The MSCI UK All Cap NR index returned -3.8% during the three months to the end of October, while the MSCI World ex UK (£) NR index returned +1.6% in Sterling terms. The UK stock market performance was undermined somewhat by additional concerns surrounding the UK government’s negotiating tactics around the trade discussions with the European Union and a resurgence in COVID-19 cases, which has triggered a variety of new lockdown measures. European equity markets also performed poorly for similar reasons (Europe ex UK (MSCI Europe ex UK NR (£), -3.2%).
In Sterling terms, all other major equity regions posted positive returns over the period. The strongest returns were exhibited by the Asia ex Japan (MSCI Asia ex Japan NR (£) Index, +6.4%) and Japan (MSCI Japan NR (£) Index, +8.5%) regions. Economies in both areas have benefited from more effective track and trace procedures (which have boosted the pace of economic recovery relative to western economies) and a weaker US Dollar. Japan’s Liberal Democrat Party managed to transition the Prime Minister’s role smoothly from Abe to Suga following Abe’s sudden resignation due to ill health.
Since the beginning of the year, the UK stock market (MSCI UK All Cap NR index, -24.5%) has materially underperformed the World ex UK index (MSCI World ex UK £ NR Index, +2.5%) and we outline reasons why we believe this trend could soon reverse in the investment outlook section below.
'Riskier' high yield debt managed to produce a marginally positive return.
Following a period of strong performance, Gilts produced a negative return over the three months to the end of October (iShares Core UK Gilts ETF, -2.2%). Investment grade debt performed better as credit spreads narrowed (iShares Core £ Corporate Bond ETF, -0.5%). 'Riskier' high yield debt managed to produce a marginally positive return (iShares Global High Yield GBP Hedged ETF, +0.1%), underlining the more constructive global investment environment.
The Brent crude oil price ended the period at $37.5/barrel, a fall of 13.5% from the price observed at the end of July. Renewed worries that demand forecasts might need to be reduced due to further COVID-19 related economic lockdowns in western economies impacted the price.
During the three months to the end of October, the gold price fell 4.9% to $1879/oz as demand for the ‘safe haven’ asset waned somewhat. Marginal Sterling weakness versus the US Dollar reduced the loss for UK based investors (-3.8%, to £1,452/oz).
Globally, ‘risk assets’ such as corporate debt and equities have recovered much of the ground lost during the first quarter of the year. This recovery in values has been fuelled by rapid monetary and fiscal policymaker intervention. These actions have been augmented by a strong economic recovery in China, which, seemingly, has returned to something close to economic normality.
These developments neatly echo the steps taken during 2008 and 2009, firstly, to prevent a depression and, secondly, to set the global economy back on a growth trajectory. The lessons from that crisis, to move early and in size, were clearly learned and this time around, in aggregate, policymakers have gone early and in larger scale than before.
Given the coronavirus doesn’t respond to the laws of economic supply and demand and price elasticity, it was unclear as to how the global economy would respond to such stimulus. However, we now know. Forecast economic growth rates for this year have been revised up and next year’s forecasts are encouraging, although news of additional economic lockdowns in the near term will have a detrimental effect.
Despite a new cycle of lockdowns in western economies, underlying demand is recovering and there are numerous tailwinds which should combine to aid economic and earnings recovery next year. Firstly, companies are going to have to overproduce in order to satisfy the need to replenish depleted inventories. Secondly, those consumers who have managed to keep their jobs have saved significant levels of their disposable income and this means that there is significant pent-up demand.
The positioning of investors in 'growth' assets now appears to be extreme.
At face value, this more positive outlook is good news for investors. However, during the past seven months or so, the mantra that western economies are now unable to escape the Japanese disease (of low growth, low inflation and low interest rates) has been fully embraced by investors. This, alongside the remarkable injection of liquidity (via interest rate cuts and quantitative easing), has meant that those assets that are more sought after when deflationary risks are at the forefront of investors’ minds have massively outperformed those assets which tend to do well during periods of economic reflation. To us, the positioning of investors in ‘growth’ assets now appears to be extreme, given the low hurdle that needs to be cleared in order to force a more positive reassessment of the outlook for economic growth and inflation.
While we have seen a few sharp rotations out of assets which benefit from the prevailing deflationary mindset to assets which benefit from a reflation narrative over the summer, these periods have been short lived. However, we view these as warning signals of what might be about to come. An analogy would be the tremors that often precede an earthquake.
To our minds there is a material risk that, at some stage in the not too distant future, positive news concerning the potential to deploy one or more COVID-19 vaccines at scale, allied with the prospect of improving economic growth as 2021 progresses, will drive a fundamental reassessment of the outlook for profits of companies which are geared to the economic cycle. Given the amount of cash and near cash sitting on the sidelines, any improvement in sentiment towards the outlook for the underlying economy could see a rush of capital back into areas of the markets which have lagged and a return of 'animal spirits'.
While we do believe that asset prices can move forward in near term, inflation could surprise to the upside in 2021.
This suggests markets will continue to rise from current levels but, unfortunately, it’s not as straightforward as this. While we do believe that asset prices, in aggregate, can move forward in near term (and perhaps materially so), inflation could surprise to the upside in 2021, given the easier year-on-year comparisons, and this may challenge the received wisdom that inflation is dead and buried. If so, long term interest rates may rise and reduce the value of assets which have long term, stable cash flows.
At the time of writing, Americans are going to the polls. There is a general belief that stock market returns suffer during terms when a Democratic President is sitting in the White House, given an underlying philosophy of relatively larger government and higher taxes, however this is not borne out by the facts. Some commentators now believe that the Democrats might achieve a 'clean sweep' and win the Presidency, the Senate and the House. In such an outcome, it is likely investors will anticipate a lengthy new normal of larger spending commitments and higher budget deficits as the new government attempts to level out some of the inequalities in US society.
If this came about, the potential switch in investor mindset, described above, could be reinforced and a weaker US Dollar versus its major trading counterparts would further exacerbate the shift towards assets which benefit more during periods when economic growth is accelerating, and inflation is anticipated to rise.
While we believe that there is a strong probability that elements of the above will unfold over the next six to nine months, we also believe that given the weight of debt at every level of the economy, the long term outlook for the global economy remains that of low growth, low inflation and low interest rates. This means that, in time, assets that benefit from a deflation narrative are likely to reassert their long term trend of outperformance.
By the end of the year there should be some long hoped for clarity as to the future trade relationship between the UK and the European Union.
The Brexit saga continues but from an investment perspective it’s plausible to believe that, regardless of what the outcome of the trade talks is, by the end of the year there should be some long hoped for clarity as to the future trade relationship between the UK and the European Union. With improved transparency, investors who have actively allocated away from the UK since the Brexit referendum may well be tempted to allocate to the UK stock market once again, particularly as the country’s stock market indices have a preponderance of companies that benefit when global economic growth and inflation are accelerating.
Senior Investment Director - Head of Risk Managed Funds
3 November 2020
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