Quarterly Investment Update: Cyclical risks to earnings continue to fade

That goes hand in hand with rising bond yields, but equity investors needn’t be overly concerned.


The diminishing cyclical risks that we noted in our last quarterly update have continued to fade. This has reinforced the shift we highlighted then to a more positive outlook on more cyclically sensitive geographies and sectors.

Economic activity has proven more resilient to lockdowns and non-pharmaceutical interventions than expected. Positive economic surprises – by which we mean data coming in above consensus expectations – have been maintained even in the UK and Europe where lockdowns have been harsher and more protracted than first anticipated. This is important because economic surprises have correlated significantly with equity returns over the last few years, and especially the last 18 months.

Hospitalizations and deaths from COVID have fallen significantly as the northern hemisphere emerged from winter and vaccination programmes have begun in earnest. That lessens the likelihood of future lockdowns. Of course we’re not out of the woods: there are still question marks over new strains and the efficacy of vaccines. We’re not epidemiologists so we’re not in a position to dismiss them entirely, but we note increasing evidence from Israel and the US that while vaccines may not stop people contracting the disease from mutated strains, they are extremely effective at preventing new strains from causing hospitalization and death. And hospitalisations and deaths dictate the stringency of government restrictions more than the number of cases.

Europe’s new wave

Admissions to intensive care units have increased alarmingly in France and Italy, as the more transmissible and possibly twice as deadly “Kent strain” that contributed to the UK’s bad winter runs amok. That hasn’t stopped the eurozone equity benchmark from being one of the best performers in March. The reasons for this are threefold: First, its manufacturing sector has become more adept at working through lockdowns. It is also buoyed by strong global demand, which we discuss below. Business surveys for March confirmed the ongoing improvement in business confidence, notably for manufacturing. The Belgian business confidence indicator is one of our favourite gauges of eurozone health because the companies it surveys are more focused on selling into the single market than outside of it: it has returned to a level not seen since early 2019. Second, while gauges of service sector activity are still contractionary, they too are coming in stronger than expected. In March the services component of Germany’s long-established Ifo survey saw the first positive reading since October. Third, the European Central Bank has responded proactively and increased the pace of its liquidity injections.

The return to trend

"Leading economic indicators are soaring, particularly in the US, with the Philadelphia Fed's business activity index hitting a 48-year high in mid March."

Thinking more broadly, if last year was more about a market recovery than a recovery in the real economy, 2021 looks set to turn that epithet on its head. Indeed, global trade and global industrial production are already back above pre-COVID levels. Global GDP and US GDP will almost certainly be back above the waterline in the next couple of months. In our opinion it will be at least a year before UK GDP and that of harder hit eurozone economies will be back above their pre-COVID levels, and there is a risk that these economies will never recoup lost ground and get back to the level of GDP implied by the pre-COVID trend – in other words there will be an element of permanent damage done. The UK’s Office for Budget Responsibility put that permanent destruction at 3% of GDP. This may prove overly pessimistic, but we would like to see more supply-side, investment-boosting policies to help ward that off. You can read more of our views on the UK economy and the policy stance in our Budget update.

Importantly, global and US GDP is likely to get back to the pre-COVID trend, and we are global investors after all. Even when we invest in the UK and Europe we tend to access global earnings. Leading economic indicators are soaring, particularly in the US – the Federal Reserve (Fed) Bank of Philadelphia’s business activity index hit a 48-year high in mid March. And if their historic relationship with monetary indicators such as the yield curve, the money supply or policy rates is anything to go by, they are likely to stay strong for another nine months or so. Consumer confidence is middling, consistent with a lagging employment recovery, but it’s around where it was between 2012 and 2015 when consumption growth was decent enough. Moreover, a less than euphoric consumer is no bad thing this year given the risks to inflation and monetary policy that might pose.

The US has passed an almighty stimulus bill, equating to c.$1.35 trillion this calendar year, with a further half trillion on the books for the following years. It makes other countries’ plans look stingy, but they are not. Most major developed markets have been exceedingly generous again when it comes to fiscal stimulus and COVID relief measures.

The consumer boom and inflation

The bulk is directed at supporting household income, and a lot of household income has been saved as we discussed last quarter. We expect a fair amount to be spent this year, but we expect savings to remain elevated. The extent to which households spend the $1400 stimulus cheques being mailed out in the States now will be an important clue to the extent of the consumer boom. We note that Donald Trump’s final $600 cheques and bonus unemployment benefits resulted in a $2 trillion month-on-month increase in transfer payments in January. Without them, total personal income would have been more or less unchanged. Yet consumer spending increased by just $350 billion. For sure, consumers are often a little shy in January after the hedonism of the holiday season, but February’s retail sales decreased by 3% despite the substantial easing of stay at home orders.

"A one off splurge doesn't necessarily translate into higher inflation."

Evidence from academic studies and the US Census Bureau suggests that lower income households didn’t amass any savings anyway, and wealthier households may not have much need to draw them down because they spend more on services which are less easily pent up (there are only so many holidays a working household can take, for example). A stronger argument can be made for the wall of cash fuelling more asset price inflation – just look at US house prices, which rose at their fastest pace in 15 years in January.

A one-off splurge doesn’t necessarily translate into higher inflation, especially when there is still room for supply to meet demand from the spare capacity in the economy. A perfect storm of factors will drive up prices sharply in the spring. We expect the annual increase in the US consumer price index to breach 3%, potentially 3.5% by May. Importantly, we don’t expect this to turn into the runaway inflation that would cause policymakers to remove fiscal and monetary support and jeopardise the rally in equity markets. This is an important dynamic to understand and we encourage investors to read our latest InvestmentUpdate dedicated to it.

Earnings and bond yields to rise

To sum up what we have discussed so far, we have economies that are more resilient to lockdowns; we have less need for lockdowns as COVID hospitalisations and deaths have fallen considerably; we have huge government support programmes continuing this year; we have easy monetary and financial conditions; and we have a consumption boom ahead of us, but one that is unlikely to be so great that it destabilises inflation. Yes, there are still some risks around long-term scarring, particularly in the UK and Europe, but the global economy appears to be getting back on track. This points to a strong year for earnings, but rising earnings go hand in hand with rising bond yields.

Indeed, the key risk to equities markets in 2021 is a further surge in real (inflation adjusted) yields on US Treasuries. Treasury yields are the benchmark for discounting tomorrow’s earnings into today’s price and so, mechanically, a higher rate means lower equity valuations, holding all other things equal. But all other things aren’t equal, and it is too simplistic to assume that rising rates mean falling equity markets because rising real yields typically go hand in hand with rising real and nominal earnings growth and increasing investor sentiment. In other words, investors demanding a lower premium for the risk of investing in equities and expecting higher long-term growth.

"Since last June, our view has favoured tilting towards quality companies with cyclical earnings found in the middle of the growth-value continuum."

We’ve analysed different sample periods and cut data different ways, finding repeatedly that rising real bond yields are usually associated with good equity returns – and often above-average ones. Rising short term/policy rates are a different matter, particularly when they rise above the neutral rate. In other words, central bankers tightening rates too far are much scarier than the’bond vigilantes’ pushing up yields. Short-term real rates – even as far out as 5 years –  are actually lower today than they were at the start of the year, and central banker policy rates are highly unlikely to rise over the next 12 months.

Of course rising yields will change market leadership; companies expected to deliver the greatest long-term earnings growth are unlikely to lead as the rate for discounting those future earnings goes up. Since last June, our view has favoured tilting towards quality companies with cyclical earnings found in the middle of the growth-value continuum. And we’ve re-emphasised that with increasing conviction each quarter since.

That said, our dissection of equity performance during the February-March bond rout revealed that while there was a clear linear relationship between some growth metrics and performance (i.e. incrementally worse performance the higher a stock ranks) not all did. Moreover, even those metrics with a linear relationship only saw negative returns for the top 10 percent. The median return among stocks in the next ten percent of most growth rankings beat the equity benchmark. In other words, you don’t have to move very far down the growth spectrum in order to protect your portfolios from rising rates, if the last two months are relevant for the remaining months of the year, which we believe they are. With a year-end target of c.2% for 10-year US Treasury yields (from c.1.7% at the time of writing), we think the worst of the bond rout is behind us. But there is more risk that yields overshoot than undershoot, and it is still important to be mindful of the growth/value dynamic. Still, our analysis suggests capital loss isn’t a fore-gone conclusion for growth aficionados.

US-China tensions build again

The first high-level meeting of US and Chinese officials took place in Alaska this month. President Biden has brought a ceasefire to his predecessor’s trade war, but this meeting confirmed that we were right to warn investors against expecting détente. As we wrote in our pre-election report Biden versus Trump the tactics President Biden may employ will be different, but the tenet of his stance on Chinese trade is nearly identical to Mr Trump’s.

The recent increase in Chinese military activities around Taiwan is unnerving some commentators. Reading Beijing’s true intentions is always difficult, but we are sceptical that a hot war is likely, mainly because attacking Taiwan would set back, rather than advance, China’s goal of becoming more self-sufficient in microchip technologies. Indeed, improving manufacturing capabilities is at the centre of the 14th five-year plan (FYP) for 2021-25 just passed by the National People’s Congress, and we conclude this quarter’s update by running through the salient features.

China’s new Five-Year Plan

The new FYP has abandoned its tradition of setting an overall economic growth target. Instead, the Congress will propose a pragmatic target each year. For 2021, GDP growth is set to be at least 6%, an easy target to beat given the COVID recovery still has further to run. With words such as “quality” and “innovation” frequently appearing throughout the plan, the switch of emphasis away from quantity signals the government’s intention to manage a controlled slowdown of China’s growth trajectory while tackling internal financial stability risks. This return to the pre-pandemic prudential policy stance is already evident in rising interbank rates and tighter loan conditions. An official long-term target has also disappeared, replaced by the woollier goal of becoming a “moderately developed country” by 2035. This implies average annual growth of 4.7%.

For most of the past four decades, China’s de facto economic motto has been to “reform” and “open up”, but given trade tensions and the general turn in international politics, China has adopted a new economic plan, the recently named “dual circulation”. It is a strategy to promote a self-sufficient economic ecosystem. However, this is easier said than done. The “Made in China 2025” initiative announced in 2015 proposed that China should achieve 70% self-sufficiency in semi-conductor production by 2025; with only c.30% self-sufficiency today, China achieved no meaningful increase. Strategic Emerging Industries (SEIs) did not gain as much ground during 2016-2020 as had been targeted: their share of GDP rose from 8% to 11.5% in 2019, well below the 15% goal.

The new plan aims to increase SEIs to over 17% by 2025. SEIs are defined to include some parts of the service sector, such as digital creative arts, but manufacturing is more dominant than before, including high-end equipment, advanced materials and green energy technology including electric vehicles. Interestingly, Beijing has axed the goal of increasing the service sector’s share of output, reflecting its desire for self-sufficiency as well as financial prudence (service sector growth has been concentrated in finance and property as well as giant technology firms which are now subject to anti-trust probes). The 14th FYP calls for at least 7% growth in R&D expenditure per year in the next five years to upgrade domestic suppliers’ product offerings. Results aren’t guaranteed and perhaps this explains why the target is not more ambitious: R&D as a percent of GDP will still be below America’s.

"China has adopted a new economic plan, the recently named “dual circulation”. It is a strategy to promote a self-sufficient economic ecosystem."

Infrastructure and real estate investment led China’s economic recovery in 2020, but these supports are likely to be withdrawn, although corporate investment is expected to pick up. The normalisation of the official budget deficit and local-government off-balance financing will be gradual, but the infrastructure targets set for the next five years have been cut down meaningfully relative to the previous FYP. The property sector will soon feel the pinch from the limited availability of bank loans, alongside slower rates of urbanisation and urban household formation. At face value the FYP contains a punchy urbanisation target, but most of this is achieved through reclassification not migration. The reiteration of houses “for living and not speculation” during the People’s Congress, the reduction in permitted new land for construction and the potential implementation of property tax add to the headwind.

China is the world’s largest emitter of carbon dioxide, and it’s worth noting its ambitious pledge of “peak emissions by 2030, carbon neutrality by 2060”.  The transition could further lower China’s growth trajectory because of necessary sectoral adjustments, but that could be offset by higher (green) investment. According to the Tsinghua University Institute of Climate Change and Sustainable Development, the goal of achieving carbon neutrality by 2060 is in line with the global endeavour to limit global temperatures to 1.5°C above pre-industrial levels by 2050. To accomplish this goal, China’s energy system will need new investment of about 138 trillion yuan ($21 trillion) by 2050, equivalent to over 2% of GDP.

Such transformation will also bring new jobs as the renewable energy sector employs 1.5 to 3 times more people per unit of capacity compared to the traditional energy sector.

All in all, while China welcomes more foreign trade and direct investment, the political reality dominates the shift in its economic strategy towards boosting domestic demand and building up resilient and advanced internal supply chains. In the near term, as growth momentum continues, the lagging progress made in China’s vaccination programme and already slowing credit growth could catch investors off guard. Consequently, investment opportunities in China, while no doubt abundant, could become more idiosyncratic.

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