Some old favourite themes have been in focus this week as we took a breather from events in Washington. Rising Treasury yields and Italian politics reminded investors of potential risks, despite volatility remaining very low. So far though, the risk-on trade remains on track. Vaccines are being rolled out, the Fed’s Powell re-stated there is nothing to fear from monetary policy for now and Joe Biden outlined a massive fiscal stimulus plan. The combination of monetary and fiscal policy support and a potential economic boom in 2021 continues to be the core scenario.
Having set out a bullish view for equities and higher beta credit last week it’s quite uncomfortable watching the news. Infection rates remain high and hospitalisation rates have exceeded the first wave in many countries. In addition, another new worrying mutation has been discovered in Brazil, a country that has already had over 8 million recognised positive cases and more than 200,000 deaths related to COVID-19. Without downplaying the current situation, the outlook is still based on the view that vaccines will work and reduce the impact of the pandemic as 2021 progresses. Without wanting to tempt fate, the daily number of positive tests in the UK looks as though it could be peaking. A similar pattern is maybe emerging in other countries too, including the US. I spoke at an investment conference organised by a large UK consultancy firm this week with “reasons to be cheerful” as part of the theme of the event. Vaccines are front and centre of any optimistic outlook for this year. My 80-plus year-old parents got their first jabs this week. For many reasons I hope it is successful.
Of interest this week...
Markets are behaving optimistically and my preference for equities over bonds in a simple allocation framework is working out still. Negative real rates, expectations of the realisation of pent-up demand and positive earnings momentum remain the key reasons to be positive on stocks still. But there are four other subjects I wanted to touch on today – 10-year Treasury yields, Bitcoin, Italy and UK equities. Given my fixed income background I write a lot about Treasuries. Suffice it to say they are probably going higher. The current strength of economic indicators like the ISM index, the likelihood of substantial fiscal stimulus, a shift in the distribution of potential inflation outcomes (to higher) and the slightly more ambiguous commentary from some Fed officials about when would be an appropriate time to taper all point in the same direction. One simple ISM-based chart I use suggests that the 10-year should already be around 2%.
Watch Treasury yields
I don’t think higher Treasury yields are a major problem for the global economy or risky assets as long as the move is not too rapid or goes too far. It would be a problem if it was driven by Fed tightening but it won’t be until inflation is a lot higher. The current move is being driven by anticipations of better economic conditions. Yields were just under 2% before the COVID crisis and could return to that level once the pandemic has faded. The Fed may ultimately lean against such a move, global duration buyers might not allow the market to sell off that much and if there is an equity correction, yields will correct lower as well. My hunch is that by year-end, 10-year Treasuries will be close to either 2% or 0.5% depending on how the things unfold. It’s better for all of us that it is 2% in sight rather than the lower level. In the short-term the concern is the relationship between yields and equities. If there is a rapid move towards 1.5% in the short-term then I would expect equity markets to react negatively. This might be the first test of the “buy on dips” thesis for this year. Any disruption to financial markets when the pandemic remains in full swing will further underline the commitment towards super supportive policy.
A digital sideshow
While infinitely more important, the volatility of US Treasury bond yields is much, much less than that of the price of bitcoin. When global stock markets bottomed on the 23rd of March last year, bitcoin traded at $6,414. It most recently made a high of $40,858 and then fell to $33,964 two days later. As I write, it is back up at $39,750. I dread to think what most risk officers would think about that being in a core investment portfolio. I struggle with bitcoin on many levels. I don’t think it is a currency because it has no legal or sovereign fundamental backing. For assets to be considered in a long-term investment portfolio one should be able to attach some fundamental intrinsic value to them – long-term earnings growth in equities, the credit risk premium relative to risk free rates in bonds. There is no cash-flow from bitcoin other than what is driven by the change in price (which can be widely negative or positive). That is certainly not derived from any fundamental economic cash-flow like profits or tax-revenues. It is a speculative instrument that ultimately lacks any legal security, that can’t really be valued and, by the way, the production of which is seriously carbon intensive. It also seems to me that the biggest supporters of bitcoin are attracted to it because they want to get rich quick – one of the very core criticisms they have of the behaviour of players in the mainstream financial system. I would consider “investing in”/buying bitcoin in the same way I would consider betting on the Grand National or putting an accumulator on the footy. But not as a serious long-term asset working to provide a pensionable income. But eh, some people are having fun with it, I just wish they wouldn’t preach that it’s the future and what the rest of us do is somehow complicit with deep state corruption!
Italian politics anyone?
Back to something more mainstream – Italian politics and the potential for sovereign risk to become a concern for investors in Europe again. Italian political crises are no surprise as they come around with a certain level of predictability. The current unrest was triggered by Matteo Renzi, leader of the Italia Viva party, withdrawing two of his ministers from the coalition government over disagreements about the European Recovery Fund and how it would be used in Italy. As is nearly always the case, the coalition government relies on different – often politically opposed – parties working together. The time is up for the current configuration although it is difficult to see how this plays out in the short-term.
So far, no big market reaction
Not surprisingly, Italian bond yields have risen relative to German government bond yields. The spread recently got down to 104 basis points (bps) and is currently about 15 bps higher than that. This is nothing compared to previous periods of volatility in the Italian bond market. However, it bears watching. Countries like Italy and Spain have been hit very hard by COVD-19 and their public finances have deteriorated accordingly. Without the ongoing support from the ECB’s asset purchase programmes and the promise of longer-term fiscal help under the Recovery Fund, spreads would be much wider. With that in mind the ECB will continue to send the signal that it is there to support the whole of the Euro Area and if there is any sense that the market feels its support mechanisms are being used to the full, the message from Frankfurt will very likely be that still more can be done. I would step back from European peripherals under the circumstances and see what happens in Italian politics. If spreads widen enough, there will be buyers again. However, keep in mind that the Italy-German spread hit 278 bps last March. So far, the widening of the spread is a mere ripple. Technicals in the bond market in Europe remain so strong that I doubt this current phase of Italian political unrest will disrupt credit markets too much. However, it is worth watching. Italy can often be the canary in the European bond market coalmine.
Is it time for UK stocks?
Finally, UK equities have started to perk up. In local currency terms the FTSE-100 index has been one of the best performers year-to-date. The leaders have been in the materials sectors with the miners and oil companies doing particularly well in contrast to their dismal performance in 2020. The broader indices have not been so strong with mid-and small-cap indices up just 1.5% and 2.5% respectively. Last year the All-Share index underperformed the MSCI World index by 25%. This left the UK market attractive on valuation grounds. Based on current consensus forecasts for earnings per share, the UK is currently trading with a price-earnings ratio of just 15.3x 2021 earnings and 13x 2022 earnings. This compares to ratios of 23.2x and 19.8x for the S&P500 and 12.9x and 11.1x for the Euro Stoxx index. The UK mid-cap sector has a PE of around 17.4x for 2021 compared to over 20x for the equivalent US index.
Earnings and growth
These relatively attractive valuations are partly based on forecasts for a strong earnings rebound this year. For the FTSE-100, the consensus average is for a close to 50% jump in earnings per share this year and a further 13% increase in 2022 (admittedly coming after an estimated 44% drop in 2020). Earnings revisions for the FTSE-100 have just started to turn net positive as well. The question is though, am I clutching at straws here? Will UK overall equity performance be able to put in a sustained recovery this year? There are many headwinds including the ongoing impact of the pandemic on businesses in the small and mid-cap universes and the disruption to trade on the back of new Brexit rules. The UK is under owned and in a generally bullish equity market global investors are more likely to bet on the US, emerging markets and other parts of Europe. Of the big sectors in the 100 index I am not sure that the outperformance of the materials sector can continue – although this may be a good cyclical value trade for a while – and UK financials might not have taken on board the impact of Brexit yet (with also the potential for negative rates still on the horizon). Healthcare and industrials look better bets to me while in the mid-cap space there should be plenty of opportunities for UK firms to perform in a cyclical upturn. Manufacturing output is recovering and the most recent purchasing manager survey for the manufacturing sector printed its highest reading since November 2017 with particular strength seen in new orders. At the overall market level I think the UK needs better macro news, less focus on the failings of the current government, and evidence that the post-Brexit world is providing new opportunities for UK firms. The rapidity of the vaccination programme should also be seen as a positive as it will hopefully allow the lockdown to be lifted by the Spring as should the ongoing strength in the global manufacturing sector as firms ramp up production and rebuild inventory ahead of a potential boom in spending in the second half of the year.
Investing is more difficult this year
In general it is a more difficult investment environment because markets came such a long way in 2020. Very few assets are cheap and the expected improvement in the global economy is well anticipated by investors. Nevertheless, there is still room for good surprises as the demand and output numbers improve this year. My hunch is that the rise in yields won’t get out of hand and this will allow stocks to continue to perform well, and the UK market will participate in that. On Italy, a name that has been discussed as a potential player post-this current crisis, is Mario Draghi. He saved the Euro once and if we appointed to any senior position in Rome, Italian spreads would surely move quickly back to their recent tight levels.
Clash of the titans
Since Sir Alex Ferguson retired in 2013, it has been a rare thing to see Manchester United at the top of the English Premier League table. The club currently occupies top-spot with a 3-point advantage over rivals and current Champions, Liverpool. The two meet on Sunday in what should be the most important game of the season so far. A win for United would stretch the lead to 6 points over Liverpool at almost the half-way point of the season. The two will also meet in the next round of the FA Cup. With Manchester City, Leicester, Everton and Tottenham just behind Liverpool it’s a very competitive season. I’ll be extremely nervous on Sunday. A win would be great, a defeat would just reiterate the need to match Liverpool’s standards. Bring it on.
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