Love and life
The natural world is something that we can’t always control. Extreme weather and epidemics are now real threats to the functioning of society and economies. Up front is the coronavirus and its impact on business, families and healthcare providers. So far, markets are taking the view that it will be contained and the fall-out will be limited. Let’s hope that is the case. If it is, there are reasons to remain relatively optimistic about the economy and markets for the months ahead.
The coronavirus is the biggest threat to markets in the near-term. A lot has been written about the potential economic effects but despite the rapid spread of expertise in epidemiology, there is little clarity on ultimately how devastating the virus will be. For the moment markets appear to be focussed on the fact that the outbreak remains largely contained within China relative to the number of occurrences in the rest of the world, and on precautions being taken globally to contain further infections. It is too soon for investors to see any economic damage in official data, but the risks are obvious given how large parts of the Chinese economy have been almost shut down for the last couple of weeks and how travel and tourism has been disrupted throughout Asia. In the coming weeks it will become clearer as to the extent of the economic impact in both China and the rest of the world. For now, however, the base case scenario of continued economic growth and plentiful liquidity is the one driving markets. The S&P500 hit a new high this week, credit default swaps indices have moved back towards the lows they reached in early January and there has been no evidence of markets expecting the US Federal Reserve (Fed) needing to rush into the next interest rate cut. There may be less hugging this Valentine’s Day, but, despite everything, markets are showing a lot of love.
Strong labour market
At the end of last week the US released its employment data for January. For me this remains one of the most important economic indicators in terms of providing investors clues on where we are in the economic cycle. If firms are hiring, the economy can’t be bad and jobs growth in the US in recent years has been remarkable, not necessarily in the pace but definitely in the duration. Total employment growth has been running at an annual rate of between 1.5% and 2.0% for most of the last ten years. Looking specifically at non-farm payroll jobs, they increased by 225,000 in January bringing the total for the last year to over two million. Taken together with the weekly jobless claims number and it is hard to come to any conclusion other than that the US labour market is very strong. Hourly earnings growth has been above 3.0% year-on-year for a while now and consumer spending remains the key driver of economic growth in the US.
Higher bond yields if Trump looks like winning again
This is important as the US election campaign gets under way. For the moment the focus is on the Democratic Party’s process of choosing a challenger to run against Donald Trump. It is too early to say how this will go but Bernie Sanders and Pete Buttigieg are the front runners with 21 and 22 delegates achieved following the results from the Iowa caucus and New Hampshire primary. There are bigger contests ahead and a lot of uncertainty as to who will emerge victoriously at the national convention in July. Whoever it is, they will have to contend with the fact that the US economy is strong, that unemployment is extremely low and that the stock and housing markets are delivering wealth to voters. Such a combination favours the incumbent, despite how much of the election campaign will focus on his character. This week the President outlined where he would like to see increased spending – almost everywhere. A central scenario for the US is that Trump is re-elected on the back of a strong economy and as a result of voters rejecting the socialist inclined policies of Sanders, and that the expectation will be of more populist policies that will increase the US federal deficit even more. Treasury bond yields rose significantly in the run-up to and in the aftermath of the 2016 election and I reckon a repeat of that is on the cards if Trump is a clear winner. Beyond that, Treasuries would look like a big buy because the impact of rising bond yields and probably higher inflation might crease a scenario where the Fed increases interest rates and tips the US economy into a downturn somewhere in the 2021-2022 period. The alternative is a less extreme Democratic candidate like Mike Bloomberg who already seems to have ruffled the President’s feathers and would offer a more centrist economic platform.
Can you bet against equities?
The S&P500 is up over 60% in total returns since the 2016 election. There was a growth wobble at the end of 2018 and a value-growth rotation late last summer. But on the whole it has been an unrelenting bull market led by technology and consumer services, sectors which have delivered the most surprises in the recent earnings season. As long as the macro environment does not deteriorate significantly, either domestically in the US or abroad because of the coronavirus, the bull market should continue. Of course, earnings need to materialise to support the ratings in the stock market but looked at from a thematic point of view there is so much going on to sustain investor confidence. I read a report this week that identified 150 trends that could have material investment implications in the years ahead, ranging from things that are pretty obvious trends like meat and dairy substitutes in the food and beverage sector to the increased use of drones in manufacturing to reduce costs and improve safety. The relentless search for low carbon alternatives in energy generation and transport will itself be a determining theme in the performance of equity markets in the years ahead. The US leads the way and, despite the rating premium, should continue to be the driver of equity market returns globally.
I spent some time this week looking at the performance of various asset classes over the last decade. One thing is for sure, the performance of financial assets has not “lived down” to the gloom and “glass half-empty” platitudes that have generally prevailed since the financial crisis. In a world where inflation has been very low it is hard to find an asset class in liquid markets that has not delivered, on average, positive real returns on an annualised basis over the last 10 years. Some assets have provided spectacular returns– like the Nasdaq’s almost 12% annualised return or the long-end of the UK inflation linked bond market which has delivered 10%. Bonds generally have performed well, obviously helped by quantitative easing and very low central bank interest rates. A lot of opportunities have also existed to benefit from income with an average of 4% income growth coming from asset classes like emerging market corporate debt, asset and mortgage backed securities in the US, US high yield bonds and credit markets in general. Even some parts of the equity market have delivered decent income, including the higher yielding part of the UK market. Even today, it is possible to get a diverse allocation to UK equities and have an indicative dividend yield of above 6% (the basket of stocks I looked at this week drove a total return of above 8% over the last year as well as double digit dividend growth).
No secular change in trend
With hindsight this also tells us that it paid not to be a bear. Naysayers will argue that these returns have all been driven by central bank intervention and the distortions that this has brought. Indeed, global economic growth has arguably not been enough to support such returns. Yet the corporate sector is healthy, banks are stronger and technological change and an increasing ESG focus is disrupting business models, largely for the better. The technicals have also been very helpful. The equity market has been shrinking in terms of outstanding shares, the net float of the bond market has been reduced by the amount of stock taken by central bank intervention. At the same time savings have been growing as western societies age. We can argue all we want about whether profit margins are in secular decline or whether deflation risks will undermine nominal economic growth, but the reality is that the vast amount of savings that are put aside for precautionary or retirement related reasons are channelled into liquid financial markets. The demand-supply balance is such that, on trend, prices have gone up. Yes, that leaves us with valuation metrics that are somewhat uncomfortable relative to this historical record, but who is willing to bet against markets right now? An alternative secular trend is possible in the future, one in which inflation might be higher, or external costs mount to disrupt economic growth, but so far, so good. Being overweight corporate credit against government bonds would have delivered a positive return 70% of the time over the last ten years (using 3-month holding periods). Holding a S&P related basket of US equities would have delivered positive returns 80% of the time. Asset backed securities and the more risky leveraged loan asset class have been extremely safe asset strategies, delivering positive returns more than 80% of the time with limited drawdowns and low volatility. Who knows what the future will bring but the past says that relative optimism pays. Even if you are not optimistic about the long-term, why give up potential financial returns in the meantime?
Back to politics, finally. UK Prime Minister Boris Johnson delivered his first cabinet reshuffle this week. It had the unintended (?) consequence of forcing the Chancellor of the Exchequer, Sajid Javid, to quit. The market took this as a sign of disagreement between him and the prime minister over fiscal policy and came to the immediate conclusion that fiscal policy is going to be more expansionary than would have been the case with Mr Javid still holding the purse springs. Gilt yields have been rising since the end of January and it is clear that the government will try to make good on many of the promises it made during the election campaign. This will be seen most visibly in infrastructure projects with the HS2 high-speed rail network receiving support this week. It may also mean a less restrictive set of fiscal rules. This should be reflected in a steeper bond curve and will serve to reduce the expectations of any additional interest rate cuts by the Bank of England. It has already got the UK equity market going with sectors like housebuilders on a tear since the election. The UK market remains one of our favourite investment ideas given that the political environment looks very different to the one which wrestled with Brexit up until the end of last year. Domestically focussed UK equities are likely to have some quite strong tailwinds in the quarters ahead.
I am accompanying my wife on a difficult medical journey at the moment. There is light at the end of the tunnel, but surgery and a long recovery lie ahead. My musings on markets and economics might have to take a back seat for a couple of weeks as a result. So, my message to you all today is keep safe from viruses, keep invested and look after your loved ones. And Happy Valentine's!
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