Hoping to give thanks
Markets want to trade with cyclical hope but we might be back in a wait-and-see regime for a few weeks. Western economies are once again constrained by the only response we have at the moment to high levels of COVID-19 infections - lockdowns. Confidence in recovery is just about hanging in but away from the markets, society is suffering from the long-hard slog of the last ten months. Investors need to continue to believe, and with good reason, that policy is still there as a backstop to economic activity and that science and technology will deliver us a healthier and more efficient future. For billions around the world, hopefully there is something to give “Thanks” for next week.
The “cyclical hope” rally that was triggered by the US election “results” and announcements about the alleged efficacy of two of the COVID-19 vaccines currently in late-stage trials, has faded a little in recent sessions. The surge in value stocks and rise in US Treasury yields at the time of the announcement of the Pfizer Inc. vaccine was echoed when Moderna Inc., announced its own vaccine trial results. Yet, since then the news on the pandemic has got worse and there has still been no concession of the election result by President Trump. This is seen to be delaying the transition to the Joe Biden Administration and renewed Federal efforts to get on top of the spread of the virus ahead of mass vaccination programmes in the early part of next year. The danger is that markets relapse into a “wait and see” type market that characterised things between the end of August and the election. During that period, US equity returns were negative irrespective of whether you had a growth or a value bias.
For stocks and credit
Equity markets are still higher since the election and value is still slightly ahead of growth. European equities, which are more cyclical, are ahead of the Nasdaq index. In the bond markets, credit has outperformed government bonds and there has been a particularly strong response from high yield and emerging market debt. The scope for additional outperformance in the high yield market has diminished given the levels to which spreads have reached. For the US high yield index, the spread above government bonds is now 448 basis points (bps) compared to a low of 338 bps in January and a high of 1087 bps on 20 March this year. Indeed, the index spread level is just 32 bps above the low of the last 5 years. The European market is not quite as stretched relative to its historical valuations, but its all-in yield is 3.4% compared to a 5-year low of 2.3% at the end of 2017.
Valuations have got rich quickly in high yield markets. Another concern for investors may be the announcement from the US Treasury this week that it was asking the Federal Reserve (Fed) to terminate some of the emergency lending facilities that were put in place during the early days of the pandemic. The Treasury wants any unused funds back ($455bn) from the facilities provided for under the CARES Act to support additional fiscal initiatives. While it has left open the option for the Fed to re-establish some of the facilities, if necessary, at the margin it looks as though the outgoing Administration has reduced the range of tools available to the Federal Reserve. Importantly, the facilities to support money market liquidity, commercial paper markets and primary dealer credit operations remain in place, but the Fed will lose the ability to intervene in the primary and secondary credit markets from the end of December. At the margin, this is a small negative for credit in the US, but the facilities had not been used that much and there is the option for them to be restored once a new Administration is in place. The Fed’s response to the Treasury indicated that the central bank sees this as an unwelcome move in the signal it may send and that it could curtail its speed of response to any sudden deterioration in market conditions. So far, market reaction has been muted.
Spend, spend, spend
In the UK, the fiscal party continues. The government announced £12bn of funding for green initiatives this week and £16.5bn in additional defence spending. The government also published its latest public sector finances. For the fiscal year so far, the net borrowing requirement is £215bn, a staggering £169bn more than in the same period last year. The level of net public sector debt exceeded $2trn last month and stands at 100.8% of GDP, a level not seen since the 1960s. It is going to get higher. Yet, like in many other countries, the bond markets are relaxed. There are good reasons. One is that central banks continue to be large buyers of government bonds, created the additional fiscal room that has become necessary because of the pandemic’s impact. Two, debt service burdens are manageable. The interest paid on government debt was actually lower in October this year than it was in October 2019. The interest paid by governments on their debt levels reflects the decline in market interest rates and the reduced cost of funding that it allows. Government borrowing is not crowding out private sector investment – which used to be the concern about the impact of high public sector borrowing. If anything is crowding out private investment it is the economic outlook and, in the UK, uncertainties around Brexit and the pandemic. The last bond issue from the UK government was a 10-year gilt with a coupon of 0.25%. Borrowing costs are not an issue. Governments have also increased the maturity of their debt to reduce the risk of high levels of refinancing coming before the global economy has had time to recover. Holders of government bonds should not worry.
Low returns for bonds
The benefits from supportive fiscal policies far outweigh the worries about deficits and debt levels, for now at least. There may come a point in the future debt levels do become a concern. Central banks may stop expanding their balance sheets, bond markets might not be so willing purchasers of government debt at negative real interest rate levels. We are not at that point today and the contributions from monetary and fiscal policy, and their new levels of interaction, are a key support for economic activity and financial markets. A quid pro quo of all of that is low returns for fixed income investors. Either central banks remain active in repressing yields and volatility – in which case returns remain low but could just about be positive – or there is a shift in expectations to some kind of “tapering” event, in which case returns could turn negative. That would be a worry and not just for government bond holders.
Dealing with debt in the long-term requires economic growth. In the face of the challenges of climate change, it is essential that some of that growth comes from investment in the energy transition and the mitigation of climate related risks and costs. To that end, the UK government’s plans are welcome. However, they don’t seem that ambitious compared to other countries. France, for example, has pledged at least double the UK amount and the EU’s recovery funds will have a significant green investment element. Moreover, many of the initiatives outlined in the plan are already being pursued and invested in by the private sector – including the development of hydrogen and the building of carbon capture facilities. Public money needs to sit alongside private investment – to help subsidise transition costs – but the estimates of what is needed are well above what the UK has pledged. There will be more focus on these plans as we get into 2021 as the UN COP26 meetings in Glasgow will be an opportunity to measure and compare updated national plans towards carbon reduction. As host, the UK should leverage its advantages and be seen to be taking a leadership position. The launch of a green gilt next year will be a good signal.
Look to industry
While rather underwhelming, taken together with a potential shift towards a greener agenda in the US and both European and Chinese pledges, the UK’s plans will contribute towards a global acceleration of the energy transition. My own view is that more needs to be done to accelerate the shift away from fossil fuels and a global approach to the use of carbon pricing may have to be part of that. This would make renewables and alternative energy sources more attractive from an economic point of view and thus easier to begin addressing some of the harder to achieve carbon reductions (long-distance transport, air and marine, certain industrial processes like steel making). There should be plenty of investment opportunities opened up by this and Europe generally could play a leading role. Many of the companies developing green hydrogen technologies, for example, are European players in the materials and industrials sectors. For longer-term performance of European and cyclical equities generally, the green revolution will be crucial.
Policy, science and technology – long live the age of reason
I am sure we are all sick and tired of lockdowns. Hopefully the light at the end of the tunnel gets brighter in the weeks ahead. Hopefully we will all be able to spend time with loved ones during the coming holiday season. In the not too distant future, we can put 2020 behind us and look to a brighter future. The lessons learned will be plenty, but the big picture is that what is crucial to our economies and societies is good institutions to provide economic support and a recognition of the importance of science and technology to our ability to deal with existential shocks and to make human progress. The age of reason is still with us, even if it doesn’t seem so most days.