Hope: A market wrap of Q4

Been to the moon for a year? The MSCI World index rose 16%, all looks good. Been on Earth? COVID-19 took 1.8 million lives and the global economy saw two years of economic output completely wiped out. Can this chasm between Wall St and Main St. be justified? We are frequently reminded that markets are forward looking and large listed companies are not representative of the wider economy. But when the high-water mark of global economic output will not be regained for another year, can it make sense for markets to be so far ahead? Unfortunately, with the cost of capital never having been cheaper, that’s an impossible question to answer with high conviction, as there are few relevant reference points. So, we enter a new year optimistic on the economic recovery as COVID vaccines are rolled out far sooner than many had dared to hope just a couple of months ago; but with little clarity on the short-term outlook for markets.

Back to the extraordinary year of 2020,  it was a year that saw the US flip from the lowest unemployment rate in 50 years to highest rate in 80 years over just 2 months; and also a year that saw the sharpest but shortest US recession ever. Turning to a global perspective and the growth outlook, the table below shows economic output and forecasts in terms of real GDP growth for 2020, 2021 & 2022. Alongside this to the right are cumulative figures for a 2 year and 3 year period, in both cases beginning in 2020.

Worst hit in 2020 were Spain and the UK, followed by Mexico, Italy and France. The economy that held up best was China, with its first in first out experience, alongside strict management to get a grip quickly . (NB for India, FY20 ends 31st March 2020, so FY21 is more representative of the 2020 calendar year experience).

The heat map shading above shows a universal return to growth in 2021, but in terms of quantifying this, the cumulative data is instructive. Few countries are shaded white or green over the 2 years of 2020-21, indicating most have not regained their prior high-water mark of output. China is head and shoulders above the rest of the world and takes emerging economies back into strong positive territory. Aside from this, only the US, Australia and South Korea scrape a net positive return over the 2 years. At the other end of the scale some countries are not even expected to have net positive output over the three year period of 2020-2022, namely Mexico, the UK, Spain, Italy and Japan.

Considering aggregate global GDP of just 0.6% expected over 2020 & 2021 combined, bearing in mind the trend rate of growth for the world not so long ago was around 3.5%, this indicates over 6% of global output lost in this 2 year period, which is sobering when remembering the view of equity markets.

Leading Indicators

Looking ahead via Purchasing Manager Indices, essentially surveys of businesses and how they think conditions affecting their business have changed in the month, the picture is shown below. White or green shading against readings of 50 or above highlights a majority of respondents seeing improvement.

The key takeaways are:

• Manufacturing and services are both on an expansionary path (>50) for the most part, manufacturing in particular with stronger readings
• Global momentum has peaked, with global manufacturing levelling off in recent months around 54 and global services levelling off around 52
• Europe and Japan are seeing much weaker readings in services, compared to stronger readings in US and Emerging Markets, no doubt impacted COVID restrictions

When interpreting PMIs, it always needs to be borne in mind that the informational value is restricted only to relative terms i.e. indicating rate of change or momentum compared with prior readings. A PMI says nothing about the absolute state of an economy. A reading of 60, for example, could either mean you are climbing out of a very large hole quickly, which sounds impressive until you remember how big the hole is; or could reflect a strong economy on steroids. Ordinarily readings oscillate within a fairly narrow range around 50. The chart below is for the ISM Manufacturing PMI in the US and its easy to see there is no clear relationship between the PMI reading and state of the economy.

Election Tantrums

Aside from following the stop/start of lockdowns and the rate of COVID-19 infections, hospitalisations and deaths, the other key focus in the final quarter of the year was the US election and considering the impact of various permutations for the different branches of government. Ahead of the result, a clean sweep for either party was seen an being the most stimulative outcome for the economy, with a Blue wave the most likely sweep scenario. A split Congress was seen as creating gridlock. Post-election under what was then seen as a split Congress, the narrative changed and markets were buoyed by reduced tax and regulatory threats. Of course at the time of writing we now know that the Democrats did win the Senate too and markets are returning to the original narrative and again taking positivity from the stimulus potential. For equity markets this is more about rotation to more cyclical and value oriented plays whereas in bond markets the story is about higher inflation expectations and longer term bond yields.

Fiscal & Monetary Stimulus

As year end approached, despite the post-election acrimony in the US, Congress did agree a further stimulus package of $900bn, which includes $600 to most adults and $600 per child. This is in addition to over $2.5 trillion in prior aid packages this year, most notably $2trillion from the CARES Act in late March.  For the Fed’s part, interest rates were long ago cut close to zero and currently are projected to stay there until 2023; and the balance sheet this year has jumped from $3.7trillion to $6.7 trillion (see below). The December meeting concluded that asset purchases would continue at the pace of at least $120 billion a month.

In Europe, various countries adopted different measures and European fiscal rules were suspended. Germany for example announced initiatives of over €1 trillion, but its important (for all countries) to distinguish between immediate support versus guarantees, deferrals or other longer-term initiatives. The immediate support was still close to €300bn or over 8% of 2019 GDP. In the UK the immediate fiscal boost was a similar percentage of GDP equating to ￡184bn. As a reference point of interest, both were not far behind the US in percentage terms, prior to the additional US year end package and both the UK and Germany had much greater back ended measures re guarantees etc. The crisis has brought about a rare victory of cohesion in fiscal policy for Europe this year, albeit for the usual reason of necessity.

The ECB took significant action through its Pandemic Emergency Purchase Program (PEPP) in December by a further €500bn of purchases to a total of €1.85 trillion; and reinvestments of maturing assets were extended until the end of 2023.

Inflation expected to rise again

In terms of the inflation forecasts of the central banks, these are shown below. Compared to last quarter, the Fed has very slightly revised up its forecast and the opposite is true for the ECB. Assuming this is on point, the US will get close to its target this year, whilst the ECB will be some way behind – although that was the case before COVID too.

Labour market gradually healing

In the US, the unemployment rate spiked from 3.5% in February to 14.7% in April. This has now moderated to 6.7%, which is of course a significant improvement, but still almost twice the level of early this year. From the 22m decrease in US non-farm payrolls over March and (mostly) April, almost 10m of those job losses remain. In Europe where jobs are harder to gain and harder to lose, the eurozone unemployment rate has seen comparatively little change, rising from 7.2% in February to 8.7% in July, but the improvement has been very limited with the rate remaining around 8.5%

Skinny Brexit

Christmas Eve finally saw the (very) long-awaited Brexit deal between the UK and Europe, albeit not particularly comprehensive despite the 2,000 pages. Tariff and quota free trade has been guaranteed covering some ￡294bn of UK exports and ￡374bn of UK imports but this will be on more restricted terms than now and with more bureaucracy, with the potential to impact flows and just in time supply chains. With the focus of negotiations on goods, there was little to promote free trade in services where the UK has a large surplus, as this would have needed more alignment of rules and regulations. We will never know of course if the decision pays off economically, as the counter factual will never be available. Those who would have preferred to remain would cite the UK’s Office for Budget Responsibility (OBR) – an independent public body funded by the Treasury – which has estimated the hit to GDP at around 4% in coming years. However those in favour of leaving may cite reasons not limited to economics and may well dispute this forecast too. Either way it’s now done and all sides breathed a collective sigh of relief that the new year has not begun in a no deal void.

Asset Class Review

The returns for key asset classes are shown in the chart below for the whole year, and then considered individually for each asset class, for the final quarter of the year. For the whole year global equities have returned 14%, nearly all in the final quarter after getting back to break even at the end of Q3. Investment grade bonds have once again surprised with a gain of 11% in 2020 (after 17% in 2019). The DXY dollar index has lost 6.7% after a steady decline set in motion in Q2. Gold’s returns moderated at the back end of the year, but still ended with a very respectable 25% gain. Oil is missed from the chart as its brief precipitous decline in April would have taken the scale to an incomprehensible level, but the net result after all the extraordinary volatility was a loss of 20% for the year.

Fixed Income

In the developed world, credit markets had already largely normalised before Q4. In terms of government bonds shown in the chart below, the UK and Europe saw a very small decrease in yields as winter worsened the short term COVID outlook and in Japan long term yields continued to be managed around zero. 

The biggest change came in the US where the 10 year Treasury yield saw a noticeable rise from 0.68% to 0.91%. This was driven by a number of factors: initially an expectation of a stimulative Democatic sweep of Congress; then shortly after that was thought not to have materialised came the first successful COVID vaccines; and the generally better economic news added further momentum too, although from early December progress was largely capped by rising infections. With the 2 year yield barely moving for months as short term rates are anchored close to zero, this resulted in the yield curve steepening to levels not seen since early 2018, with the spread between 2 and 10 year Treasury bond yields (the extra yield premium for holding longer dated bonds) rising to 79 basis points (0.79%). 

Considering credit spreads (the extra yield premium demanded for holding riskier corporate bonds compared to Treasuries), US investment grade bonds that had provided more than 3.5% extra yield compensation back in March ended the year with a yield premium of less than 1%. Riskier US High Yield bonds that had provided almost 11% extra yield compensation back in March saw this spread decline to around 3.8% by year end. In both cases these levels are no more than before the crisis at the beginning of 2020. Funding and liquidity conditions have improved in most emerging markets too.

Back in the depths of the sell of in March, one of the measures of credit risk considered was the (3 month) LIBOR-OIS spread i.e. what banks charge each other compared to the central bank rate. After hitting a peak of 1.38% at the end of March (it hit 3.65% in 2008), this had normalised by the end of Q2 and has remained stable since. 

Similarly, commercial paper spreads (over Treasuries) have remained low and stable for many months, after declining from over 2% back in March to almost nothing by year end. Despite the Fed having withdrawn some of these facilities that gave rise to the easing in credit conditions, the working assumption is these measures or similar ones would be brought back if needed.

In terms of the Q4 performance of various segments within credit, the Barclays USD liquid investment grade bond index gained 3.5% in Q4 for an annual return of 11.3%. The BofA Merill Lynch High Yield index added 6.5% in Q4 taking its annual return positive again, ending 2020 with 6.2%. Finally the JP Morgan Emerging Markets Bond index added 5.5% in Q4 to round out the year with a return of 5.9%.

Equities

The picture in the opening part of Q4 looked quite different from now. The final week of October saw the worst week for US equities since March due to multiple concerns: new restrictive measures, stimulus gridlock and the upcoming US election. However this was quickly forgotten in the early part of November when the US election was called by the networks for Biden; and more importantly when soon after that Pfizer announced the efficacy of their vaccine, followed in short order by Moderna and Oxford/AstraZeneca. An effective vaccine was hoped for in the first half of 2021, but few dared to think 2020 would be possible, so equity markets took a major leg up and thereafter made steady progress to year end, taking in many new highs along the way. The table below shows the outcomes for key equity markets for the quarter and the year, in each case both in local currency and USD.

For ease of reading, the local returns in Q4 are also shown in the chart below.

This was clearly a very strong period universally, with double digit returns the norm across the board. In major developed markets Japan led the way, with Europe and the UK and few points behind and then the US. Naturally not all starting points were equal though and the UK and Europe, especially the UK as one of the most unloved markets in 2020, still ended the year in negative territory (in local terms). Japan’s outperformance brought it in line with the US for the year (in local terms), as both markets showed a total return of just over 18% for the year.

In emerging markets, China’s 8% quarterly return looks unimpressive compared to India and Brazil. However this is deceptive given China’s much earlier recovery and China’s local return for the whole of 2020 is not far behind leading developed markets. India too has performed in the same ballpark for the year thanks to a very strong 4th quarter. For Brazil on the other hand, whilst it outperformed India by a whisker in Q4 (local terms), the 2020 return lags most other countries ex Europe by a wide margin; and in USD terms the result was awful, after the collapse of the Real. No one matched Venezuela with a local return for 2020 of 1379% !!

Sector Leadership

Energy and Financials had clear sector leadership in the US in Q4. For energy, demand expectations picked up on vaccine rollout optimism and in the financials sector a steepening yield curve improved the outlook. As expected in such a strong risk on period, the more defensive areas of consumer staples, utilities and health care fared worse. Even technology stocks only had modest relative returns in the quarter as a clear cyclical/value tilted rotation took place. 

At the end of such a tumultuous year, its worth perhaps reflecting on the following for perspective (or just because it’s arguably interesting). These are courtesy of Credit Suisse and Goldman Sachs and US focused:

• March was the most volatile month in market history, with more global equity market cap lost than the entire US GDP, followed by the strongest rally out of a bear market since 1932
• The peak to trough drawdown of 34% was largest since a 48% drop in 2008
• The worst single day of -12% was worst since Black Monday in 1987
• The Nasdaq 100 index rose 48%, 30% more than the S&P 500, the largest spread in 20 years
• The S&P 500’s total return of 18% comes after a -34% decline from Feb highs and a 68% recovery from March lows
• Growth dominated value, US topped EAFE, tech outpaced other groups
• The top 5 (Apple, Microsoft, Amazon, Google, Facebook) gained 65% v 10% for rest of S&P 500
• IPO volumes doubled and M&A matched 2019 levels, unprecedented for a recession
• S&P 500 EPS declined 16% in 2020 with positive growth in 2/3rds of index.  EPS forecast +23% for 2021
• Tech and Health Care EPS likely grew 7%, with contractions of -1%, -24% and -47% for Non-Cyclicals (ex-healthcare), Financials, and Cyclicals, respectively
• The market multiple closed 2020 at 22.5x, up from 18.2x a year earlier, but well below the mid-1999s of 25.5x. While P/Es are quite elevated, Price/Free Cash Flow is in line with historical averages.
• The cost of capital declined substantially from 1.9% to 0.9% (10 year Treasury yield)
• An old fashioned 60/40 stock/bond portfolio (S&P 500 index and 10 Year Treasuries) would have returned 15%  

Commodities

Oil

Oil followed a similar path to that described for equities above in Q4. A shaky start followed by risk off in late October for the reasons alluded to earlier; then buoyed in a general sense from post-election (mostly) relief and vaccine euphoria. More specifically related to the vaccine news, the fundamental impact this would be expected to have on global oil demand with transport and travel slowly resuming. Supply dynamics were also in the spotlight too, with OPEC+ agreeing in early December to increase production by 500,000 barrels per day (bpd) beginning in January, but for a limited period stated then as to ‘at least March’. For context the original cuts of 9.7m bpd began May 1st and were reduced to 7.7m bpd in August. So this action was a fairly modest amendment trimming cuts to 7.2m bpd (against the pre May 20 baseline). Therefore whilst it might seem counterintuitive for an output increase to support the price, the backdrop is that it represented only a minor amendment to prior cuts, specified for only a short period; and also occurring in an environment when demand was expected to meaningfully firm, whilst the original cuts were agreed when there was no visibility on the demand outlook. Draws in inventory ahead of Christmas also boosted sentiment. As shown in the chart below, WTI ended the year at $48.52 representing a gain of just over 20% for the quarter. 

The International Energy Agency (IEA), in its December report, speaks of the recovery (in demand) in the second half of the year as almost entirely due to China’s fast rebound from lockdown, whereas in the OECD they see the picture as bleak and Q4 worse than Q3 with renewed lockdowns. For 2021 their demand forecast has been revised down again driven by another downgrade in jet fuel/kerosene demand, which will account for 80% of the shortfall of 3.1m bpd in consumption in 2021 v 2019. Gasoline and diesel though are seen as returning to 97-99% of their 2019 levels. The market interpretation sounds rosier than the IEA, perhaps because of its forward-looking nature, but given the way that oil trades (physically), there is room for retracement. Of course all of this is before the New Year announcement by Saudi Arabia of its latest large cuts, which will be part of the 2021 story.

Gold

Being offered a 25% return for gold on Jan 1st 2020 would not have been a poor proposition; but from a peak of $2063 in early August and some wild predictions of much more to come, it will have come as a disappointment to many investors to end the year 8% lower at $1,898 and a return in Q4 of +0.7%.

The truth about Gold is that it fiendishly difficult to point to reliable relationships that hold up statistically at present. The safe haven trade has often not been evident, with gold frequently disappointing on pullbacks whilst being positively correlated with equities for much of the year until this violently broke down in November. Equally the cited relationship with inflation expectations has been rather flaky of late. It seems the best purpose and method of holding, if any, may be physically as a longer-term diversifier, as trying to predict any shorter term direction is a fools errand right now. That said, with more widespread vaccine distribution on the way, safe haven buyers may be reducing in number, reducing support.

Commodities by Category

Overall its been a strong year for most commodities ex energy, with precious metals, industrial metals and agriculturals all making good progress. In Q4 all areas made progress with the exception of precious metals. Unfortunately the impact of energy is significant, so when viewing the asset class in aggregate, the S&P GSCI index lost 6.5% for the year, but in Q4 itself gained almost 17%; and the Bloomberg Commodity index lost 3.5% for the year but was up 10% in Q4.

Forex

Dollar weakness continued universally in Q4, a trend that set in in the second quarter and has continued ever since (see asset class overview chart above). The DXY dollar index, dominated by the euro in terms of weightings, lost 4.2% in Q4 taking its 2020 loss to 6.7%. The chart below shows the gains of various developed market currencies against the dollar; and the emerging market index in aggregate.

Of these, the Australian dollar led the pack in Q4, gaining 7.4% with the currency ending the year at 0.77 whilst sterling’s Q4 gain of 5.8% in large part driven by Brexit deal relief took it to 1.367. The euro’s gain of 4.2% mirroring the dollar index loss led to a year end rate of 1.222 and the yen’s more moderate strengthening of 2.1% took the rate to 103.25. Notable within emerging market currencies was the renminbi’s quarterly gain of 3.9% to end at 6.52. It’s also worth highlighting that whilst the Brazilian real and the Russian rouble gained 7.3% and 4.1% respectively in the quarter, this still left annual losses at 29% and 20%, with the real now having tumbled to 5.19.

It might initially seem counterintuitive that the dollar is not acting as a safe haven in times like these – but the (inverse) relationship is actually between the direction of risk assets against the dollar. As can be seen from the chart below, the DXY dollar index (white line, right hand scale) has been almost perfectly negatively correlated with the MSCI All Country World Index (orange line, left hand scale), since the beginning of the sell off.

There have been various factors in the dollars demise. With the Fed having slashed interest rates to effectively zero earlier this year and no expectations for any change until 2023, interest rate differentials are no longer the draw for the dollar that they once were, with Europe, Japan and many other nations also close to zero rates (or lower) and with no imminent change. The difference between the US 10 year yield and German 10 year Bund over the year fell from 2.1% to 1.5%.

The other factor that has favoured the dollar previously was its relative growth advantage and whilst the US economy held up better than Europe and many other developed economies in 2020, markets are forward looking and this difference is expected to narrow (see growth forecasts at the top of this note). The rollout of the COVID-19 vaccines will raise growth prospects across the world.

Outlook for 2021

2021 begins with a mixture of sobriety and optimism. The US has just reported 4,000 deaths from COVID-19 in a single day and global deaths are approaching 1.9m at the time of writing. Winter (as expected) and new COVID variants (not so much expected) are conspiring to make things worse in the short term. Yet a raft of successful vaccines will surely offer solid grounds for optimism once meaningfully rolled out, coinciding with Spring in the northern hemisphere. The period in between remains uncertain and will largely depend on whether governments can persuade everyone to behave responsibly rather than just a majority – there is only so much power than governments can have in western democracies and so choices by individuals will determine the outlook as much as science, weather or medical intervention.

The markets have begun the year in ebullient mode given that the year-end additional US fiscal stimulus was approved, a Brexit deal agreed and further US stimulus is now more likely under a Biden presidency, given the outcome of the Georgia Senate races handing the Senate to the Democrats too.

The risk of a contested election never really went away completely but rather just evolved in nature. The Economist briefing from early September war gaming election outcomes including a scenario where Trump was escorted from the White House on inauguration day by the secret service proved to be not too wide of the mark and in some ways more benign than the shocking events recently witnessed. Who would have predicted that a former President from the same party would feel compelled to publicly liken the situation to that of a banana republic; or that comparisons would be made with the storming of the Capitol in 1812. From a markets perspective, it speaks volumes that the lack of concern is probably only a function of the (few) number of days that the incumbent has remaining in office.

The coming weeks will see how Biden defines his Presidency and to stick on topic to the fleshing out of policy that will determine the market perception and reaction. At present there is a net positive from the clean sweep leading to greater stimulus expectations and the fact that the result has now been certified by Congress. Coming weeks will see how much this is offset by any tax or regulatory reform; and also what other new initiatives may lead to favouring certain sectors (or not), for example renewable energy and differentiating within healthcare sub sectors.

Key to all asset classes though will be the path of bond yields, driven by growth and inflation expectations, in turn driven by the size and timing of new stimulative policies. The significant lowering in the cost of capital over 2020, as 10 year Treasury yields fell from 1.9% to 0.9%, has been one of the key supports allowing equity markets to move up so fast. Whilst it is frequently (correctly) cited that there is no precedent for analysing markets with yields at these levels and so history is of limited value, that doesn’t mean that there is a blank cheque if yields move up and discounted cash flows decrease. Clearly flows, momentum, sentiment, technicals and other factors all play a role; but ultimately maths is maths, so it will be interesting and key to see how yields and yield forecasts evolve in coming weeks.

For equity markets and other risky assets, there is no science behind how forward-looking markets are or should be, so even with all the analysis in the world, whether current levels are justified remains largely a matter of opinion. As with any area of life changing the assumptions changes the outcome and as with chimpanzees, statistically some managers will be proved right after the event, which doesn’t necessarily mean they are any smarter than those who are proved wrong. So to the question of should the MSCI World Index have gained 16% last year, there are 2 perfectly valid answers right now, but one will be redundant this time next year. This isn’t meant to trivialise or be flippant about the role of investors or the fiduciary responsibility of managers, but just to highlight the perils of trying to be too clever in the short term with unprecedented valuations, unpredecented rates and a global pandemic with an uncertain path.

What can be said about equities is that the cyclical and value rotation is likely to have further legs as the economy gradually reopens over the course of 2021 and for those with a time horizon of over 12 months this offers new opportunities. Yes things may get worse still before better, but this is of course not news to the market so should be priced in. It is no longer a punt as it would have been before the vaccine announcements beginning in November.

Within commodities, with road transport and aviation making up around half of overall oil demand and with the new year beginning with sharp output cuts from Saudi Arabia, there is further room for upside as demand returns, although much of this will be priced in and ultimately supply will return. Industrial metals had a very strong year and all constituents have returned to above pre pandemic levels so progress will now be harder with a risk that China’s demand may weaken as fiscal stimulus is dialled down. The outlook for precious metals seems at best ambiguous, given that safe haven demand will reduce and so called established relationships have been ‘disestablishing’.

The reasons for the dollar’s demise were discussed above and predictions for more of the same are in vogue at the moment alongside eye watering forecasts for equity markets. The problem with currencies is that whilst equities trend upwards over time reducing the risk the longer the time horizon, currencies are mean reverting over time, so its far easier to be wrong and more akin to gambling. For sure interest rate differentials no longer move the needle today and growth leadership is less clear. But whilst a large stimulus may increase the twin deficits, higher spending could ultimately translate to US outperformance and higher yields. Ultimately positioning can only go so far before it reverses like a pendulum.

In a not particularly festive message at the end of year briefing, the World Health Organisation warned that the coronavirus is ‘not necessarily the big one’ and also that it may become endemic and something we need to learn to live with. So despite all the grounds for optimism over vaccine rollout and what has been achieved by science, a full cyclical rotation seems premature. Overall, a conservative/incremental approach of gradual repositioning for renewed economic activity would seem to be prudent as 2021 begins.

Sources: All charts and tables are attributed within the text or within the specific chart or table, where relevant. Any data, charts or tables without explicit sources are from Bloomberg or made using data from Bloomberg.

The above commentary is as of Saturday 9th January 2021

The above is for information only and does not constitute advice