Macro Overview
The story of the quarter was that global manufacturing managed to shake off a series of new lockdowns, particularly in Europe and the UK but also in California and some of the more northern US States. Japan didn’t lockdown but did impose another state of emergency in some regions.
Indeed, many businesses had hunkered down for a manufacturing Armageddon which in reality proved fleeting. Instead shortages, particularly in the automobile and semiconductor industries became commonplace.
Several of the manufacturing companies we spoke to estimate that it will take six to nine months to rebuild supply chains and alleviate all shortages. It was also mentioned that the supply chains won’t all be reconstructed exactly as before, with more local content and buffer inventory now being actively encouraged.
The extent of the boom is depicted below, as many gauges of manufacturing activity and confidence have reached multi-decade highs.
Another big change since November has been the evolution of the geopolitical jousting between the US and China.
President Biden has been adamant that the US will outspend China on innovation and infrastructure and that China won’t become the world’s wealthiest or most powerful country in the world on his watch. Putting his country’s money where his mouth is he proposed a further $2.25 trillion fiscal package for consideration later this year which would be concentrated on infrastructure, digitalisation and a ‘greener’ economy. As a reminder, China has earmarked $1.5 trillion for investment on semiconductors alone over the next decade so we are likely at the start of an innovation and infrastructure spending competition which will help the real economy for the foreseeable future, if not budget deficits.
The EU’s incoherent vaccine non-policy was the best present Brexiteers could have hoped for and has meant that Europe is likely to be at the tail end of the recovery sequence, along with certain Latin American countries.
In China the Services part of the economy has recovered well and, in the US, a very big improvement has developed as more government cheques have arrived at a time when lockdowns were generally easing – a potent mix in a consumer society. The UK should be next beginning in April with our Continental friends one, or at the most, two quarters behind.
Chart Two; PMIs have been improving
Several Emerging Markets have danced to their own tune and actually dared to raise interest rates, for idiosyncratic reasons, during Q1. Commentators do not view this as an automatic reaction to rising US bond yields and dollar strength as would have been the case in the past. China has not raised rates but the authorities have instructed banks to limit the amount of credit they extend this year and given them quotas for lending to small businesses. This is the Chinese attempt to prevent overheating whilst not derailing the economic recovery.
Markets
Bond yields finally began to move higher despite the extreme interventions from Central Banks in a concerted effort to keep yields artificially low. The ECB even began to accelerate interventions in response to a very modest rise in yields. This is a reaction to economic numbers generally being much better than feared.
As depicted above investors globally, including those in the UK market have increasingly embraced the reopening story with regards the economy and economically sensitive stocks continued the outperformance which began on November 9th after the vaccine breakthrough was announced. This has happened more or less around the globe. The table below highlights how dramatic the recovery has been in many instances. It also highlights which companies have recovered more of their total enterprise value (combined value of their equity and debt) via a share price recovery as opposed to mostly through taking on more debt (which could imperil the company in the future).
The table below shows the performance of certain key asset markets during the quarter;
In many markets individual participation in markets has risen to extremes and with it pockets of speculation, even wild speculation, have arisen. The exponential rise in the number of Special Purpose Acquisition Companies (SPAC’s) and the activity of traders inspired by Reddit and Robin Hood platforms in previously inconspicuous stocks like GameStop. The former are companies with no specific business plan except to buy other companies whilst the latter see multi decade share price movements condensed into a few weeks or even days. The ascension of both phenomena doesn’t attest to a market dominated by long term circumspect investors and are likely to end in disaster, at least on a localised level.
Late in the quarter Nomura, Credit Suisse and several other global banks all suffered meaningful share price declines after a big US based hedge fund (Archegos) had the rug pulled from under it by its main brokers and was therefore forced to liquidate positions at unfavourable prices. This is just another example of how high leverage in financial markets seldom ends well. We have attempted to stay well clear of this type of activity regardless of how in vogue it is for a period. We won’t change this approach.
Another development that bears watching is a sea change in the Corporation Tax regime. UK Corporation Tax increases are likely to take 3-6% off of 2023 earnings per share for both the FTSE 100 and FTSE 250 Companies and President Biden’s mooted increase in US Corporation Tax to 28% would decrease S&P 500 EPS by 8% if enacted in full. Markets are not too bothered by those distant events at the moment but they could cause ripples as the dates draw closer.
Activity & Positioning
Last year at this time we were piling into equities as we considered it a once in a decade opportunity to buy. Humans had recovered from the Black Death, Great Plague and Spanish Flu (as well the more recent SAARS) so it was likely that more modern medicines and more robust social safety nets would enable a faster and more robust recovery this time round. Thus far the thesis has played out and therefore we have begun to slowly take our equity level down to a less elevated level as prices and valuations have recovered very quickly and bond yields have risen significantly from the pandemic lows.
We still consider equities our preferred asset class and within equities still consider small and mid-cap stocks as offering the best risk reward. However, just as we stuck to our principles amidst the tumult of Q1 2020 and bought more, we will stick to them now and therefore incrementally take some money off the table.
Figure 2. Portfolio changes in Q1 – RJIS
Please note that we are just finishing our due diligence on some Japan funds we have been considering for a while so most of the money raised from the JO Hambro Japan sale will be recycled and doesn’t represent a permanent step function increase in cash levels. Although we think our moves represent good housekeeping we do bear in mind that there was already pent up demand in sectors associated with both domestic UK and global trade before the pandemic struck. There is now even more pent up demand and the recovery is, at best, nascent. Therefore, it is not appropriate to go underweight equities, especially as governments and Central Banks seem hell bent on supporting the recovery until they think it is robust enough to be self-sustaining. When one adds to this that valuation spreads within and between markets were at, or close to, all-time highs as far back as 2019 then there is certainly still money to be made as the travails of a protracted Brexit and US-China Trade War are left behind.
Some of the larger names we considered overpriced through 2018 and 2019 have now underperformed by over 30% and we will reconsider adding on a case by case basis in order to balance our twin goals of generating attractive absolute returns over time whilst paying heed to appropriate volatility levels for each of our client portfolios. On the other hand, some cyclical sectors have re-emerged into the limelight with ‘’Dr Copper’’ stealing the show as both a mainstay of traditional manufacturing and construction activity and as a vital play on the growth of Electric Vehicle sales. Whist, as noted above, we are proponents of both a strong and protracted recovery from COVID we need to continually be alert for signs of over exuberance in financial markets and short-term industrial commodities could be such an example.
Whilst there may be a short-term contra trend rally in government bonds we still consider this a much riskier proposition than it is meant to be as both growth and inflation are picking up. There is pent up demand combined with supply destruction (e.g. airlines, hotels and pubs going bust) and there has been huge build ups in government debt from already elevated levels. With real yields still very negative in most of the developed world we think the unwinding of ultra-low rates still has a long way to go, in spite of the efforts of Central Banks.
We are using the short-term US Bond ETF we bought more as a dollar proxy than a bond holding as we thought the dollar was due a rally against Sterling which has rallied from around $1.16 to over $1.40 since the March 2020 low. The Chinese Bond fund was bought because that market still offers real yields (and a nominal yield of c.3.5%) and the RMB is likely to appreciate modestly against Sterling in the coming years. Historically the market has performed well in risk off periods and therefore has an added attraction as a diversifier. Chinese bonds are also grossly underrepresented in global indices relative to their market value and this is now in the process of changing, further bolstering demand.
Conclusion
Equities remain our preferred asset class although the dramatic rise in prices over the last twelve months means opportunities are not as compelling as they were last year. However, not all equities are created equal and we must remember that authorities have taken unprecedented action to help the real economy recover from the pandemic induced meltdown. We should also note that the economic calamity that many had been predicting since about 2015 has finally came to pass and it is likely we are close to emerging out the other side.
On the policy side the Federal Reserve and the ECB have already made it clear that they are in no hurry to remove their ultra-accommodative stance. When one considers all of these factors in conjunction with the gigantic spending targets from China and the US mentioned above then it is unlikely there will be a dearth of growth globally anytime soon, especially as many companies have used COVID as a touch paper to rapidly accelerate their rate of change and productivity enhancements. Therefore, we look to systematically add back to equities on any near term set back of the type which form a natural part of a market lifecycle.
Current Asset Allocation
Important Information/Risk Factors:
Past performance is not a guide to future performance and investment markets and conditions can change rapidly. Investments in equity markets will be more volatile than an investment in cash or fixed deposits. The value of your investment may go down as well as up. There is no guarantee you will get back the amount invested. If your fund invests in overseas markets, currents movements may affect both the income received and the capital value of your investment. If it invests in the shares of small companies, in emerging markets, or in a single country or sector, it may be less liquid and more volatile than a broadly diversified fund investing in developed equity markets.
The views expressed herein should not be relied upon when making investment decisions. The article is not intended as individual advice and if you require advice or further information you should contact us.