“The first lesson of economics is scarcity: there is never enough of anything to fully satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics.” “It does not matter how smart or intellectual you are, unless you can stop and think.”

 – Thomas Sowell, American economist, social theorist and free market champion.”

LAST QUARTER REVIEW 

After the phenomenal gains across global equity markets in the last few months of 2020, the first quarter of this year has seen investors rather more hesitant due to concerns of rising inflation caused by the unprecedented fiscal and monetary stimulus in the US and other developed market economies. Additionally reports of increases in Covid cases in parts of Europe and elsewhere have often spooked investors during the quarter.

However notwithstanding these concerns, most major stock

markets with the exception of China have made modest gains so far this year. Towards the end of 2020, we witnessed a rotation in market leadership both on Wall Street and in London away from the larger companies and tech giants to the perceived value of medium and smaller domestic focused stocks, together with more cyclical sectors.

This has continued so far this year as evidenced on Wall Street by the Nasdaq 100 index being up just 1.6% since January 1^st, while the broad based S&P 500 large cap index is up almost 6%, and the smaller companies based Russell 2000 has gained more than 12.5%. The UK stock-market has seen a not dissimilar pattern with the FTSE 100 up less than 4%, while the FSTE Small Cap index has risen more than 9%!

Meanwhile in government bond markets, inflation concerns have resulted in institutional investors selling their longer dated holdings causing yields at the long end of US Treasury bonds and UK gilts during the quarter to rise dramatically. During the quarter, the interest rate on the benchmark 10 year Treasury almost doubled from 0.93 to 1.73 (having touched a fifteen month high of 1.75 during March), while the yield on the 10 year gilt has more than quintupled from 0.17 to 0.86 (remember when bond yields rise values fall).

US Treasury yields have been on an upward trajectory since August as coronavirus vaccination and more future fiscal stimulus support prospects of a strong economic recovery and potentially increasing inflation. In late March Federal Reserve (Fed) Chair Jerome Powell responded to market fears by reiterating that the inflation spike is temporary and there’s no need to react to rising Treasury yields.

The Fed left the target range for its federal funds rate unchanged at 0-0.25% during its March meeting, and signaled a strong likelihood that there may be no rate hikes through 2023. Policymakers noted that indicators of economic activity and employment have turned up recently, although the sectors most adversely affected by the pandemic remained weak.

The American central bank revised up its GDP forecasts for 2021 and 2022 due to the approval of President Biden’s $1.9-trillion recovery package and the ongoing COVID-19 vaccination program. The world’s largest economy is seen growing by 6.5% this year (vs 4.2% projected in December) and by 3.3% in 2022 (vs 3.2%), while the Fed’s preferred inflationary measuring model, the personal consumption expenditures (PCE) price index is expected to rise by 2.4% in 2021 (vs 1.8%) and by 2.0% in 2022 (vs 1.9%).

Here, the Bank of England (BOE) voted unanimously to keep its benchmark interest rate on hold at a record low of 0.1% and to leave its bond-buying programme unchanged during its March 2021 meeting, saying the UK GDP was projected to recover strongly over 2021 towards pre-Covid levels and that consumer price index (CPI) inflation was expected to return towards the 2% target in the spring. BOE policymakers continued to envisage that the pace of government bond purchases could remain at around its current level, with flexibility to slow it later; but signalled that the central bank stood ready to increase the pace to ensure the effective transmission of monetary policy.

On the economic data front, the UK government borrowed £19.1 billion in February, the highest February borrowing since monthly records began in 1993. The unprecedented debt borrowing gloom was offset by news that the UK’s consumer morale came in stronger than expected in March at the highest level in a year.

Across the channel, the European Central Bank (ECB) left key interest rates at record-low levels during its March meeting, and said it would conduct emergency bond purchases at a significantly higher pace over the next quarter, aiming to bring government bond yields down and to support the Eurozone economic recovery. The ECB kept its overall inflation outlook broadly unchanged, but revised slightly up its 2021 GDP forecast to 4%, while the central bank expects the bloc to grow by 4.1% in  2022, which encouraged investors in German listed companies to push the Dax index to successive new record highs during the quarter.

In the land of the rising sun, the Bank of Japan (BOJ) left its key short-term interest rate unchanged at -0.1% and maintained the target for the 10-year Japanese government bond yield at around 0% during its March meeting, as widely expected. Meantime, the central bank decided to widen the band at which it allows long-term interest rates to move around its 0% target, amid efforts to make its ultra-easy policy more sustainable on the back of the COVID-19 pandemic and a continued battle to boost inflation.

In the currency markets, the US dollar regained most of the value it lost in the previous quarter (4%) against a basket of currencies as measured by the popular DXY index, while sterling was broadly unchanged against the greenback. Gold bullion was a big loser falling almost 10% which many sceptics cited as further evidence that the recent inflationary concerns are likely to be cyclical and short-lived as opposed to secular and a major drag on long term corporate values because the traditional market canary (in the gold mine if you’ll excuse the pun) is not signaling confirmation of an end to the long secular deflation that has prevailed since the turn of the millennium.

GDP Data shown are to the 31^st December 2020; Interest Rate, Equity & Bond Index Data are to the 31st March 2021; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.

CURRENT CONSIDERATIONS

It is apparent from reading the financial press and watching analysts and institutional investment managers on CNBC and Bloomberg TV, that the direction of future inflation is the primary key that is central to their portfolio allocation decisions. Perhaps this is understandable following the proposed $1.9 trillion fiscal stimulus bill from the American Congress and the potential $3 trillion fiscal bill for American infrastructure put forward by President Biden, when combined with the unprecedented size of the Fed’s balance sheet, which has almost doubled since the beginning of 2020 (from $4.2 trillion to more than $7.7 trillion).

However we are not overly concerned, since as we noted earlier, the Fed appears relaxed about the potential of rising inflation, and as far as bond yields are concerned most years in recent history have seen temporary spikes before the resumption of the decades old secular bull market in US Treasuries, and ever lower not higher interest rates. It is worth noting the recent views of Dr. Lacy Hunt, an economist and institutional money manager at Hoisington Investment Management in Texas who is renowned for having consistently called American long term interest rates over several decades, and who suggests that  as a result of a combination of the negative economic effects of the Covid-induced lockdowns, and the increased negative drag on growth from even more monetary, government and corporate debt, a secular inflation cycle is not at hand.

Of more immediate concern for UK investors is the likely direction of the greenback in relation to the pound, following the recent reversal in the US dollar’s fortunes. The widely followed DXY index ($ measured against a broad basket of currencies) this past quarter erased almost all the 5% losses it incurred in the last quarter of 2020, while staying unchanged against sterling.

It is perhaps too soon to tell whether this short term cyclical rise in the dollar will continue or if the consensus view of a gradual decline will resume. Whereas in the past several years due to the long running Brexit saga, the cable (sterling dollar) exchange rate resulted in a weakened pound, the reverse is now a strong possibility.

This combined with the continuing discounted value of the companies listed in London relative to the majority of Wall Street valuations suggests there is a strong argument for British investors to increase portfolio allocation to the home market. This could be achieved through a reduced exposure to highly valued overseas holdings and in particular US stocks where the currency risk could further dilute returns.

Looking at the UK market, the FTSE 100 Index tracks the performance of the 100 largest capitalized companies trading on the London Stock Exchange (LSE), and its constituents represent about 80% of the entire market capitalization of the LSE. The remaining 20% capitalisation can be found in the mid-cap FTSE 250 and FTSE Small Cap indices.

On a global capitalisation (dollar equivalent) comparison, the UK stock market is the fourth largest in the world representing 4.1% of the value of global stocks. Stocks listed in the US represent more than half of global capitalisation at almost 56%, while Japanese stocks are a distant second at 7.4% and China third at 5.4%. French listed stocks are the fifth largest by capitalisation at 2.9% followed by Switzerland and Germany, both at 2.6%, while Canada and Australia have 2.4% and 2.1% respectively with South Korean listed companies at 1.8% completing the top ten.

Anyone investing in large cap UK stocks since the FTSE 100 index was launched in January 1984 at a starting level of 1000, would have experienced a rollercoaster journey with an exciting and largely rewarding first decade and a half, as the index increased almost seven fold reaching a record high of 6930.20 on the last trading day of 1999, before the dot com crash of 2000 saw a dramatic retracement during the ensuing bear market to a low of 3,287.00 on the 12th March 2003. The FTSE index then recovered to a level of 6732.40 on the 15^th June 2007 during the cyclical bull market that followed the end of the dotcom bear market, before the collapse of the major US investment banks Bear Stearns and Lehman Brothers signalled the beginning of the sub-prime credit collapse that took the index back down to 3512.10 on the 3^rd March 2009.

The severe sub-prime bear market of 2008-9 ended when the Fed introduced its zero interest rate (ZIRP) and quantitative easing (QE) policies to stimulate the American and global economy post Lehman, and investors in UK stocks enjoyed a largely positive subsequent decade (albeit with setbacks in 2010/11 and 2014/15) until the index hit its all-time intraday high of 7930.50 and closing high of 7877.45 on the 22nd May 2018. The short-lived pandemic induced global bear market of early 2020 saw the FTSE 100 plummet to a low of 4993.90 on the 23^rd March.

While the post-Covid recovery on Wall Street resulted in the FTSE’s American counterpart index the S&P 500 hitting successive new closing highs in recent months (hitting its all-time intra-day high of 3994.41 on the last day of the quarter) and to currently be valued more than 70% higher than its bear market low of March 2020, the FTSE 100 is only a little over 30% higher and still some 15% off its record high achieved way back in May 2018!

There are many arguments put forward as to why UK large cap stocks that constitute the FTSE 100 have not in the last decade performed anywhere near as well as their counterparts listed on Wall Street that constitute the S&P 500. Included among these is the suggestion that the FTSE 100 companies are more globally diversified and have a much higher representation of energy and commodity stocks and much lower exposure to technology companies than the Wall Street index.

These are undoubtedly contributory factors, since in a normal year, about 70% of the revenues generated by FTSE 100 companies come from overseas, and so the strength or weakness of sterling relative to the currency of the country being traded with at any given point will impact upon share prices. Additionally since the decision by the British electorate to exit the European Union in June 2016, the prolonged inability of successive UK parliaments to negotiate mutually agreeable divorce terms until late 2019 would have undoubtedly made many foreign investors wary of investing in the UK stock market while sterling’s exchange rate remained volatile. 

Unfortunately, the Brexit frustration had not long been finally resolved when Covid struck early last year, and both the severity of the UK infection rates and the economic fall-out from the enforced lock-downs that followed meant the long overdue catch-up in the valuations of FTSE 100 listed stocks was nowhere near fully realised. That latent potential remains and a number of factors suggest that 2021 could well be the year when this is finally realised.

These include the belief that a cyclical if not secular commodity bull market that began last year has some way to play out, led by energy and base metal companies, largely due to short term supply being unlikely to meet the increased global demand as the developed economies all emerge from economic lockdown this year. Almost a third of the FTSE 100’s listed companies are in the materials, energy and industrials sectors that have an interest in the commodities market compared to less than 15% in the S&P 500 while the London index has less than 2% exposure to the information technology sector that has resulted in the phenomenal gains in the Nasdaq and to a lesser extent S&P 500 (28% exposure) in recent years.

Additionally, let’s not forget that in a world of negligible and often negative interest rates, to have the potential of investing in a portfolio of UK large stocks that offer an attractive yield should increasingly  appeal to both domestic and foreign institutional and private investors  on a medium to longer term outlook. The yield on the FTSE index is currently 3.12% but many selective stocks especially in the energy and materials sectors are offering in excess of 5% such as for example Rio Tinto (6.08%), Polymetal International (6.83%), BHP Group (5.41%), and BP (6.29%).

Finally, one of best ways historically to compare the relative value of competing companies, sectors or markets as represented by indices is through the price earnings ratio (PE). The PE measures a company’s (or in the case of an index the aggregate for the constituents) current share price relative to its earnings per share (EPS), and is also sometimes referred to as the price multiple or the earnings multiple.

Currently the FTSE 100 index is trading on a PE of just 26.01 compared to 40.7 for the benchmark Wall Street US large cap index the S&P 500. While it has to be recognised that no valuation measurement that has historically worked will necessarily produce the same results in the future, all of the anecdotal evidence suggests the FTSE 100 index representing UK large capitalisation stocks is on any long term measure cheap compared to most comparable markets and especially Wall Street.

FORWARD OUTLOOK

Despite a stuttering start to 2021, the global equity bull market looks set to continue for a while yet, albeit with some of the less glamorous domestic and resource based companies that have attractive yields and less challenging valuations looking the more likely winners this year and especially in the UK where many large cap stocks that make up the FTSE 100 index look especially attractive. Accordingly, we shall be seeking to gradually shift asset allocation more towards funds that offer these opportunities while commensurately reducing exposure to funds most heavily focused in the US and other foreign markets where the potential could be further constrained by a stronger pound as the UK comes out of lockdown and the economy returns to some semblance of normality.

We have been watching the developments in far eastern markets with interest, including the impressive run equities listed in Tokyo have had in the past year or so. Additionally, markets in other parts of the region such as Mumbai, while trading on relatively high PE’s remain attractive on a long term view and accordingly we shall be looking to selectively recommend a small exposure to the region through both generalist Asian funds, and emerging market funds that have a focus on the far east.

Although many market commentators see inflation concerns on the horizon, we share Jerome Powell’s view at least for the foreseeable future, and believe any inflationary spike will be short-lived. Accordingly, we remain comfortable from a portfolio diversification perspective in continuing to recommend some exposure to balanced bond funds that focus upon a combination of blue chip government debt markets (primarily US Treasuries and UK gilts) and investment grade corporate debt exposure.

While we remain optimistic about the potential gain for investors in 2021, helped by the combination of fiscal and monetary stimulus that should drive global stock and bond markets, there are concerns that temper any over enthusiasm. These as referred to previously include the precarious government and corporate debt liabilities that exist in most major economies post Covid, and especially considering the debt-to-GDP ratios in the US (129%), UK (109%), Italy (165%), France (118%) and Japan (271%).

Additionally stock valuations particularly on Wall Street remain at excessive levels by historical standards. The gradual re-balancing recommendations we referred to above should help ensure capital preservation via more defensively positioned portfolios, while retaining optimally risk-adjusted returns. 

As always, investment risk is at the forefront of our advice and, whilst it is often necessary to undertake adjustments in portfolio allocation in order to maintain individual preferences, we are confident that our advised portfolios remain well placed in meeting our clients’ needs.

Copyright © Ash-Ridge Asset Management 1^st April 2021.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; Macro Voices; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.

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