Market Comment 07/01/2021
Market Commentary - January 2021
Hector Kilpatrick provides his latest Market Commentary of December 2020 and Investment Outlook.
The MSCI UK All Cap NR index returned +12.4% during the three months to the end of December, while the MSCI World ex UK (£) NR index returned +7.7% in Sterling terms. Initially, 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 triggered a variety of new lockdown measures. However, the announcement of successful vaccine trials in November boosted returns of all major equity regions.
Elsewhere, in Sterling terms, the strongest returns were exhibited by the Emerging Markets (MSCI Emerging Markets NR (£) Index, +13.2%) and Asian ex Japan (MSCI Asia ex Japan (£) index, +12.2%) 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.
The US equity market produced the weakest returns of the major regions during the quarter (MSCI USA NR (£) index, +6.9%) however this was entirely driven by US Dollar weakness versus Sterling. In local currency terms the US stock market produced good relative returns (MSCI USA NR Index, +13.0%).
We anticipate the UK stock market will make up some of the lost ground against other equity indices during 2021.
During calendar year 2020, the UK stock market (MSCI UK All Cap NR index, -11.5%) materially underperformed the World ex UK index (MSCI World ex UK £ NR Index, +13.8%). We anticipate the UK stock market will make up some of the lost ground against other equity indices during 2021 as economic recovery takes hold globally and uncertainty over the country’s trading relationship with Europe is removed. Relative to other major regional indices, the UK stock market index of large companies has a higher exposure to companies whose earnings are sensitive to the economic cycle and this should be a benefit in 2021.
Following a period of strong performance, Gilts produced a marginally positive return over the three months to the end of December (iShares Core UK Gilts ETF, +0.6%). Investment grade debt performed considerably better as credit spreads narrowed (iShares Core £ Corporate Bond ETF, +3.9%). However, ‘riskier’ high yield debt produced even stronger returns (iShares Global High Yield GBP Hedged ETF, +5.5%), underlining the improved investor sentiment following the confirmation of successful COVID-19 vaccination test results.
The Brent crude oil price ended the period at $51.8/barrel, a rise of 26.5% from the price observed at the end of September. Optimism that vaccine deployment will result in a resurgence in demand in 2021 improved sentiment as did continued OPEC production restraint.
During the three months to the end of December, the gold price rose 0.7% to $1899/oz as the metal was caught in the cross hairs of waning demand for the ‘safe haven’ asset due to the more risk on environment, but improved demand due to the declining US dollar. Significant Sterling strength versus the US Dollar produced a negative return for UK based investors (-4%, to £1,391/oz).
Markets continued to push higher during the final quarter of 2020 as positive vaccine trials were announced and investors started to believe that the roll out of vaccinations in 2021 would return the global economy back to something approaching normality. As a result, sectors that have been seen as ‘COVID losers’ (such as travel & leisure, oil & gas and financials) have started to outperform. Alongside the remarkably swift development of effective vaccines, the COVID-19 induced economic collapse and recovery would appear to be moving at ‘warp speed’ compared to previous economic cycles.
A synchronised, global, economic recovery during 2021 is now anticipated by market participants.
A synchronised, global, economic recovery during 2021 is now anticipated by market participants, helped not only by the lifting of lockdowns but also the dual tail winds of pent-up demand and restocking. Globally, the number of companies seeing earnings forecasts revised up relative to those seeing downward revisions is high relative to history.
An increase in ‘mergers and acquisitions’ activity can be expected as private equity and strongly capitalised listed companies take advantage of cheap and plentiful debt financing to consolidate sectors by acquiring firms with good market positions but compromised balance sheets.
These positive developments, allied with greater clarity over the direction of US policy following the US elections (and, more marginally, Brexit), are likely to continue to persuade investors to move cash, which has been sitting on the side lines, back into equity markets.
Our base case, therefore, is that equity markets can continue to move higher, perhaps materially so, and those more economically sensitive companies which have started to lead the markets higher in recent months will continue to do so, boosted by the news from the United States that the Democratic Party (which favours introducing additional near term economic stimulus measures) controls both the House of Representatives and the Senate, albeit with wafer thin majorities.
However, there are some significant caveats.
Firstly, there is a distinct risk that one or more COVID-19 variants may materialise which require the reformulation of existing vaccines to ensure good efficacy and this could reduce the speed and scale of the recovery.
Secondly, policymakers are generally agreed that policy tightening measures (such as austerity and interest rate rises) were brought in too swiftly following the global financial crisis of 2008/9 and these errors impaired the subsequent recovery. The same mistake must not be repeated.
Thirdly, the consensus believes the outlook for inflation, in the medium term, is benign. This is crucial as low inflation helps anchor interest rates at low levels which, in turn, are used to value companies. Any sustained increase in interest rates, as a result of higher inflation expectations, could have the twin effects of undermining corporate valuations and reducing economic growth.
Policymakers will have to tread a fine line between allowing economic momentum to build a head of steam and ensuring investor confidence that inflation will remain under control in the medium term holds.
Policymakers will have to tread a fine line between allowing economic momentum to build a head of steam and ensuring investor confidence that inflation will remain under control in the medium term holds. This will become increasingly difficult as the year progresses, as year-on-year comparisons of inflation could come in significantly higher than expected due to base effects at a time of strong global economic growth. Furthermore, we believe companies in numerous sectors will try to boost margins (via pricing) in order to recoup some of their 2020 losses and/or service their expanded debt obligations. As a result, we expect interest rates to continue to rise as the recovery progresses. Nonetheless, we also believe that there is a decent amount of headroom available before interest rates could be considered problematic. We will continue to review and challenge this view as a future change in investor sentiment from ‘greed’ to ‘fear’, as a result of higher interest rates, could be both swift and brutal.
Given our thoughts concerning the economic recovery and the potential for interest rates to rise from current very low levels, we believe government bond prices are likely to produce negative returns in the near term. We prefer index-linked Gilts which protect against inflation expectations rising. While falling government bond prices will have an impact on corporate credit returns given their use as a reference price, we believe spreads can tighten further such that higher yielding corporate credit can still generate positive returns.
We continue to hedge some of the risk that Sterling might rise from current levels. If this happened, it would reduce returns on overseas assets held by UK based investors. The announcement of a new more transmissible UK COVID-19 variant has induced harsher lockdowns and will produce an even larger budget deficit than previously forecast and we think this news has dampened sentiment to Sterling despite the announcement of a Brexit deal. However, it is possible that the UK manages to roll out vaccinations more swiftly than its major trading partners, thus boosting confidence in a return to ‘normal’. We may also discover that the new trading arrangements with Europe are manageable and the negative short-term effects of increased paperwork may diminish as a source of concern. We anticipate the European Union will start granting equivalence to some segments of the UK’s financial services industry in the coming months and this will also improve sentiment. Given Brexit clarity and a stable, relatively business friendly government, international investors should start to buy Sterling assets and this would provide further support for Sterling.
Overall, we remain constructive on the outlook for risk assets.
Senior Investment Director - Head of Risk Managed Funds