Value stocks outperformed momentum by almost 30% in November, but then gave back a third of this by the beginning of 2021 (Figure 1). Is the Georgia vote and Democrat win in the Senate the catalyst that reverses this? US investors did not think Senate control would switch to the Democrats, yet former president Donald Trump alienated centrist votes with allegations of stolen elections, which energised Democrats. If you include the casting vote of the vice president they now have a majority in the Senate.
However, it will still be difficult for the Democrats to enact any radical plans with such a thin majority in both houses of Congress, at least until the mid-term elections in 2022. At that point the Republicans will have 21 Senate seats to defend while the Democrats will have only 13.1 There are subtle things that the Biden presidency can do until that time, but Biden himself is a known quantity having been in office as VP for eight years under Barack Obama. We can expect reflationary policies, infrastructure spending and a focus on renewables – all of which will be expansionary. The recent $900 billion stimulus package2 is likely to be enhanced with another of a similar size.
Senate rules dictate that most legislation requires 60 votes to pass or avoid the filibuster, the exceptions being the annual budget reconciliation and Supreme Court nominations. Until the mid-terms, the Biden administration could force through additional stimulus and some tax increases but could not pass any contentious regulatory changes without Republican cooperation. The implications of this are likely a continuity of policy relating to economic reopening, vaccine rollout and fiscal and monetary stimulus. All of which is likely to reinforce the shift towards reflation and value stocks.
The side effects are higher inflation expectations and therefore bond yields. Figure 2 shows the compelling correlation between inflation break-evens/forwards and the 10-year US Treasury bond yield. This gap could at least partially close.
For the first time since the global financial crisis, US inflation expectations, as measured by five- year break-evens, have risen above that for the subsequent five years as measured by 5Y5Y break-evens.3 Though currently small, it indicates that investors are beginning to consider a return of inflation over the medium term.
It is surprising how many people think that yields cannot go up because of quantitative easing. The correlation between bond yields and the equity market direction is in fact positive. The general view of 2018 is that bond yields rose from 1.5% to 3% and the market sold off. In fact, in the first nine months of the year yields went from 2% to 3% and equity prices rose.4 Equities sold off thereafter because PMIs collapsed as a result of global trade uncertainty and because the US Federal Reserve chairman, Jay Powell, said interest rates were a long way from neutral.5
The key issue is not the level of yields but the reason for any move. If yields are moving up due to convergence, easing of trade disputes, commodity prices rising, the money supply rising in China and elsewhere, and PMIs moving up sustainably, then the rise in yields will be perceived positively. For this reason, we don’t believe a move in the US 10-year yield – for example a rise from 1% to 1.5% or even 1.75% – should necessarily be taken as a negative.
Despite another surge in Covid-19 cases and lockdowns all over Europe, actual economic data is improving: French consumer confidence improved in December 20206, while German retail sales and factory orders were also improving.7 The ISM manufacturing survey for December was strong with new orders at 67.9 and prices paid at 77.8 In mid-December the Atlanta Fed GDP Nowcast forecast was indicating 9% GDP growth for Q4 2020 as well as a very strong Q1 2021, given the recently passed fiscal stimulus.9
In terms of sectors, cyclical technology such as semiconductors should do well. Regulatory tightening will be limited to enforcement actions and executive orders rather than wholesale regulation of technology. Financials obviously benefit from rising yields. Utilities are also attractive because of the green agenda. Going forward, President Biden will be speaking regularly about the Paris Accord (one of his first orders of business was to rejoin the agreement10) and renewables and this should be positive for a large section of utilities. What is less attractive in a rising yield environment is healthcare, consumer staples and media.
A big gap has opened up between technology sector performance and its relative earnings revisions. It is not true to say that tech earnings are not growing, but relative to the rest of the economy they are not growing as fast. Some claim technology is in a bubble, but we do not agree. This is not 2000-01. The structural story is still strong and buybacks are still happening. But technology delivered supernormal returns in 2020, helped by a 100bps plunge in the discount rate.11 If Covid-19 now gets priced out, then the rest of the market will get repriced. Technology sector earnings will still grow structurally but the rest of market will grow faster.
Healthcare earnings and price performance follow each other closely. The sector looks cheap and has good earnings momentum. Political risk is not high because the Democrats do not have a sufficient majority to carry out dramatic reform of US healthcare. But over the next one to two years the sector’s earnings relative will turn negative, and in that scenario it is difficult to see the sector outperforming, especially if the US dollar is weaker. Stock performance will follow relative earnings momentum.
For some portfolios we are considering carefully our exposure to consumer cyclicals: autos, aerospace and travel etc, as well as financials, mining, steel and construction. From around Q2 this year, household savings that have built up over the past year will start hitting the economy. Money supply shot up everywhere in 2020 and tends to lead the PMI by around nine months. This is not yet discounted in bond yields, which are strongly correlated with PMIs.
Traditional cyclicals have already done well. Bond yields are still some way from inflation forwards. QE might stop US bond yields from backing up to 2.5% or 3%, but it is hard to see how they do not back up to 1.5% or higher. This move will be less extreme in Europe because the European Central Bank intends to buy all of the bonds issued by European governments this year, plus €350 billion on top.12 Meanwhile, the Fed will be buying $600 billion less than what the government is issuing, so the yield effect will be much stronger in the US. These are wartime levels of government bond issuance.
After 40 years with budget and current account deficits of around 3%, the US budget deficit in 2021 will be in the high teens after similar levels in 2020.13 The deficit could remain close to double digit levels for years. The Fed has stated it will continue to stimulate even if we return to full employment because it believes the Phillips curve is flat. Powell stated that he would continue to stimulate even if core PCE rises above 2%, as the aim now is to target medium-term average inflation from now on. As the core PCE has remained below 2% for the past 11 years, this suggests the Fed will tolerate core PCE at double this level (ie 4%) in forthcoming years in order to get the 15-year average back to 2%.14
This is very different policy from that seen in the past few decades. Persistent accommodation from the Fed will ensure strong flows of offshore dollars which will bolster global trade (Figure 3) and fund EM investment, raising growth and asset returns in emerging markets.
The combination of $700 billion of QE and $800 billion of Treasury drawdowns may guarantee strong money supply growth in the coming months. Banks themselves went into the lockdown with three times the amount of capital and twice the liquidity compared to what they held during the global financial crisis (Figure 4). Delinquencies have fallen and lending should surge from here, in sharp contrast to the experience in the financial crisis when contracting loan books offset 80% of the positive liquidity effect of QE.
The consensus is that there will be no meaningful inflation and bond yields cannot go up very much. But the Fed’s policy of average inflation targeting means that much higher levels of inflation will be tolerated before rates rise or the Fed starts to taper. A year ago, US yields were at 1.9%. Despite going much lower in the interim they are only at 1% now, despite the biggest fiscal and monetary stimulus of all time.15 Why could they not go back to where they were at the start of 2020 if Covid-19 starts to be priced out?
However, a steepening can only go so far, otherwise fixed income investors would start buying the carry along the curve. If short rates remain at zero, the curve can’t steepen that much. We should begin to start seeing some normalisation from around the middle of this year. More cheques will start to arrive in the hands of US households in the next two weeks. Several million people are still waiting for original $1,200 cheque to arrive.16 This fiscal largesse has led to US net debt ballooning from 75% of GDP in 2019 to 98% in 2020, and might reach as high as 110% in 2021.17 If the Biden administration wants to add to its majority at the mid-terms it could do more.
Central banks might not want to do more but governments most likely will. H2 will begin with stronger PMIs and hopefully no more Covid shocks. Central banks will not reverse their current policies even if they do not do more monetary easing, and will increasingly fall behind the curve. This is already showing up in wild swings in bitcoin and the volume of IPOs. It is likely we will see a new leg of the value rally when the market starts to extrapolate what is going to happen in H2 2021. It might not be as extreme as in 2016 because the positioning is not as extreme as it was then. Cyclicals and commodities had a huge collapse in 2015 when it was feared that China was going into recession and the renminbi would devalue. China is not doing as much now as it did at the end of 2015, which turned the situation around. Corporates have not collapsed as much over the past year as they did in late 2015. Central banks got even more involved during the pandemic, meaning bond yields might not double but just back up to 1.5%, for example.
Bank lending standards are easing. The ability of banks to support the economy is normalising. It is hardly surprising that the credit market is in fine fettle given that the money supply is ballooning everywhere. The velocity of money collapsed last year. But if it stabilises and then picks up, it is likely to lead to inflationary pressures. This is different from Japan where the velocity of money has been falling for years due to property and other losses and banks not recognising them. Deleveraging became a self-fulfilling problem; animal spirits never returned in Japan. In the US, on the other hand, wage growth is once again accelerating and house prices are rising. The market PE is positively correlated with earnings revisions. While they stay positive, valuations will be supported.
Global economic surprise indices remain very high. They have been for six months but show no sign of rolling over. Earnings surprises tend to follow economic surprises over time, and while earnings revisions are at 10-year highs they are still lagging economic surprises. This suggests the risk to consensus is on the upside not the downside. The same picture emerges when you look at relative earnings revisions of cyclicals versus defensives. When assessing earnings growth in the US and eurozone, analysts are usually too optimistic. The only time brokers were too conservative was in the recovery years of 2003 and 2009-10. Recoveries in turnaround years usually see earnings upgraded, not downgraded. Earnings growth in 2021 should be believed and possibly exceeded.
If US bond yields go up a lot, the dollar will be supported. The dollar is a risk-off currency and in a global reflationary scenario is likely to weaken further. There is a clear inverse correlation between the global equity market and the dollar. This is doubly true for emerging markets. EM only really rallies when the dollar falls. A weaker dollar is another support for the rotation reflation trade.
The next year looks extremely positive for risk assets with strong economic growth coupled with monetary and fiscal stimulus. Consumers will start to travel and spend again, thanks to the savings they racked up during the various lockdowns (Figure 5). CEOs and CFOs who are currently reluctant to spend and invest will begin to anticipate the upturn in consumer demand and start to increase capex, helped by easy credit conditions (Figure 6).
All of this is happening just as policy uncertainty is falling.
The decade since the end of the global financial crisis was marked by a bull market in the dollar and the outperformance of developed markets versus EM, and growth stocks versus cyclicals and financials. The macroeconomic picture is now changing and the dollar is likely to weaken in the medium term, which will help EM assets, cyclicals and value stocks generally. The US budget deficit will be much larger than would have been the case with a Republican-controlled senate. This is bearish for the dollar since higher overall demand (and government spending) will force the US output gap to close much faster than would have been the case. This will raise domestic inflation and, if the Fed takes no action, will push real rates down further still, which again will lower the dollar.
The US current account deficit helps to fund investment. If the budget deficit remains at high levels, foreign investors will demand a higher risk premium on US assets via higher yields and/or a lower exchange rate. Given that the Fed has committed to keep interest rates (and yields) at low levels, it is the level of the dollar that will have to give (Figure 8).
Biden has committed to raise levels of corporate and personal income taxes (Figure 9). That might not be easy to do in the first year, but after the mid-term elections it might get easier.
That will lower the return on capital of US investments and potentially be another reason why US equities might become less attractive to foreign investors (Figure 10).
The world’s two largest economies are recovering fast. China has already moved beyond its pre- Covid levels of output, while in the US the run rate is only 0.9% below those levels, if the Atlanta Fed Nowcast forecasts of Q4 GDP are correct.18 Though economies will reopen this year, things will not ever be quite the same again. Will business travel return to former levels or office workers ever fully work from city centre offices again? Is high street retail damaged for good? Retail employs around 10% of all workers in the US and the UK, most in bricks-and-mortar locations.
The (earnings) yield premium on technology stocks versus the US 10-year US Treasury bond yield is at the 2.5% level which has anticipated the last four market corrections, so there could be some short-term turbulence. But after that, loose monetary policy, new fiscal stimulus and a bounce back in economies mean it is too early to get fundamentally cautious on equities.
1 Washington Post, Why Senate Republicans start the next cycle from a position of strength, 4 December 2020 2 FT.com, US Congress approves $900bn stimulus package, 22 December 2020
3 Bloomberg, January 2021 4 Bloomberg, January 2021 5 FT.com, Stocks rally after Powell says US interest rates nearing ‘neutral’, 28 November 2018 6 Business Insider, French Consumer Confidence Improves In December, 6 January 2021 7 Reuters, German retail sales rebound before partial lockdown, 2 December 2020 8 ISM Manufacturing Report on Business, December 2020 9 Federal Reserve Bank of Atlanta, December 2020 10 FT.com, What the US rejoining the Paris accord means for climate policy, 22 January 2021 11 Bloomberg, January 2021 12 FT.com, ECB to gobble up more debt next year than governments can sell, 29 October 2020 13 Bloomberg, January 2021 14 Bloomberg, 2021 15 Bloomberg, January 2021 16 CNBC, Still waiting for a $1,200 stimulus check? Lawmakers urge more action to get outstanding money to Americans, 4 December 2020 17 Reuters, U.S. starts fiscal 2021 with 111% jump in October deficit, 12 November 2020 18 Federal Reserve Bank of Atlanta, January 2021
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