The Kingswood Investment Podcast

Global equities ended last week on a negative note and were down around 4.5% from their all-time high in early September. This morning, European markets have fallen back a further 3%.

The initial catalyst for the correction was a sharp run-up in the mega cap tech names which had left them looking extended and ripe for some profit taking. The FAANGs are now down over 10% from their highs and the froth looks like it has been blown off. While they may well remain volatile, there is no obvious reason for them to be at the forefront of any further sell-off. The fundamentals behind the tech sector remain strong and valuations are once again looking more reasonable.

However, the correction also clearly had its roots in the sheer scale of the rebound from March with global equities up some 50% from their low. This inevitably left markets vulnerable to a set-back, particularly with valuations at twenty-year highs.

The rebound in turn was in good part a result of the massive policy stimulus. The weakness late last week was triggered by disappointment that the US Fed had not extended its QE program. Even so, the Fed is still buying $120bn of bonds a month and remains a major support for equities. Indeed, it made it clear that it has no intention of raising rates for at least another three years.

The Bank of England also decided to leave policy unchanged last week. However, it kept open the possibility of cutting rates into negative territory next year if it should be necessary. An extension of its QE program later this year also remains quite possible.

All the same, the fact of the matter is that central banks have now spent most of their ammunition. Going forward, changes to fiscal policy will be much more important than any tweaks to monetary policy in shaping the economic recovery. And on this front, the news is not particularly encouraging as the markets may now be appreciating.

The US has failed to agree an extension of the fiscal stimulus measures which expired in July and may now not do before the November elections. As for the UK, Rishi Sunak is still resisting calls to extend the furlough scheme beyond October.

Just as important for markets will of course be Covid-related developments. This morning’s declines are a response to the second wave of infections now being seen in the UK and across much of Europe and fears that renewed social distancing measures/localised lockdowns could disrupt the economic recovery.

While the latest wave of infections is clearly a major cause for concern near term, it shouldn’t be forgotten that the longer term outlook regarding Covid is not all bad. Several late stage vaccine trials are now underway and a vaccine could quite possibly become available within a few months.  Some countries, most notably China, also seem to have avoided a major secondary spike despite the reopening of their economies.

In short, the outlook remains quite uncertain. We believe it remains prudent at this juncture to maintain a broadly neutral stance on equities until some of these unknowns are cleared up - one way or another.  

Last week was very much a week of two halves for equity markets. Global equities saw gains early on and by mid-week were brushing their all-time high in February. But markets fell back around 3% at the back end of the week, with global stocks ending the week down 0.5-1%.

The driving force behind these gyrations were the tech giants which have soared this year. The FAANGs (Facebook, Apple, Amazon, Netflix & Google) were up over 80% year-to-date at their high point before they fell back some 7% at the end of last week.

Everyone still refers to this group of stocks as the FAANGs but the fact is that this acronym is looking decidedly dated. There are two additional companies which should really also now be included in this exclusive club.

Microsoft has reinvented itself in recent years, and is once again at the leading edge of the tech sector. And who could forget Tesla whose price has risen five-fold this year. A better acronym might be FANMAG+T although Tesla is still a comparative minnow relative to the others (other than Netflix) and it’s debatable whether it should be counted as a tech company at all.

The latest setback for the tech darlings is really no big surprise given the size of the gains seen so far this year. These seem to have been inflated recently by big positions taken out by the Japanese investment house Softbank and also the stock-splits announced by Tesla and Apple – even though in theory the latter shouldn’t make any difference.

We don’t believe last week’s sell-off is a harbinger of a repeat of the bursting of the tech bubble twenty years ago. With the odd exception such as Tesla, tech valuations are nowhere near the levels reached back then. The business models of the tech giants are also much more robust now, as is their cash generating capacity. With Covid-19 only reinforcing the secular trends already in its favour, the tech sector remains well placed going forward even though it is now facing a regulatory crackdown.

Unlike with tech, another pronounced trend seen this year continued unabated last week, namely the underperformance of UK equities. UK stocks fell 2.6% and are now down a little over 20% year-to-date whereas global stocks are up 3%.

A warning from Boris Johnson and Rishi Sunak that tough times lie ahead and taxes will need to rise cannot have helped UK equities. In part, their comments only stated a blindingly obvious if unpalatable truth. The surprise was more Sunak’s intention to start raising taxes as soon as the Autumn Budget.

Such a move could only endanger the fledgling recovery and differs markedly from the policy being adopted elsewhere. France, for example, only last week announced a new €100bn economic recovery plan worth some 4% of GDP. Anyway, Sunak’s plans provoked howls of anguish from his party, with tax rises later this year now look likely to be modest in scope.

Tax increases, however, are not the only bogeyman on the horizon, with a No-Deal Brexit looking increasingly likely. Johnson has said a Brexit deal needs to be agreed by 15 October and, with both sides seemingly far apart and digging their heels in, this will be a tall order. While Johnson is still proclaiming that even a No-Deal would be a good outcome, the market is almost certainly rather more sceptical.

Global equities continued their rebound last week, rising a further 2% in local currency terms. They have now recouped all their losses earlier in the year and are back to their all-time high last seen in February.

The US Federal Reserve, rather than any economic releases, can claim credit for the latest move higher. At last week’s annual get-together of the world’s central bankers, the Fed announced a refinement of its longer-term monetary policy objectives. Rather than having a simple 2% inflation target as before, it is moving to an ‘average’ target; inflation will now be allowed to overshoot following a period of undershooting.

Over the last few years, US inflation has undershot the 2% target significantly with the Fed’s favoured inflation measure currently only at 1.2%. So, there is definitely grounds for inflation to be allowed to run above 2% over coming years and higher inflation would be good news for equities.

Past experience over recent years, however, suggests central banks will continue to struggle to hit, let alone overshoot, their inflation targets. So, the Fed’s move is for the moment rather academic and will have few policy implications for a while yet.

Longer term, by contrast, the massive fiscal and monetary stimulus does clearly carry some inflation risk. And whereas before, a rate rise had looked possible in a couple of years’ time, US rates now look set to remain close to zero for maybe at least another five years.

Rate hikes also look unlikely as far as the eye can see in the UK and Europe. Indeed, BoE Governor Andrew Bailey was at pains last week to emphasise the Bank still has ample firepower to support the UK economy if needed. Further quantitative easing is quite possible and, if absolutely necessary, the BoE could introduce negative interest rates.

Still, the sad fact is that despite the Fed’s latest move and the BoE’s protestations to the contrary, monetary policy is reaching the limits of its effectiveness. Additional stimulus may well boost asset prices further but, in terms of its impact on the economy, it is more akin to pushing on a string – to quote the old adage.

Back closer to home, one of the more notable moves of late has been the marked rise in the pound against the dollar. Sterling is now back to $1.34, up from a low of $1.15 at the height of the sell-off in mid-March. It would be nice to say that this is all down to renewed confidence in the UK economy but this doesn’t seem to be the case.

Sterling’s gains have been concentrated against the dollar, which has been weakening generally, and have been much more muted against the euro. Equally telling, UK equities have continued to underperform other markets in sterling terms, whereas normally sterling strengthening is associated with outperformance.

The underperformance of UK equities may in part relate to worries about Brexit, the winding down of the furlough scheme now underway and the government’s erratic handling of the crisis. However, it will also in part just be down to the continued outperformance of tech stocks, which account for over 30% of the market in the US but a mere 2% in the UK.

We believe tech stocks should continue to fare relatively well and thus UK equities may continue to struggle. Even so, their value does offer some hope that the bulk of the UK’s underperformance should finally now be behind us.

Global equities edged higher last week with no great enthusiasm, as indeed did US equities which inched above their all-time high in February.

Beneath the surface, however, the week was rather more eventful. Technology stocks outperformed with a gain of 2.5%, led by the mega-cap FAANGs (Facebook, Apple, Amazon, Netflix & Google) which were up close to 8%. UK equities, by contrast, were down 1.2%.

This pattern of technology outperformance and UK underperformance has been the story, not only of the past week, but the whole year. The technology sector has outperformed global equities by over 30% since the start of the year while the UK has underperformed by over 20%.

In fact, this story has been playing out for a lot longer than this year and we have just seen the passing of a depressing milestone for the UK market. The entire market cap of the FTSE 100 index is now smaller than that of Apple whose market cap has burst through the $2 trillion mark!

In good part, this is down to Apple’s share price, which is up as much as 70% year-to-date and now trades on a heady forward price-earnings ratio of 33x. But sadly, it also reflects the fact that the market cap of the FTSE 100 has gone nowhere over the last twenty years.

The FAANGs undoubtedly face increased regulatory and tax headwinds going forward. But we believe this is more than compensated by the secular tailwinds in favour of the tech sector more generally which have only been reinforced by Covid. Meanwhile, tech valuations are still nowhere back to the highs seen back in the 1999-2000 tech bubble. Consequently, we plan to retain our tech exposure.

As for UK equities, they may be cheap with a forward price-earnings ratio currently 25% lower than for the rest of the world, but there is little obvious on the horizon to trigger a major change of sentiment for the better and we remain somewhat cautious. Last week’s economic data did surprise on the upside, with business confidence improving further in August and retail sales in July above their levels a year earlier. Indeed, UK GDP now looks likely to see a gain of as much as 14% in the third quarter.

However, even such a large bounce would still only re-coup some 55% of the drop seen in the second quarter. And with the government’s furlough scheme being unwound over the next couple of months, the pace of the recovery is likely to slow considerably later in the year, particularly with Brexit lurking in the wings.

The latest round of UK-EU trade talks ended on a sour note with no progress being made. No deal, or even a bare-bones deal, at year end can only pose another unwelcome drag on the economy. Talking of which, last week saw UK government debt hit the £2 trillion milestone and exceed 100% of GDP for the first time, which only highlights the difficult path ahead for the economy.

To end on a slightly more positive note, UK and European equities are up close to 2% this morning, buoyed by talk of a new plasma treatment for hospitalised covid patients and a vaccine possibly being released ahead of the US election. Both developments are encouraging although neither will provide a silver bullet. We believe equities remain vulnerable to a possible correction over coming months, even if longer term they have more upside.

Global equities had another good week, gaining another 1% or so. In local currency terms, even if not yet in sterling terms, equity prices are now back to where they were at the start of the year. US equities have fared even better and are now up close to 6% year-to-date and are re-testing their February highs.

Markets have taken heart from the corporate earnings season, which is now drawing to a close in the US and Europe and has not been as bad as feared. Just as important maybe, equities continue to draw support from the fact that there is no real alternative for anyone looking for a half decent return given the measly yields now on offer from fixed income.

Unlike global equities, the UK did not have a good week. Just as many A-level students found their results worse than expected, last week’s results for the economy were also very much at the bottom of the class.

UK GDP contracted a massive 20% q/q in Q2. This was the largest decline seen by any major economy, with only Spain coming close with a 19% decline. The US and Germany fared relatively well with falls of the order of 10% while today’s numbers showed Japan holding up better still with a decline of a little under 8%.

However, as with the A-level results, this league table is not entirely fair to the worst performers. The UK’s dire Q2 performance in part reflected its consumer services-heavy economy but was also partly just down to timing and the relatively late date of the UK lockdown.

To the extent there was any good news, it was that the drop in output was no larger than expected. Moreover, unlike the Government which is still digging, the economy has begun to climb out of its hole. GDP rebounded in June and is already 11% above its April low point. Even so, activity remains down as much as 17% on pre-Covid levels and the speed of the rebound is likely to slow significantly later this year. Government support measures are being wound down and the initial burst of pent-up demand will come to an end.

The Chinese experience certainly suggests continued consumer caution may hamper a rapid return to pre-Covid levels of activity. China has led the global rebound and been in recovery mode for a few months now. But even here, consumers remain quite cautious with retail sales remaining lower than a year ago.

The UK Government can at least take some solace from the fact that the US response to the virus has been just as open to criticism. While infection rates are now showing signs of peaking in the US, Congress is still arguing over the content of the support package badly needed to replace the stimulus measures which came to an end in July.

The major news last week in the US, however, was political. Joe Biden announced Kamala Harris as his running mate. Biden was already ahead in the polls and this appointment can only boost his chances. Her gender, ethnicity and relative youth should widen Biden’s appeal which is rather limited by his old, white, male and gaffe-prone nature.

Biden’s poll ratings rose substantially over the last few months while he was hunkered down in his Covid-bunker. Boris Johnson must be praying for the same as he remains squirrelled away in Scotland, his hopes dashed no doubt that it would only be the midges, rather than an exams fiasco, which would be spoiling his holiday.

SUMMARY

• Global equities have recaptured most of their losses from earlier this year
• The massive monetary and fiscal stimulus has fuelled hopes of a V-shaped rebound in the economy
• An economic upturn is underway, although, as expected, its pace has slowed following an initial spurt
• We expect the recovery to be a stuttering affair, although the outlook hinges on Covid-related developments
• Equity valuations now look on the high side and there is the risk of a correction over coming months
• Further out, equities have additional upside and return prospects are significantly better than for fixed income
• We are relatively cautious on UK and US equities but more positive on Asia and have added an exposure to healthcare
• Prospective returns from corporate bonds look limited but are significantly higher than for government bonds

Last week was a choppy one for equity markets, with global equities ending the week little changed in local currency terms. A strengthening in the pound to $1.31, however, left markets down 2.0% in sterling terms.

Second quarter GDP numbers for the US and Europe confirmed the extent of the collapse in activity caused by the lockdowns. US GDP contracted a record 9.5% q/q but even so fared better than the Eurozone where GDP fell 12.1%. Within Europe, Germany was most resilient with a decline of 10.1% while Spain fared worst with a fall of 18.5%. The UK numbers have not yet been released but most likely the UK will be one of the worst hit economies.

In the US, the Fed left policy unchanged last week as expected and Chair Jerome Powell went out of his way to emphasise how dependent the path of the economy was on Covid developments. The renewal of government support measures, however, is also critical if the recovery now underway is to be sustained. Congress has as yet failed to agree an extension of the government stimulus measures which ended in July but most likely will do so over coming weeks.

The second quarter earnings season is now past its halfway mark in the US and the collapse in earnings is proving less than feared. Earnings are now expected to be down some 35% on a year earlier, compared with expectations for a 45% fall at the start of reporting. The tech sector has been a major reason for the positive surprise with Apple, Amazon, Facebook and Alphabet (Google) all reporting last week and beating estimates. Along with healthcare, the two sectors should actually see second quarter earnings up a little on a year ago – in contrast to the sharp declines being seen elsewhere.

Tech stocks have also been in the news recently because the leaders of the tech titans were testifying last week before Congress in an attempt to limit the regulatory crackdown heading their way. Increased regulatory and tax headwinds, along with higher valuations, mean the backdrop for tech stocks is no longer as favourable as it once was. Still, their latest results very much confirm the underlying growth story of the sector and we plan to retain our allocations to technology and artificial intelligence.

Currencies have also been a focus recently. For UK investors, the focal point has been the recovery in the pound against the dollar from a low of $1.15 in March to back above $1.30. This rise has been very much a result of dollar weakness rather than sterling strength with the pound losing, rather than gaining, ground against the euro.

The dollar has suffered from the flare up in Covid infections and much reduced interest rate support. With much of the dollar’s decline likely to be behind us now and the UK once again drawing closer to a Brexit cliff-edge, the pound could well unwind some of its recent gains later this year.

Last week was really a week of two halves as far as equity markets were concerned, with initial gains subsequently reversed, leaving markets down a little over the week as a whole.

A further escalation of tensions between China and the US, with the tit-for-tat embassy closure, was the most obvious reason for the change in market tone. But the continuing uncertainties over the prospects for the economic recovery may also have contributed.

Last week’s economic data on the face of it looked encouraging but in reality was rather less so. Business confidence recovered further in July and is now back above pre-Covid levels in the UK and Europe. However, these surveys basically just ask businesses whether conditions are improving or not. Given how dire the position was a couple of months ago, the fact that most businesses are now saying things are getting better is hardly a sign that the economy is back to normal.

Retail sales have also shown a sharp V-shaped recovery and in June, in both the UK and US, they had regained almost all their collapse in March/April. But again this is not as reassuring as it first looks. It is far from clear how much of this bounce just reflects one-off pent-up demand and will not be sustained going forward. Retail sales also only account for around 30% of total consumer spending. The recovery in spending on services etc. is likely to have been much more subdued.

In short, the debate over the strength of the recovery from here is alive and kicking, not least because the outlook is so dependent on how soon a vaccine is developed and rolled out and whether there is a major secondary spike in infections. Recent news has been encouraging on the former but discouraging on the latter, with infections still not under control in the US and also now picking up again in Europe.

The outlook hinges not only on the virus but also on the government’s policy response. For Europe at least, there was good news last week. At the eleventh hour after a marathon summit, EU leaders finally managed to overcome resistance from their more frugal members and agree an economic recovery package totalling €750bn or 5% of EU GDP. For the first time ever, the EU itself – rather than just individual countries – will issue debt to finance a mixture of grants and loans to EU states.

This week, it will be the turn of the US to try to agree a new fiscal stimulus package to replace the current support measures which expire at the end of July. As with the EU, the terms of the new package are being fought over tooth and nail, this time by the Democrats and Republicans.

One asset which has performed very well this year has been gold and its price rose a further 5% last week, breaking above $1900 and its previous high in 2011. The gold price is now up over 25% so far this year. Gold is the archetypal safe haven risk-off asset and one would expect it to do well in a time such as now of heightened economic uncertainty and geo-political tension.

However, the scale of its gains are down in good part to the super low level of interest rates. Government bonds used to be an obvious source of protection for portfolios in the event of a major sell-off in risky assets. Now, by contrast, the scope for further declines in yields is minimal with rates already so low, and the ability for bonds to provide such protection is much reduced. In addition, with government bonds now yielding virtually nothing, the fact that gold pays no income is no longer a particular disadvantage.

These various factors mean gold should remain well supported for the time being and could well rise further. But one shouldn’t forget that gold is volatile. If and when we do eventually see a return towards normality, gold could well retreat significantly. After all, the gold price more than doubled in the three years following the global financial crisis, only then to unwind half of those gains over the following couple of years. Finally, for UK investors, there is also currency risk associated with investing in gold with part of the latest rise in gold just a function of the recent weakness in the dollar. Gold may be a risk-off asset but it is a risky one.

Equity markets continued their upward trend last week, with global equities gaining 1.2% in local currency terms. Beneath the surface, however, the recovery has been a choppy affair of late. China and the technology sector, the big outperformers year-to-date, retreated last week whereas the UK and Europe, the laggards so far this year, led the gains.

As for US equities, they have re-tested, but so far failed to break above, their post-Covid high in early June and their end-2019 level. The recent choppiness of markets is not that surprising given they are being buffeted by a whole series of conflicting forces.

Developments regarding Covid-19 as ever remain absolutely critical and it is a mixture of bad and good news at the moment. There have been reports of encouraging early trial results for a new treatment and potential vaccine but infection rates continue to climb in the US. Reopening has now been halted or reversed in states accounting for 80% of the population.

We are a long way away from a complete lockdown being re-imposed and these moves are not expected to throw the economy back into reverse. But they do emphasise that the economic recovery, not only in the US but also elsewhere, is likely to prove a ‘stuttering’ affair.

Indeed, the May GDP numbers in the UK undid some of the optimism which had been building recently. Rather than bouncing 5% m/m in May as had been expected, GDP rose a more meagre 1.8% and remains a massive 24.5% below its pre-Covid level in February.

Even in China, where the recovery is now well underway, there is room for some caution. GDP rose a larger than expected 11.5% q/q in the second quarter and regained all of its decline the previous quarter. However, the bounce back is being led by manufacturing and public sector investment, and the recovery in retail sales is proving much more hesitant.

China is not just a focus of attention at the moment because its economy is leading the global upturn but because of the increasing tensions with Hong Kong, the US and UK. UK telecoms companies have now been banned from using Huawei’s 5G equipment in the future and the US is talking of imposing restrictions on Tik Tok, the Chinese social media platform. While this escalation is not as yet a major problem, it is a potential source of market volatility and another, albeit as yet relatively small, unwelcome drag on the global economy.

Government support will be critical over coming months and longer if the global recovery is to be sustained. This week will be crucial in this respect for Europe and the US. The EU, at the time of writing, is still engaged in a marathon four-day summit, trying to reach agreement on an economic recovery fund. As is almost always the case, a messy compromise will probably end up being hammered out.

An agreement will be positive but the difficulty in reaching it does highlight the underlying tensions in the EU which have far from gone away with the departure of the UK. Meanwhile in the US, the Democrats and Republicans will this week be engaged in their own battle over extending the government support schemes which would otherwise come to an end this month.

Most of these tensions and uncertainties are not going away any time soon. Markets face a choppy period over the over the summer and autumn with equities remaining at risk of a correction.