Stock market and economic commentary May 2021

“I’ve got to admit it’s getting better, a little better all the time.”

– A song from The Beatles’ 1967 album Sergeant Pepper’s Lonely Hearts Club Band

Coronavirus update

Despite occasional, and often welcome, distractions from the world of politics, sport, weather, travel and, sadly, crime, the coronavirus pandemic continues to dominate headlines.

The world’s response to Covid-19 is diverging along the lines of those who have been able to implement a proactive vaccine rollout, and those who, for various reasons, have not. More than 1.45 billion doses have now been administered to people across 176 countries. The latest rate works out at almost 24 million shots each day with Israel, North America, and the UK leading the way while India, Brazil, and parts of the EU lag behind.

Israel remains the furthest ahead in numbers vaccinated amongst countries with significant population size, with approximately 120 jabs per 100 people. The most recent rolling seven-day death statistics and confirmed infected cases in Israel have fallen into single figures. The UK’s alternative strategy of maximising first jabs has had a similar statistical effect, with UK confirmed cases now into the low thousands and daily deaths also into single figures. UK hospital data from the NHS shows a consistent decline in both hospital beds occupied and patients on ventilators due to Covid-19.

The pace of vaccinations in the US has now topped more than 2 million a day and following the recent emergency authorization for use of the Pfizer-BioNtech vaccine for 12- to 15-year-olds, this daily rate is likely to increase considerably.

Sadly, at the other end of the spectrum, many countries continue to struggle with subsequent waves of the virus. India has seen a surge of remarkable severity with confirmed daily cases rising from 65,000 at the beginning of April to 400,000 by the beginning of May. The situation resembles the agonising position of Northern Italy during the initial wave of the pandemic last year when doctors were placed in the position of deciding who would live or die, due to the lack of medical supplies.

This disparity in the response to Covid-19 has resulted in the more proactive nations becoming close to achieving herd immunity, while others have struggled with mismanaged rollout plans (viz. the EU27) or remain dependent on the vaccine sharing COVAX scheme or direct aid from other countries. Israel, the UK, and USA have now protected most of their vulnerable age groups, but countries such as India are suffering from oxygen shortage and overflowing medical facilities.

The new “Indian” variant poses a significant threat to the continued easing of lockdown restrictions in the UK and were it not for a recent surge in cases in Bolton and other parts of Lancashire, UK recorded cases would be down to the low hundreds.

However, with months of vaccination data now available, the evidence is becoming overwhelmingly clear that vaccinations are cutting transmission rates and reducing the burden on medical facilities, with lower hospitalisation and death rates. Barring a black swan event such as a challenging mutation which vaccines are not prepared for, investors can realistically look forward to a world in which Covid-19 is no more problematic than a typical flu season.

Freedom beckons

The joy of travel, of family re-unions, socialising indoors, handshakes and cuddles and that long forgotten feeling of freedom is gradually returning to most, if not yet all, parts of the world. Freedom is not everything but as we now know, without Freedom, everything is nothing. We must hope and pray that the situation in Lancashire is brought under control swiftly.

Markets and economies

Opportunities to make and lose money abound and both are seemingly being pursued with equal vigour by polarised factions within the investment community.

Around 15 per cent of current US stock market investors began investing for the first time in the last 12 months largely down to the fact that they have the cash, the time, and the apps to do so. This creation of a lockdown generation of investors is a phenomenon that has also happened in the UK. Such events typically come with the side effects of manias and bubbles. And, because the arrival of the ‘new cohort’ typically coincides with a rising stock market, often the initial, but incorrect, view is that investing is a doddle.

The dangers of following an investment trend can be demonstrated by the recent volatility of a favourite asset with amateur investors. Bitcoin saw its value fall from its recent highs, plunging by c.$7,000 over the space of three days, resulting in more than 20% of its value being wiped out in a week. This excessive volatility is one of the significant risks of cryptocurrencies and the possibility that such deregulated currencies could become a hedge against inflation, as some market participants have speculated, looks a long way off. Despite this, the industry has taken a tentative step towards legitimisation, with the recent flotation of the cryptocurrency exchange Coinbase on the New York Stock Exchange valuing the company at $80 billion.

Many of the world’s biggest investment banks were badly affected by the liquidation of the Archegos Capital hedge fund, with over $10billion of losses declared so far. The biggest casualties were Credit Suisse and Nomura, who disclosed losses of $5.5bn and $2.3bn respectively, with more expected as a percentage of the leveraged positions remain unresolved.

Concerns over the level of margin debt in the financial system are also growing, with recently released data showing these positions have accelerated rapidly since the Covid-19 induced market falls in March 2020. Gillian Tett’s recent article in the Financial Times put this in some context, showing that in the dotcom bubble and financial crisis, US margin debt hit c.3% of GDP, but the present figure is closer to 4%. That is an extraordinary level of margin debt and could pose a threat to financial markets if interest rates rise rapidly and/or asset prices fall.

Inflation risks

There has been much debate about the return of inflation and several straws in the wind render this well-founded. We have, however, been here before following the financial crisis and in the early 2000s. Inflation scares have come and gone but the prospect is once again becoming a concern for investors, with the bond market wobbles of the first quarter an evident symptom. In the US, funds with a focus on TIPS (Treasury Inflation-Protected Securities) saw their 30th week of consecutive inflows, which is the biggest run of positive flows since the financial crisis.

The Federal Reserve’s intention to let inflation run hot, with an average 2% target over time rather than moving interest rates as the target approaches, means that a sustained period of inflation over 2% would be countenanced to offset the recent past in which inflation has been lower. The $1.9tn fiscal stimulus package passed earlier this year also runs the risk of contributing to overheating the economy, as the size of the stimulus far exceeds the current output gap (i.e., the difference between actual and potential GDP), which historically has been inflationary.

The break-even rates on TIPS (calculated as nominal yield minus real yield, e.g., 10-year Treasury minus 10-year TIPS) have seen an inversion in 2021, providing some evidence that market expectations are for short-term inflation to give way to a lower longer-term inflation outlook. The two and five-year break-even rates, at c.2.63% and c.2.57% respectively, have leapt ahead of the ten-year break-even, which currently sits at c.2.3%.

Evidence of the reflationary trade can also be seen in the continued rise of copper prices, which recently broke through the $10,000 per tonne mark for the first time ever. As a significant element in the construction of electric vehicles and semiconductors, the metal is likely to see continued demand as manufacturing picks up. Copper is often considered a leading indicator due to its integral place in the industrial manufacturing supply chain, pointing to a bullish market sentiment.

The effects of the massive monetary and fiscal stimulus may result in inflation settling into a pace of 2.5% per annum compared to an average of 1.5% before the pandemic. Higher than recent history but not yet dangerously high.

Money debasement

It is incredibly hard to write anything original about the present phase of this cycle. Not only hard but probably superfluous as it seems clear that things are about to change. We are where we are due to the debasement of money by governments and their not-so-independent banks. The printing and distribution of freshly minted money (around 25% of “M1” money in circulation today was created in the past twelve months) has led to a bull market in everything.

Protecting against the continued debasement of money involves taking investment risk. Protecting against a return to “normal” with price levels reflective of long-term averages, involves managing that risk appropriately.

Valuations

The US stock market currently trades on 22x price to earnings ratio, which is unremarkable these days, despite the very long-term average hovering closer to 15x. This premium may not seem high, but there is a major intrinsic risk in ignoring the lessons of history. The future is highly uncertain, and this decade may be very different from the last. There is a meaningful risk that valuations will revert to their long run averages at some point in the next five years or so.

Even if earnings per share were to grow at 8% per year indefinitely from here, any return to a ratio of 15x would result in a loss from holding “the market” over that period. Quite a stark reality if the 2020s are more redolent of years prior to the 2010s,

Those strategies wedded to expensive stocks are concentrating risk to a dangerous degree. The fall in valuations may not happen but the risk is real and growing in likelihood.

Value or growth

Some commentators have enthusiastically drawn comparisons between the recent shift to value investing and the aftermath of the dotcom boom. We believe that today’s circumstances are more nuanced for several reasons. In 2000, the stock market was elevated by technology stocks trading at extreme valuations. Many ‘dotcoms’ had unproven business models, which later collapsed. Twenty years on, the technology sector represents a third of the US equity market and substantial value can be attributed to it in terms of historic earnings, current growth, and cash rich balance sheets.

This ongoing value creation must be seen in the context of a seismic shift of digitisation. The accelerating pace of technological change provides a far firmer footing for the next decade of returns than any short-lived cyclical puff. The direction of travel is no secret and pockets of excess have unsurprisingly led several to dismiss the sector out of hand. But there are still excellent opportunities hiding in plain sight. Microsoft and Alphabet, for instance, have valuations not dissimilar to the overall market despite the superiority of their financial productivity and growth. Their valuations and proven business models simply do not compare to the fragile extremes of 2000.

Risks ahead but also opportunities

Inflation corrodes most asset values but few more than fixed income and very high growth companies without a proven track record. Those that ignore valuations altogether may be in for a nasty surprise. This is what makes a conventional balanced fund very wobbly indeed. Commodities, inflation linked bonds, short-dated bonds, and equities with pricing power offer at least partial protection but there are no guarantees.

The environment is not as riskless as may first appear. Pent-up consumer demand combined with accumulated savings will lead to an economic rebound although much of that has already been discounted. There are plenty of signs of investor excess in electric vehicles, alternative energy, new issues, cryptocurrencies, and special purpose acquisition vehicles. Speculative retail investor activity is animated by stimulus cheques, working from home and fewer opportunities to gamble on sport.

And yet investment opportunities are plentiful with many excellent companies with strong balance sheets trading at valuations no higher than the market average.

Staying the course

Amid these challenges, we continue to do what we do best and what has stood the test of time over the past 35+ years. Structuring a sound, long term financial plan and cash flow analysis, combined with a strong investment proposition in a good range of top performing funds to provide diversification of investment style and securities.

We prefer not to think in terms of the commonly cited stock market cohorts such as growth, and value, or anything in between. The bottom line is that we use fund managers who invest in companies which have sustainability, are highly profitable and are growing not shrinking. A stagnating or declining business will struggle to make the requisite investments to stay afloat. On the other hand, accumulation of financial firepower affords companies the long-sightedness and dexterity to stay relevant. Sensible and constructive investment diversification alongside a robust financial plan is the key to achieving peace of mind and fulfilling one’s objectives.

As always, we wish all our clients, their families, and friends the very best of health and good fortune as we all return to normality and a life of freedom. Our office is now open and is Covid safe and secure, for both staff and clients alike. We are back to business and we look forward to welcoming you to the familiarity of face-to-face meetings in Overbank in the coming weeks and months. We are, of course, available for contact via the office number, email address and all normal forms of communication. 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

May 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.