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Markets have remained a little fragile over the last week, with continued troubles for technology stocks in the first few days, however these have now started to stabilise. As we emerge (hopefully) from lockdown, we still expect GDP / economic growth to surge in the months ahead after a difficult winter. Headline GDP will be stronger than seen for years, due to where it is rebounding from. The rise in bond yields (which results in a capital loss for bond holders) is limited in comparison and it is interesting to see how relaxed central bank policy makers are so far. Certainly more relaxed than investors have been in recent weeks. Ultimately, fiscal stimulus and pent-up demand should deliver more growth than the rise in bond yields will take away. The question is whether market sentiment and current valuation levels allow this to translate into strong portfolio returns. We remain optimistic on this point.
Let us consider two main questions for equity investors. Do you think that the positive impact on economic growth (due to the combined effect of pent-up demand and government fiscal stimulus) is more important than the potential negative impact of (marginally) higher long-term bond yields? We do. The second question is a relative value one. Does the (marginal) increase in bond yields or even the expectation that bond yields could go even higher (say, to 2% for US 10 years Treasury’s) make you want to switch out of equities into fixed income? In other words, has the prospect of an equity overall dividend yield of 1.5% and a growth rate of 3%-6% over the next few years become less attractive relative to a 1.5% risk-free Treasury bond yield? We think not. Therefore, we remain comfortable with equities, especially our higher weightings in value equities that we expect to benefit from the release from lockdown, such as UK Mid Cap stocks.
A good example would be to look at China. First in, but very quickly out of the lockdown effect of the global COVID-19 pandemic. China grew by 6.5% in Q4 2020 and is set to record more than 8% GDP growth this year, according to the consensus of forecasts compiled by Bloomberg. Pent-up demand in the private sector, plus fiscal stimulus and continued plentiful growth in liquidity from central banks, are the engines behind this growth.
Let us then deal with the expectation of higher inflation over the next few months. From an incredibly low base due to global lockdowns, GDP growth in the developed economies will be higher this year (beyond Q1) than at any time since the 1980s. It will be higher than most market participants have experienced in their careers. It will be higher than most policy makers have faced. The idea that central bankers will sit back as nominal growth surges is not something that traditional investors and commentators would expect. It is therefore little wonder that bond yields are moving up alongside a surge of news on the traditional effect of rising inflation – such as when central banks will hike rates or taper their bond buying. For the moment, the prudent position to take is to expect yields to move slightly higher still, but central bank guidance will keep the drama in check. Remember, the current monetary and fiscal policy is not remotely “normal”, so maybe the effect on markets will be different too.
Further positives can be seen in corporate earnings growth that should support a better 2nd quarter in 2021. The 20-25% increase in earnings that is expected for 2021 is not out of line with fundamentals, given how much earnings fell in the first half of last year. As growth is expected to remain strong into 2022, this means that there is still upside to earnings forecasts. That should be a key support for our positive stance on equities.
Last week’s UK budget fitted into the broader policy narrative. Chancellor Sunak made some concessions to those in his party concerned about the size of the UK budget deficit and the increase in outstanding debt by pre-announcing an increase in the tax take. However, the benefits of that to the public accounts will not be seen until 2023. In the meantime, there was another £65bn of emergency funds announced with the extension of the furlough scheme, the stamp duty partial holiday and other measures. The Office for Budget Responsibility estimates that the budget deficit will decline this year – from 13.3% of GDP to 7.6% next year largely on the back of the increase in GDP growth.
The key to the extended recovery remains central banks keeping financing costs low. The policy agreement does not seem quite as joined up in the UK as it is in the US, but keep in mind the Bank of England has not entirely closed the door on negative interest rates. We cannot see the Bank of England changing policy anytime soon despite the improved outlook for the UK economy. For governments, borrowing costs are way below expected nominal growth so there is an opportunity to reduce debt to GDP ratios in the next few years even with aggressive fiscal stimulus today. For now, the message from central banks has to be “Keep Calm and Carry On”. Tightening is not on the cards yet, there is more recovery to come and the rise in bond yields is totally for the right reasons.
I hope that this update finds you well, as always, should you have any queries, please do let us know.