 market update is brought to you by LGT Vestra
Following the positive news that Covid-19 vaccines had been developed, there was hope that life might return to normal sooner rather than later.
This optimism caused investors to rotate out of many companies that have fared well during the pandemic, to businesses in relatively harder-hit cyclical sectors. This rotation continued into the new year; however, as concerns over new variants of the virus have developed, optimism has waned, and to some extent, this rotation has reversed.
Whilst the flow of news has been unrelenting, the prospects for further fiscal support, prolonged low interest rates, and the wider rollout of vaccines are expected to continue to support equity markets.
In the US, Joe Biden was sworn in as the 46th President. The transition may have been delayed by Trump, but the Biden administration is progressing quickly. His focus, as was reflected in his inaugural address, is on the pandemic and climate change, seeking unity and multilateralism in achieving these goals.
The new President has already listed a stream of executive orders; including a $1.9 trillion relief package, which has been opposed by most Republicans; however, he may yet seek a compromise deal.
US Treasury secretary, Janet Yellen, said the US could reach full employment next year if Congress passes the stimulus package. Her comments on stimulus, delays in tax rises, and reassurance that Trump’s corporate tax cuts are to be only partially reversed, were taken favourably by the stock market.
As former Chair of the Federal Reserve (Fed), she is likely to give them all the powers they need to support the economy. There have always been fears at the start of Democratic administrations, of them being less business friendly, but historically, the US stock market has generally done as well under Democrat Presidents as Republicans.
At the Bank of England (BoE) Monetary Policy Committee meeting, they discussed if they could include negative interest rates as part of their toolkit. They decided to rule this out for the time being. However, if new variants of the virus become prevalent and cause further lockdowns, curtailing economic activity for longer, then the BoE may have no choice but to resort to negative interest rates.
Throughout the pandemic, the BoE’s main tool for easing policy has been quantitative easing. However, with the BoE now owning much of the bond market, using this tool in the future against unexpected economic shocks may prove less effective, and may mean resorting to interest rate policy again.
Whilst the outlook for growth in the UK was revised downwards given the current lockdowns, a strong rebound is still expected later this year. When the economy re-opens, consumers will be eager to spend their savings to enjoy leisure activities. The success so far of the vaccination campaign gives increased confidence in this outlook.
Following the Brexit deal at the end of last year, companies that trade across the border are adapting to the new trade rules. As this happens, difficulties are emerging, particularly over the Irish border. An extended grace period may be needed whilst these issues are smoothed over. Anecdotally, trade across the channel is also being delayed by the new paperwork.
In Europe, the delivery of the vaccine has been much slower than in the UK, highlighting some of the problems associated with European bureaucracy. The EU threatened to stop deliveries of vaccines manufactured within the EU to the UK, but this was in breach of the Brexit agreement, and they backed-off rapidly.
Overall, we expect fiscal and monetary policy to continue to support developed economies. However, we continue to encourage a selective approach to equities and corporate bonds, focussing on companies with attractive long-term growth prospects, robust business models and strong balance sheets.
Market View Changes
US dollar ◄►
The dollar has shown itself to be a safe haven currency throughout the pandemic. Looking forward the dollar is likely to balance the rise in cases against fiscal policy and the rollout of vaccines.
The euro has been supported given the announcement of a mutual fiscal programme but rising cases and relatively slow pace of the vaccine rollout in Europe have brought short-term concerns.
Following an initial rise after the announcement of the Brexit deal, sterling has been swayed by the spread of the new variant of the virus and the renewal of lockdowns and further restrictions. We expect the pound to remain range-bound as investors consider the prospects for growth in the UK, balancing the cost of restrictions in the short-term, with the vaccine improving the outlook for jobs and growth over the medium-term.
Government bonds Conventional Inflation-linked
UK Gilts ▼ ◄►
US Treasuries ◄► ◄►
German Bunds ▼ ◄►
The pandemic has resulted in near zero interest rates across the developed world. Given the pushback on negative interest rate policy and the potential recovery later this year, gilts offer little value.
In the short term, inflation is expected to rise as some of the price falls last year drop out of the annual inflation rate figures. As the pandemic eases, there may be a pick-up in demand, giving a further boost to inflation.
However, higher unemployment, ageing populations and technological innovation, such as the use of robotics and artificial intelligence, are likely to keep inflation low longer term. Inflation expectations have risen particularly in the US. Given this scenario, we continue to see value in inflation-linked bonds.
US Treasury yields have risen since the start of the year, as supply is likely to increase under the Democrats; however, prices have moved rapidly and could correct if the economic outlook deteriorates.
At current valuations, we cannot justify investing in conventional German bunds and retain our negative stance but see some scope for inflation to pick up over the medium-term in light of fiscal stimulus.
Investment Grade Corporate Bonds ◄►
With central banks rushing to support this vital market in order to avoid further economic damage, credit spreads have retracted from their widest point, in March last year. As spreads on offer are now meaningfully lower, our stance has evolved to neutral.
This reflects the support that central banks continue to offer the market, albeit with much less attractive yields on offer, thus tempering our enthusiasm.
High Yield Credit ◄►
The wave of defaults that investors expected at the onset of the pandemic has thus far failed to materialise, given the broad-based support that governments and central banks have provided.
While defaults were concentrated in the heavily affected retail and oil segments, the intervention of the Fed into exchange traded funds and newly junked bonds has seen liquidity conditions of highly indebted companies remain loose. This has supported the market, however, questions remain on balance sheet strength should there be a choppier economic recovery.
Hence, we retain our neutral stance but stress selectivity.
Emerging Market Debt
Local currency denominated debt ◄►
Hard currency denominated debt ◄►
Whilst emerging markets typically benefit when the US loosens monetary policy and the headwinds from a stronger dollar fade, the concern is their ability to respond to further outbreaks of the virus, and the resilience of their economies to cope with the restrictions.
Hence, selectivity remains as important as ever and we retain our neutral stance across this diverse asset class.
UK equity ◄►
The FTSE 100 index started the year strong, buoyed by its exposure to energy and materials. However, following the news that new variants of the virus have developed, this has somewhat reversed.
The market continues to trade at valuations that look cheap relative to markets elsewhere in the world, which has spurred some takeover interest, given the opportunity to pick up companies at discounted prices.
However, concerns over the new more virulent variant of the virus, and the lack of Brexit deal for the service sector may weigh on sentiment. We thus find it hard to justify anything more than a neutral stance for the time being.
Europe ex UK equity ◄►
Whilst on the grounds of valuation the European market looks attractive, the vaccine rollout has emphasised divisions within Europe that are hard to ignore.
European manufacturing has fared better during the pandemic than the service sector, which continues to be held back by pandemic restrictions. Given the pace of the vaccine rollout, these restrictions may be in place for longer in Europe than some other developed countries.
For these reasons, we retain our neutral stance on European equities.
US equity ▲
The US remains the market that we consider home to the highest quality companies that have both held up well during this turbulent time, and whom we believe can sustainably compound growth over the longer term.
We continue to favour these companies, with robust balance sheets in less economically sensitive areas. Many have the ability to come out of this global crisis stronger, with fewer competitors, and the ability to use their cash for tactical M&A.
As the US economy emerges from the pandemic, we expect smaller companies to perform well. Whilst the market is home to many uniquely innovative companies, this has come with high expectations from investors. We stress that certain US stocks have become rather expensive; however, this does not change our longer-term preference.
Japan equity ◄►
In general, Japanese companies have plenty of cash on their balance sheets and should be able to weather the storm. Dividends have been cut in Japan, but not to the same extent as in many other regions.
Whilst we recognise that Japanese equities rebounded strongly as investors have become more confident in a global recovery, we still prefer broader Asian exposure than country-specific exposure to Japan.
Asia ex Japan equity ▲
Although the initial coronavirus outbreak was reported in China, they are one of the few countries to have grown in 2020. Vast testing infrastructure has helped to supress minor local outbreaks, and life has largely returned to normal.
Pent-up global demand is likely to boost prospects for the region in the coming months. Many countries in Asia have come through the pandemic better than countries elsewhere, the valuations look relatively attractive and the prospects for long-term growth are substantial.
The Chinese equity market, in particular, has been performing strongly. Given the long-term growth potential for China and the rest of the region, we maintain our positive stance.
Emerging markets ex Asia equity ◄►
The difference between many emerging market economies remains stark; some are likely to be resilient, whilst others are likely to suffer. The robustness of their respective healthcare systems and the speed of government action is likely to determine how these countries fare.
On the vaccine front, it is likely they will not be able to inoculate their populations until later than more developed economies. Whilst we recognise that current headwinds are significant, the long-term growth prospects for many emerging markets continues to be high.
We continue to stress selectivity in this diverse region, so maintain our neutral stance.
Hedge Funds/Targeted Absolute Return
As economies around the globe recover from the pandemic, and interest rates remain low, we expect M&A to continue to take place. We therefore favour event-driven strategies within this space.
When using these strategies, we look for funds that have the ability to diversify returns away from the directionality of conventional bonds and equity markets. However, we continue to stress the importance of finding the right vehicle and investment manager, which requires extensive due diligence on the strategy and fund.
Whilst we acknowledge the yields on offer may look attractive relative to other sources of income, the property market remains challenged, particularly the retail and office segments.
We continue to suggest that any exposure to property should be selective and prefer closed-ended over open-ended vehicles, given the liquidity mismatch. The accelerated trends towards online shopping and working from home have clouded the outlook for commercial property.
Although news of the vaccine has caused a reassessment of property investments, the longer-term trends still apply. Office rents are likely to remain under pressure until businesses decide how to balance the desires to work more flexibly, with the benefit of having employees collaborating in an office environment.
We expect demand for high quality office and retail space in city centres to recover from 2022 onwards; however, we are more cautious about space for back office functions, where demand is likely to be undermined by new technology.
The impact of Covid-19 on future property demand remains ambiguous; therefore, it remains important to be selective and not chase the otherwise attractive yield when investing in this asset class.