Hopes for global economic recovery are still pinned on a successful vaccine rollout which should allow services and consumption to catch up with the rebound in manufacturing. With monetary policy remaining supportive and more fiscal stimulus expected, there is increasing optimism that growth will surprise on the upside enabling equities to make further gains. Although central banks have reiterated their willingness to look through a temporary rise in inflation as a result of supply disruptions during the pandemic, bond investors are concerned that quantitative easing could be tapered earlier than anticipated.
The upward momentum in equity markets continued during the first part of February with the US recording another all-time high mid-month before giving back some of the gains. UK equities rose in line with other markets in local currency terms but sterling appreciation eroded returns on international investments. After tracking higher since late 2020 alongside the economic recovery, bond yields have risen sharply in recent weeks causing increased equity volatility. Having started the year around 91bp, US 10-year yields breached 160bp in late February albeit this is below the 200bp pre-pandemic. In the UK, they touched 84bp – against last August’s 6bp low – and are now back at their pre-pandemic level. While the normalisation of nominal yields is part and parcel of economic recovery, real inflation-adjusted yields are also starting to rise. These are still negative – and therefore broadly supportive of growth – and we doubt that central banks would allow a move into positive territory given borrowing costs above inflation limit wealth creation. Higher prices for commodities such as copper and Brent crude, which closed at $66, reflect a combination of restricted supply and an uptick in demand. Gold eased back to $1,728 on higher real yields.
The global economy continues to strengthen but with a marked differential between China, the US and Eurozone. Global GDP estimates of 5.2% this year follow a 3.5% contraction in 2020 and developed economies (4.3%) are expected to lag emerging ones (6.4%). China’s GDP could expand by over 8% before settling at a more sustainable 5.5%. Although the authorities have talked about withdrawing stimulus measures and are particularly concerned about property speculation, January credit data suggests this will be a gradual process. With private consumption anticipated to increase by 15% and more than offset a marginal decline in net exports, the minor resurgence in Covid-19 infections and official advice not to travel over the New Year holiday is unlikely to derail the recovery.
The other main engine of global growth this year is the US where GDP is expected to expand by 5.4% and 3% in 2022. The fiscal packages in late 2020 and early 2021 will provide a boost equivalent to over 10% of GDP – mostly in direct support to individuals and small businesses. A Covid-19 resurgence and cold weather have not helped employment in the short-term and over one-third of the jobs lost during the pandemic have yet to be reinstated. However, as the vaccine rollout gathers pace and leisure activities and travel resume, there is a huge potential spending boom on the way. Despite wages and rents remaining subdued, price pressures for certain goods are causing concern about short-term inflation.
While the Eurozone may lag the US, export-orientated economies – notably Germany and Holland – have fared better than those like Spain and Italy that rely on domestic demand and tourism. Although extended lockdowns suggest there could be a further contraction in Q1 GDP, once vaccine supply issues are resolved the rollout should bring much needed relief enabling GDP to expand by 3.6%. There is not the same degree of fiscal stimulus for consumers as in the US and the European Union is promoting a “Recovery and Resilience Facility” which focuses on longer-term objectives through grants and loans to green and digital projects.
Having been hit particularly hard during the initial stages of the pandemic, the outlook for the UK economy is improving as vaccinations reach 20 million and the extended lockdown reduces hospitalisations. The “road map” for easing restrictions suggests there could be a rapid recovery in Q2 but, with Q1 GDP expected to show another fall, it will be surprising if growth exceeds 3.5% this year. Expectations that pandemic savings will provide an additional boost may prove wide of the mark given these are narrowly concentrated and the true state of the jobs market will not become clear until furlough support is unwound. With unemployment likely to rise to 8%, companies are not facing wage pressures although higher energy costs and Brexit supply chain disruption could result in producer pricing pressures which may be difficult to pass on.
The way in which equities, credit spreads and commodities are responding to aggressive monetary and fiscal measures is a familiar one. With growth picking up, policy starts to lag, nominal yields rise and “expensive” growth stocks tend to underperform “cheap” cyclicals. The higher equity valuations are, the greater their sensitivity to interest rate movements. This rotation is not just about the impact on analysts’ forecasts because the real economy also changes. As the recovery broadens out, the proportion of profits generated by “growth” companies – predominately in the US – limits opening-up opportunities in other sectors and economies. An increase in manufacturing and global trade clearly benefits industrial companies and, as the yield curve – the difference between long and short rates – steepens, this also helps financials. In our view, any inflation that signals recovery is “good” and it is when real rates turn positive that problems arise particularly for over-optimistic and over-borrowed business models. Against this background, UK equities appear good value with energy, mining and financials giving exposure to the cyclical trade. However, as higher corporation tax will eventually affect dividend distributions, we see international markets offering better opportunities for long-term structural growth.