Market Update: Pausing for Breath

Markets rebounded very strongly in May and early June before a nasty dose of reality last week led to renewed heavy falls in all global stock markets. Investors had increasingly been taking a glass half full stance, in effect ‘looking through’ the dreadful growth and earnings numbers we will be seeing in coming months and focussing instead on the recovery later this year and beyond. This rally has paused for breath and we expect a period of consolidation with markets trading around current levels for the next few months, with bouts of unsettling volatility along the way. Sadly though we have learned to ‘expect the unexpected’ so this is at best a working hypothesis, having plausibility if not total conviction.

Market Returns

The chart shows the returns from markets in their own currency and illustrates how strong the rebound has been. Wall Street has clawed back most of its losses and prior to last week had actually made it back to positive territory for the year. The FTSE, with its high weighting in ‘old economy’ energy, industrials and financials and burdened by Brexit and the UK’s poor response to the pandemic remains by some distance a laggard.

The table shows the sector average returns from funds, broken down by asset class and geography. The overseas returns differ significantly from the chart in that they are the return when translated back into sterling, not local currency. As sterling has been weak this year these returns are enhanced with the pound falling around 6% against the dollar, euro and yen. In this context, UK funds are even further behind the pack.

Figures from Financial Express Analytics

The following table, with data courtesy of the JPM Asset Management Weekly Brief, shows the winners and losers in terms of industrial sector and style:

In terms of ‘style’ the winners continue to be the sectors in which the companies have visible, growing and consistent earnings streams, cash rather than debt on the balance sheet, resilient margins, and revenues that are less economically sensitive to changes to growth in GDP in the current environment of recession and radical change to business and social behaviour. Technology and healthcare companies best demonstrate these attributes. Despite still being significant laggards on the year, there has been a rally in recent weeks in the cyclical and recovery ‘value’ sectors, notably energy and financials, in line with the markets more positive view on growth and earnings prospects next year.

Outlook: Markets in Monochrome

Markets are usually coloured in shades of grey but in extremes become a very binary ‘risk on/risk off’ black and white. Never has this been more true than this year in what has been a classic ‘one story’ market. For the first six weeks of the market crash to the trough at the end of March markets behaved in the classic ‘risk off’ way:

• Equities fell heavily
• Growth stocks outperformed value
• Bond yields fell/prices rose
• The yield curve flattened
• Corporate credit spreads widened so Government Bonds outperformed Corporate Bonds.
• The price of gold rose, the price of oil fell
• The dollar, yen and swiss franc rose/sterling, emerging market and commodity currencies fell

As markets found a floor in April and tentatively began to rise these factors began to reverse, though not markedly. Credit spreads tightened considerably but high-quality growth stocks continued to outperform cyclical and recovery value stocks, long dated bond yields remained anchored close to zero and the ‘safe-haven’ currencies remained firm. The market was signalling that the fall had been overdone and that the policy response from Government and Central Banks will be enough to prevent long term recession.

Sentiment improved markedly in May and early June with the markets ‘looking through’ the bad news, assuming the worst of the pandemic is well behind us in developed countries and that economic recovery will be robust as countries ‘de-escalate’ from their lockdowns. They were further cheered by a stronger than expected policy response in Europe and some surprisingly positive economic data from the US indicating that the recovery has already begun.

As a consequence, ‘risk off’ turned to ‘risk on’ with a vengeance with an abrupt volte-face in asset class behaviour. The US 10 Year Treasury yield rose back to nearly 1%, credit spreads tightened, and the dollar weakened by around 4% against sterling. Most strikingly, the pariahs of the stock market, energy, materials, retailers and financials bounced very strongly and the markets which have a greater weighting in these sectors, notably the UK and Europe, fared better after taking the worst of the pummelling.

It always felt rather too Panglossian for this recovery to continue in a straight line, as we saw last week. The markets have been buoyed by economic optimism and carried along on a flood tide of Central Bank liquidity. Despite a very supportive statement last week by Jerome Powell, head of the US Federal Reserve Bank, they have been having second thoughts. Markets were very happy to hear his commitment to keeping interest rates at near zero for the next couple of years and pledge to virtually unlimited QE, less so about his bleak and sombre outlook for economic growth. Together with fears of a ‘second wave’ of infections in US this was enough for markets to turn tail and head south again. Our sense is that we will have a summer oscillating between hope and fear.

Drowning or Waving?

Waving not Drowning, a 1957 poem by Stevie Smith, tells of a drowning man whose cries for help are mis-interpreted by those on the shore. The vast size of the UK national debt is not a thrilling topic but has been the subject of considerable media debate, much of it ill-informed and rather too sensationalist and scare-mongering for such a dry subject. So are we drowning in this ocean of debt, or comfortably staying afloat?

In any discussion of this rather arcane subject it is important to understand that it is the ability to service the debt on an ongoing basis is more important in the medium term than the actual size of the government debt itself. An understanding of the level of public indebtedness in past decades is also useful to provide perspective.

The total level of Government Debt was £1.8trn in 2019/20, around 90% of national income (GDP) or £27,000 for each person in the UK. This will now rise to over 100% of GDP, a level not seen since the end of WW2 where it was around 200%, the servicing of which crippled the economy for a decade but had fallen to 50% by the 1970s and to as low as 25% by 1990. The debt exploded again post the 2008 great financial crisis, rising from 38% pre-crash up to 80% by 2010 where it has pretty much stood ever since.

It is crucial to understand the difference the Government Debt and the Budget Deficit which are totally different beasts. The Budget Deficit is the annual difference (nearly always a shortfall) between government expenditure and income (tax revenue) and is the amount the government thus must borrow to balance the books and is primarily funded by issuing Gilts. Since 1970 the average budget deficit has been 3.5% of GDP, rising in the mid-70s and then again in the early 90s and peaking at £158bn or 10.2% of GDP in 2009/10 in the aftermath of the great financial crisis. This year the deficit will soar from £63bn in 2019/20 or 2.8% of GDP to around £300bn which will be around 15% of GDP which is record busting as both a total amount and as a percentage.

These are of course, as we’re always being told, unprecedented times. The furlough scheme is forecast to cost around £120bn alone at a time when tax revenues are collapsing. GDP is going to fall by over 10% which isn’t going to help the percentage number, and the strain on government finances and need to get the economy moving again is one reason for the easing in lockdown restrictions.

Strangely, but crucially, these massive numbers are not a current worry and are quite manageable because debt servicing costs (i.e. bond yields) are so low. Even though the total level of government debt increased dramatically post 2008 the cost of servicing it fell significantly because interest rates and bond yields fell to historically low levels. Last year the public sector debt interest as a percentage of public sector revenue fell to below 4% for the first time ever, whereas between the 1950s and 2000s it fluctuated between 6% and 11%. With bond yields collapsing again to virtually zero during the pandemic then servicing costs will fall again making higher debts sustainable with the UK actively locking in low costs by issuing a lot of long dated bonds.

But will there be anyone willing to buy government bonds at such low yields to fund the budget deficit? The demand for safe haven assets remains very high and in any case around £200bn is being bought by the Bank of England through its QE programme. This is not going to be rushing for the exits any time soon so there is no threat of a solvency crisis which could possibly have been the case if held by overseas buyers. In effect the Bank of England is using monetary policy to fund the fiscal policy that is keeping us all afloat. The concept of the Bank of England buying bonds in the market that have been newly issued by the UK Treasury’s Debt Management Office does seem a strange one, the two bodies being different pockets of the same coat as one commentator neatly put it.

We are not on the verge of a sovereign debt crisis and reducing debt is not now the primary focus, instead tax policy and public spending are needed to drive growth. Several years of high borrowing can be easily supported by QE, very low interest rates and plenty of keen buyers with the national debt plateauing over 100% of GDP quite comfortably. The ‘hopeful’ scenario is that we will grow our way out of this debt. As lockdown is eased spending should recover and tax receipts grow in line with a stronger economy. The problem in years to come will be a difficult balancing act between a declining budget deficit but increasing debt servicing costs as interest rates will likely rise in line with economic recovery. If in time the wobbly tricycle of total public debt, the annual budget deficit and the cost of serving that deficit looks like it is going to fall over then some very difficult political decisions will have to be made. Raising taxes, cutting spending or letting inflation do the work all have a cost, and one which is not shared equally across different sectors of society.

For now our swimmer is waving, though maybe unaware that a large wave is out there somewhere in the ocean heading his way.