Seizing an opportunity in equities | April 2021
In this episode we’ll be talking about the Ides March and whether that will be a bad omen for stock markets.
While a rise in longer-term bond yields has hurt parts of the market in the short-term, we believe any potential equity market vulnerability should be transitory: US interest rates are still low, economic recovery continues at pace and growth expectations are higher.
That said, the tug of war between stronger growth on one hand and higher rates on the other is likely to give rise to volatility. We discuss how we are approaching this in our portfolios, where the key risks lie and the outlook for financial markets over the next few months.
[0:25 ] Just as they did for Caeser, the Ides of March proved pretty awful for investors in 2020 as the economy and financial system fell into turmoil. Are there reasons to be worried today?
Certainly, there are some concerns that equities appear vulnerable once again due to another source of risk - a rising US interest rate environment. US Treasury yields of 10-year maturity have risen from a trough of 0.6% to 1.7% today1. Warren Buffet, the American investor and CEO of Berkshire Hathaway, has described interest rates as having a gravitational effect on valuations. When interest rates are high, they can exert a big pull downwards on valuations, but when they are nothing, as they are now, valuations can be almost infinite.
[1:17] Are you concerned? Or do you believe equity market vulnerability will be transitory?
US interest rates are still too low to cause a sharp economic slowdown. For instance, mortgage debt servicing costs (interest and principal) are at an historically low level of 4% of US take-home pay, suggesting favourable affordability to owning a home2. Furthermore, household aggregate net worth has recovered from rising equity and house prices to stand at a record 7.5 times disposable income3. While not equitable, this wealth provides an additional source of funds for consumers (~70% of GDP) to spend when rates are rising4.
[2:13] What about the economic recovery? Is that still on track and will this support equities?
Yes, it should certainly mitigate some risk related to an increase in the cost of borrowing. Growth remains supported by highly accommodative policy. The US has already legislated a new $1.9trn fiscal stimulus, with more to come from the Biden administration’s infrastructure and healthcare plan currently being discussed in Congress.
Given the extent of the upcoming fiscal stimulus, the OECD recently revised up its 2021 US real GDP growth target to 6.5% from its 3.3% forecast in December, which if realised would be the strongest rate since 19845.
Treasury yields tend to rise when growth expectations are rising which is good for equities. Looking back to 1990, there have been eight episodes of a sharp rise in US 10-year yields (defined as at least a 1% increase)6. Global equities gained in all those periods, with MSCI All-Country World Index rallying the most during June 2003 – June 2007 (+83.4%), as yields rose 2.1% points7.
[3:35] Could this tug of war between stronger growth on one hand and higher rates on the other be a source of market volatility?
Potentially, yes. But provided the rise in yields doesn’t occur too quickly and reflects a return to growth, it is still a conducive backdrop to favour equities over bonds. We see specific opportunities in value-focused recovery themes as economies are opened-up again. These include non-US markets, like emerging markets (and particularly in Asia) and the UK.
A market risk is that a booming global economy absorbs excess capacity left over from the pandemic much quicker than central bankers anticipate. That could potentially lead to overheating, where higher inflation erodes real incomes and hinders output growth. It would also show that the Fed is behind the curve on interest rates and possibly lead to a broader market decline.
[4:38] Let’s just quickly talk about the Dollar: it was falling, but it’s shown some strength in recent weeks. What might this do to equity markets?
US dollar appreciation is another potential risk to our positive stance on equities, since it is an implicit form of monetary tightening for non-US equities, and particularly for emerging markets. Rising US yields this year have halted the downward US dollar trajectory which has been in place since March 2020. Nevertheless, sizeable US debts and deficits are likely to remain a drag on the dollar for some time to come and there is a growing reluctance of overseas investors to own Treasuries. Moreover, as a counter-cyclical currency, the dollar tends to depreciate as risk appetite increases with stronger, broadening output growth.
[5:33] Let’s go closer to home and talk about the UK budget. What’s your verdict?
Given that much of the content was flagged to the press already, the only real surprise in UK Chancellor Rishi Sunak’s second budget in March was that tax increases would be postponed until 2023. Essentially, the chancellor went against his political rhetoric at the virtual Tory party conference last autumn to balance the books after the pandemic.
With the UK economy still constrained by lockdowns, more money is to be found to support growth. Some prominent government measures to support consumption include extending the residential stamp duty holiday threshold of the first £500k to end June and the furlough scheme for workers till the end of September. Business investment is also likely to be brought forward and boost growth thanks to a capital allowance that is 10 times as generous as it was in 20098.
[6:31] Will all this largesse boost the economy?
The OBR projects GDP growth of 7.3% in 2022 and for the economy to return to pre-COVID-19 levels by the middle of next year, 6 months earlier than its projections in November9.
In short, the chancellor chose to ensure that near-term economic support would be maintained, while ensuring the long-term sustainability of government finances. We expect this growth-friendly policy mix (at home and abroad) to be seen as a tailwind for UK equities and should offset concerns over the impact of sterling appreciation as a risk for owning UK stocks with a large proportion of international earnings.
1-7 Refinitiv Datastream, data as at 31 March 2021
8 HSBC, Tough questions on World Maths Day, data as at 3 March 2021
9 Office for Budget Responsibility, data as at 31 March 2021
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This episode was recorded on 01/04/2021
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The Pulse from Smith & Williamson
Investment Show: Seizing an opportunity in equities
Broadcast on Smith & Williamson at 09:00, 9th of April 2021
Available online from 10:00 on the same day .