Stock market and economic commentary July 2021

“There are as many atoms in a single molecule of your DNA as there are stars in the typical galaxy. We are, each of us, a little universe.”

Neil deGrasse Tyson, American astrophysicist, planetary scientist, and author

Coronavirus update

The pandemic has been the main determinant of economic activity in the last 18 months. Rising case rates, last spring and autumn, and then at the start of this year, triggered lockdowns that shrank the economy. But that link between case rates and growth has softened. The steep rise in cases and hospitalisations, driven by the Delta variant, have not yet dented business sentiment. On the contrary, economists have been raising their growth forecasts and the regular economic data has been coming in on the strong side of expectations.

The emergence of more infectious or vaccine-resistant COVID-19 variants is the greatest danger to economic growth and personal freedom. The Delta variant has already driven a surge in cases in the UK, Spain, Portugal, Cyprus and the Netherlands and slowed down the planned reopening of the British economy. The speed of increase is breathtaking; within three weeks of the Netherlands scrapping most remaining restrictions on 26 June, case rates rose by a factor of 15. The Dutch government has apologised for the premature easing and imposed new curbs.

For countries with high vaccination rates, the link between case rates and hospitalisations has weakened. However, the elevated infectiousness of the Delta variant means that large case numbers can still be disruptive. The FT reported recently that some UK companies are missing a fifth of their staff due to self-isolation requirements. Countries with high vaccination rates also run the risk of the emergence of a vaccine-resistant variant, while those with low vaccination rates must bear the cost of renewed restrictions to limit further outbreaks. High levels of infection globally create a large pool from which new variants seem likely to emerge.

The range of uncertainties around the future direction of the pandemic remains significant. We may be tired of COVID-19 but sadly, it is not tired of us.

Complete elimination of the virus no longer seems realistic in the foreseeable future. With the virus continuing to circulate at scale globally, further variants are almost certain to emerge. In a recent statement, Chris Hopson, the chief executive of NHS Providers, and Martin Marshall, the chairman of the Royal College of GPs, said, “We will have to live with the COVID virus for a long time to come, building a long-term set of defences, as we’ve done with influenza.” The chief medical officer, Professor Chris Whitty, has warned of the possibility of a further “very significant COVID surge” over winter. Under such circumstances the question, as framed in a recent Financial Times article, is whether it is possible to define an “acceptable mortality level”.

After 18 months of COVID, it is striking how much is still unknown – the durability of vaccine immunity, the nature and transmissibility of future variants, and our ability to counter them, and human behaviour in times of low, continuing case rates.

The flu season poses an additional challenge. Prevalence has been low in the UK in recent years and last winter’s lockdown all but eliminated flu. That seems likely to have reduced immunity, creating new vulnerabilities. Earlier this month, Professor Anthony Harnden, the deputy chair of the Joint Committee on Vaccination and Immunisation, warned that flu could be a bigger problem than COVID-19 this winter. The UK is planning a vaccine booster programme later this year, possibly in tandem with a flu vaccination programme.

A report commissioned by the G20 countries said that governments need to spend at least $75 billion over five years to avert future pandemics. “We are completely unprepared. The system is set to fail, and it will fail”, said the report’s authors.

Higher taxes in one form or another seem inevitable which means that planning is more essential than ever before. The various tax concessions on retirement savings and pension contributions would seem a likely target for a Chancellor desperate to balance the books as are increases to both capital gains tax and inheritance tax.

Economic update

So far 2021 has been a year of improving global economic prospects, particularly in advanced economies. The rollout of vaccines and an easing of restrictions across the West have underpinned a strong recovery in activity – albeit one marked, increasingly, by surging cases of the Delta variant.

Growth forecasts for developed economies this year have risen sharply. In May the OECD raised its 2021 GDP forecasts for all but two of its 38 member countries. This drove an upwards revision of its 2021 global GDP growth forecast from 4.2% to 5.8%. The US and the UK have seen particularly strong revisions, driven by a head start on vaccinations and, in the US, expansionary fiscal policy.

The positive global picture masks the varied experience of individual countries. Some major economies, including China, South Korea and the US, have already recovered to their pre-pandemic size. But others, including Mexico, Saudi Arabia and South Africa, are not expected to recover until 2023–24, according to the OECD.

Recent business surveys confirm that company directors’ perceptions of external uncertainty have dropped below the average of the last five turbulent years and businesses have moved away from the defensive strategies that helped them through the downturn. Cost reduction was by far the top priority for UK business last year. Now the focus is on growth, with 77% of companies expecting to increase hiring and 71% planning to increase investment in the next 12 months. Investment in technology features prominently. Mergers and acquisitions seem set to play an outsize role in reshaping the business landscape, with companies rating expansion through acquisition a higher priority than at any time in ten years.

Expansion is the order of the day for most companies. Yet this is no normal economic cycle. Years of normal growth are likely to be compressed into a few months. The pandemic, like all major shocks, will reshape the economy. Many business owners see an opportunity – to use investment and business change to jolt productivity onto a higher path. Many companies believe UK productivity will run higher in the wake of the pandemic. That offers hope of a broader and more convincing recovery than that which followed the global financial crisis.

Haulage companies are reporting a significant shortage of lorry drivers. A combination of delayed tests for new drivers due to the pandemic and existing drivers leaving the UK because of Brexit is pushing up wages.

Britain’s construction industry is growing at the fastest pace for 24 years amid booming demand for homes and commercial property. UK job adverts have recovered to pre-pandemic levels, according to the Recruitment and Employment Confederation.

Over a million workers came off the furlough scheme in May as the UK economy continued to recover. At the end of May 2.4m people still relied on the scheme, which expires at the end of September.

Stock markets

The US S&P 500 index recently closed at a new all-time high albeit followed by a bout of volatility. Since last year’s pandemic-induced crash, the index has almost doubled in value, reflecting a surprising feature of the COVID-hit global economy – buoyant equities. Share prices have rallied since last March when the global economy was on the verge of the deepest downturn in more than a century. At that point stock markets had fallen 40% in 23 days.

So far, investors have shrugged off a deadlier second wave, further lockdowns, the more transmissible Alpha and Delta variants and, most recently, concerns over rising inflation.

So, what has sustained this surprisingly resilient rally in stock markets?

Last year, markets took heart from the unprecedented fiscal and monetary support announced by governments and central banks. Lower interest rates and further quantitative easing boosted equities (a lower discount rate inflates the present value of future earnings). And, with government support for jobs and incomes mitigating the scarring effects of the recession, investors bet on a rapid recovery once restrictions were eased. As a second wave of infections took hold in winter, forcing new lockdowns, investors held their nerve, taking the view that mass vaccinations would deliver a more sustainable reopening of developed economies.

Now, with vaccine rollouts and the subsequent easing of restrictions underway, the West is in throes of a strong rebound and global equities are up more than 70% from their trough in March 2020.

Beneath this story of apparent strength, the tumult of the pandemic is evident in the changing fortunes of technology and cyclical stocks. The rally in spring 2020 was powered by a clear preference for fast-growing technology firms, especially the US ‘FAANG’ stocks, which benefited from greater home working and the move to online retail. In the autumn of last year, as vaccines raised the prospect of a lasting easing of restrictions, investors shifted their focus from pricey tech stocks to cheaper cyclicals, in sectors such as commodity or retail, more likely to benefit from an economic rebound.

The global recovery has pushed commodity prices even higher. The S&P/Goldman Sachs commodity index is up 29% this year, appreciating more than twice as fast as global equities, driven by a sharp rise in the price of crude oil. Strong demand, especially from China, has also supported iron ore, copper, and agricultural commodity prices.

Assets that are traditionally perceived as safe in times of uncertainty have underperformed. Gold is down 6%, the yen has lost ground against other currencies and US treasuries and gilts sold off heavily in the first quarter. In corporate debt markets, riskier high-yield bonds have clearly outperformed their safer investment-grade counterparts.

After more than doubling in value in the first four months of this year, Bitcoin has sold off and is now virtually flat year to date. This is a weak performance by recent standards for the cryptocurrency, which saw a four-fold rise in its price last year as traditional investors warmed to it.

Low interest rates, government support schemes and, with many working remotely, a growing preference for bigger houses have continued to bolster house prices in most major economies. The price of US housing rose by 15% year on year in June, the fastest pace in more than three decades. House prices are up 11% in the UK and 9% in Germany.

For corporates, the boom in equities means that their market value is now well above the replacement value of their assets. Such an environment incentivises businesses to acquire new assets, with the market rewarding these acquisitions with a significant valuation premium. This could bode well for investment in new technology and kickstart productivity growth, which has been lacklustre since the financial crisis.

But risks remain. Despite the positive earnings outlook, on several measures of asset overvaluation, equities markets seem toppy and could be prone to volatility. One such measure, the Case-Shiller price earnings ratio, has only ever been higher during the dotcom bubble. Another wave of infections, driven by a vaccine-resistant mutation of the virus, or a continued rise in inflation, forcing policymakers to raise rates, could trigger a correction.

The latter risk is a concern as we have seen significant corrections due to policy tightening over the last decade – during the taper tantrum in 2013, after the Federal Reserve announced a slowing of quantitative easing, and the stock market slide in 2018, in response to rate rises by the Fed. Investors seem sanguine. According to Bank of America’s latest Global Fund Manager Survey, almost three quarters of fund managers see recent price pressures as transitory and, therefore, unlikely to initiate rate rises.

Prospects for global growth have clearly improved this year and that is reflected in the performance of equities. Investors are pricing in a recovery that is just right – with strong growth and higher, but limited, inflation. That seems the most likely outcome. But it is by no means assured.

A quotation from renowned American entrepreneur, stockbroker, and investment writer William J. O’Neil provides some comfort “It is one of the great paradoxes of the stock market that what seems too high usually goes higher and what seems too low usually goes lower”

The Clarion funds

In the meantime, amid all the uncertainty but in a world awash with cheap money, we continue to manage the Clarion Funds and model portfolios with a cautious eye on the opportunities that lie ahead. We think of our client investments as we do our house. That is to observe and supervise, checking the meter reading from time to time but not changing paint colours every other week.

We prefer our select band of Fund Managers to ignore popular opinion and to stay focused on the important things; the fundamentals of a business – its profits, cash flow and balance sheet. If the fundamentals are deteriorating and management is incapable of rectifying the situation, it might be time to abandon ship. Being a quality fund manager requires more than just having the courage to stick it out, it requires courage to change one’s mind and to sell, even at a loss, if this prevents any further damage to a portfolio. We have learned that inexperienced and/or overly sensitive investors get drawn into risky gambles far too often, overlooking factors such as absurd management and the potential to expand geographically.

We are confident that our asset allocation and fund selection will continue to generate good risk-adjusted returns for our clients albeit with uncomfortable bouts of volatility along the way.

And finally, A prison guard from South Carolina was fired and arrested after trying to smuggle prescription drugs into a women’s prison by hiding them in Rice Krispie Treats – snap, crackle & pot!

As always, we wish all our clients, their families, and friends the very best of health and good fortune as we look forward to a new normal and a life of comparative freedom. We continue to take all necessary precautions to ensure that our office is Covid safe and secure, for both staff and clients alike. We look forward to welcoming you to the familiarity of face-to-face meetings in Overbank in the coming weeks and months although if preferred we are happy to conduct client meetings via Zoom and/or Microsoft Teams. As always, please do get in touch if you have any questions.

We look forward to updating you regularly over coming months.

Keith W Thompson

Clarion Group Chairman

July 2021

Creating better lives now and in the future for our clients, their families and those who are important to them.

Risk Warnings

Any investment performance figures referred to relate to past performance which is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments, and the income arising from them, can go down as well as up and is not guaranteed, which means that you may not get back what you invested. Unless indicated otherwise, performance figures are stated in British Pounds. Where performance figures are stated in other currencies, changes in exchange rates may also cause an investment to fluctuate in value.