Say goodbye, say hello
It seems we might have reached the point when it is reasonable to expect that growth will extend beyond online shopping, communications, payments systems and distribution businesses. All being well, a coronavirus vaccine should allow economies to re-open fully in the next year. We might be transitioning from a defensive bull market to a more cyclically offensive one, but more clarity is required in terms of when social mobility will normalise. And that isn’t clear yet. Once again infection rates are high and rising in the US. The euphoria created by the Presidential Election result and the vaccine announcement will give way to a more sober analysis of how long and smooth the road to recovery will be. And while it is likely to be bumpy, bond markets have given us a better entry point to provide some protection from the inevitable disappointments. However, the light at the end of the tunnel is clear for all to see.
This week investors were given sight of pathways to the end of the Trump Administration and the COVID-19 pandemic. Markets reacted very positively to both. Not having those two things shaping the world is clearly seen to be better than having those two things continuing to shape the world. But we are not there yet. At the time of writing, President Donald Trump was still refusing to concede the election there are tough times ahead as far as the pandemic goes. Yet there is light at the end of the tunnel and that has enormous implications for the investment outlook
Policy and hope
Investment returns have been positive year to date. Since March markets have been driven by two fundamental anchors – the swift and massive policy response from central banks and governments, and the belief that a vaccine would be eventually be found. The nuance was, however, that the former was much more certain than the latter. The policy response was real, in front of our eyes – from furlough schemes, loans and grants, to credit facilities and bond purchases. These actions helped markets and prevented an extended liquidity and default crisis. However, the road to a vaccine has not been as smooth given the complexity of the challenge and the fact that developing a vaccine against a major global virus normally takes many years. As such, there has had to be a trade-off between economic activity and levels of public health. To improve the public health situation, governments had to shut down economic activity. When they allowed economies to re-open up, public health deteriorated in that infection and death have increased.
This on-off scenario has driven a defensive bull market. A huge positive for markets was the policy setting, which is well understood by now and continues to be important. Yet, before progress on a vaccine there was little confidence about when that trade-off between activity and health would improve. It meant that parts of economic activity could not fully re-open and there has not been much visibility on when they would be able to. At the same time, we all had to adapt. So, in equity market terms, there was little confidence in the timing of a recovery for those businesses most impacted by the pandemic. Instead the best performers have been in sectors where the solution to the crisis could be found (i.e. health) and those that have benefitted from the changes forced upon us by the pandemic (digital, online and non-contact). These are industries which have had stable long-term growth, that benefit from the dislocation caused and should continue to have stable long-term expansion because of strong secular trends. The defensive bull market portfolio ideally would have been quality growth stocks with long duration government bonds in case the trade-off deteriorated again. The concept of a defensive bull market dominated by growth stocks also allows people to reconcile the apparent contradiction between the economic data and the level of benchmark indices, especially in the US. Note that it was only on 5 November that the equally weighted S&P500 index rose above its 31 December, 2019 level. The market cap-weighted benchmark index achieved that milestone in late July.
Is it now time for an offensive bull market? The announcement this week of 90% efficacy rates for a vaccine has changed the outlook for many. We can now project to a time in the not-too-distant future when the trade-off between health and economics improves enormously. We will have less infections and higher levels of economic activity. Indeed, if everything goes well in terms of efficacy, the logistics of manufacturing and distribution, and take-up, it means herd immunity could be in reach by the end of next year. That means back to normal in travel, hospitality, education, in-person health services, hotels, leisure and retail. Thus, where those businesses are represented in listed markets, they should be re-rated on the basis of higher earnings in the next couple of years (relative to where they would have been without a vaccine). Moreover, the marginal outlook for interest rates changes too. A quicker return to normal may shorten the time period that the Federal Reserve and other central banks remain on hold, even if that still might be a few years. Forward interest rates have risen, and the yield curve has steepened. The offensive bull market portfolio looks as though it should be characterised by more credit and high yield, value over-growth, and an exposure to cheap COVID-19 bombed out assets. This has been the story of the last week.
There are some special themes to play as well. Chinese equities are favoured on a “fifo” trade (first in, first out). Small-cap stocks are due a run against large cap-equities if we start to see the most shut-down parts of the economy open up (the phoenix trade). Long term, the special themes are clear in my opinion. The working/shopping/being entertained from home phenomena is here to stay and the businesses and services that facilitate that should continue to do well. We know we can have decent online business meetings now. The continued roll-out of faster broadband together with 5G wireless networks will make it even easier in the future. I’ve heard more than one person this week speak of the 2020s as being the decade that will see huge technological innovation – a lot of it driven by climate change considerations (even more under a Biden Administration) but also by the opportunities that have been opened up by the changes that have been forced upon us over the last seven months. I don’t confess to fully understand distributed ledger technology but from the opinions I have read of people that do, it appears we haven’t even started to scratch the surface of its applications in a whole range of businesses. If people are going to be less centrally distributed because of new ways of working, then connected work-life communities and the internet of things are potentially huge opportunities for investment as well. Not all of it has to be “labour-lite” either. A lot of physical building needs to be done in the energy transition. There can be lots of jobs.
This weeks’ market moves have been huge. Just between the close of business last Friday - when the outcome of the Pennsylvania ballot in the US market was still unknown - and the close of business on Armistice Day, the S&P500 was up 1.8%. However, that disguised a 5.3% outperformance of the value index relative to the growth index. Europe outperformed the US by a similar amount and Japan outperformed China by 10%. In bond markets, high yield beat government bonds by 1.3% in the US and Europe. The question is - whether the rotation in market leadership and the more value-driven cyclical upturn is sustainable?
Clouds are lifting, but...
The longer-term picture is clearer in the wake of the election and the vaccine news. However, many western economies are locked-down again and if Biden’s team have any influence in the coming weeks, lockdowns could get even stricter in the US given the acceleration of coronavirus cases. As a result, data from the final quarter of this year and the first of 2021 will be weaker. That should prevent the move we have seen in government bond yields becoming a bear market and I suspect that 10-year Treasuries find a near term ceiling at levels well below 1.25%. Central banks still have the pedal to the metal as far as policy goes and the Fed is not likely to want higher real yields in the US just yet. On the equity side, analysts and investors may want to see more positive news on vaccines and how they will be deployed. Cyclicals can only continue to lead the next phase if earnings forecasts are revised higher, but it is still too early for that. The most recent 12-month forward earnings estimate for the hospitality and leisure, airline, and restaurant sectors are off their lows but not by much. These are businesses that have been damaged and while there is a road to recovery, it is not clear how arduous their journey might be.
Bears shouldn't predict much higher bond yield - it just doesn't make sense
I don’t think rates will derail the bull market any time soon. It might be too early for a full-on offensive cyclical bull market. My outlook is more of a hopeful one characterised by increasingly broader participation in performance – not one dominated by a particular style or concentration of names. Should investors worry about much higher bond yields? Certainly, we are not going to see monetary tightening for a long time, so the next two years are not going to be like the 2017-2018 period when the US was raising interest rates. At that time both bond and equity returns were pretty flat. For now the Fed has said, explicitly, that higher rates need higher inflation. There could be some pressure on yields to move higher and the curve to steepen from upward growth revisions on the back of a vaccine and a fiscal stimulus from the Biden Administration. The 10-year US Treasury yield was in a range of 1.50%-1.60% before the equity markets crashed in February. A return to those levels is possible on strong growth and more stimulus. We will see. For the moment, yields have backed off the highs reached earlier this week. The idea of the Fed taking the punch-bowl away from this bull market in the foreseeable future is fanciful. In the meantime, I suspect a buy-on-dip approach to longer duration government bonds will be the pattern of things.