The end of a challenging year

In the following paragraphs we attempt to briefly summarise our thoughts on some of the key factors and markets in the year ahead:

We are likely to continue to experience an economic rollercoaster as the revolving door of COVID led lockdowns perseveres well into 2021. Much output has been lost and whilst it will be recouped in time, do not expect it to be immediate. Government and central bank support measures have been lifelines but nevertheless, the post[1]pandemic world will be one with many industries, businesses and individuals struggling. It is both expected and paramount therefore that stimulus measures and ultra-easy monetary conditions remain in situ for some-time to come; policymakers were too quick to enact tightening headwinds in the aftermath of the Global Financial Crisis and they are unlikely to make that mistake again. So ‘easy’ conditions look set to be with us for a while – at least until it becomes very clear economies can withstand diminishing stimulus - and that monetary and fiscal support will be an important tailwind for growth conditions in the quarters ahead whilst vaccines are being distributed. The side effect of this of course is worsening government deficits – but that is likely to be story for another year. Most economies experienced deep ‘services led’ recessions in 2020 as lockdown measures were enforced and whilst much of this lost output will not return, it is natural to assume that when they re-open (at or near full capacity) consumers, with pent up demand, will spend – in fact, we already have evidence of this with the robust economic activity evident in the third quarter of 2020. However, growth doesn’t have to be robust, indeed it wasn’t before the pandemic, it just needs to be travelling broadly in the right direction and at a pace strong enough to chip away at the economic wounds of COVID-19. Boom economic times may be reserved for the history books in favour of ‘new norm’ growth levels and without doubt hurdles remain (protectionism, de-globalisation, trade disputes etc.), but support measures remain overwhelming and therefore we are optimistic that global economic growth will once again prevail in 2021, although it is likely to be patchy and uneven as many industries and economies will remain suppressed due to ongoing COVID disruptions.

Source: IMF staff estimates. Note: The aggregate growth rates are calculated as a weighted average, where a moving average of nominal GDP in US dollars for the preceding three years is used as the weight, WEO = World economic Outlook. 1 Difference based on rounded figures for the current, June 2020 WEO Update, and April 2020 WEO forecasts.

The announcement of multiple vaccines with efficacy rates higher than forecast coupled with Joe Biden’s US Presidential election victory led to a strong equity market rally during the final quarter of the year. Whilst our client portfolios participated in the rally, aided by the decision to move from marginally underweight to marginally overweight equites due to the positive vaccine data, relative performance lagged due to the considerable market rotation away from large cap growth companies in favour of value-style and more cyclical sectors. However, given the strong outperformance in the previous nine months global USD and GBP multi-asset portfolios generally ended 2020 favourably on an absolute basis and reasonably inline on a relative basis. The UK FTSE All-share TR index fell -9.8% for the year, its worst showing since the 2008 financial crisis. Domestic GBP portfolios struggled throughout 2020 on both a relative and absolute basis although with a trade agreement now signed between the EU and UK, we are hopeful of a recovery in UK companies in the year ahead as they breathe a big sigh of relief that they can continue to trade with ‘zero-tariff’. On a year-to-date basis, US Dollar and Sterling Fixed Income mandates have delivered positive returns ahead of cash. However, performance has lagged our internal benchmarks due to our ongoing cautious short duration strategy as risk/return metrics continue to appear very unfavourable.

We have been adding to risk assets such as global equities at a measured pace following news of the development of successful high efficacy vaccines. We acknowledge that valuations are not cheap by historical standards but would expect an improvement in the outlook for corporate earnings to continue to support returns in the year ahead. The earnings recovery cycle (pre-crisis levels) for the MSCI All Country World Index is expected to be completed towards the end of 2021, implying 25% growth in earnings per share over the next 12 months. Furthermore, many companies will reinstate the payment of dividends after one of the most challenging years in history which will provide an additional underpin for patient investors. Equity returns have been very concentrated during 2020 and outside of the US, China and a handful of mega large information technology and other growth shares, returns have been disappointing, especially for those companies that have been severely affected by the pandemic. Going forward we expect the dispersion of returns from equities to broaden as the global economic recovery becomes more widespread with the support from policy makers. We will continue to invest in companies with strong balance sheets and secular growth drivers which will ultimately result in sustainable and predictable growth in profitability.

Long dated government bonds stand to lose the most from a sustained global economic recovery and as such we remain underweight fixed income securities. We do not expect interest rates to be raised anytime soon but do believe that significant downside risks persist for holders of longer dated government bonds. Two thirds of all developed market government bonds are yielding negative yield-to-maturities, meaning that investors are guaranteed of earning negative returns if these bonds are held to maturity. In the US, unlike Europe and Japan, long dated (10 year) bonds are at least trading at positive income yields, but these yields are still well below long term inflation expectations. Not only are the starting yields unattractive, duration risk (capital risk) has also become extreme with a 1% upward parallel shift in the yield curve resulting in capital losses in excess of 8% for many long dated developed market bonds.

We have been selectively and opportunistically increasing exposure to investment and non-investment grade dated bonds. This has and will continue to bolster returns, but at current spreads we are not looking to add aggressively to credit. Although our positioning favours short dated bonds, we have been taking advantage of the modest sell[1]off in government bonds towards the end of 2020 which has resulted in the steepening of the yield curve, to extend duration.

Cash weightings have been reduced and remain tactical in nature, ready to be deployed as further investment opportunities arise.

The sheer pace and magnitude of the recovery in most global equity indices from the March lows has surprised. However, as alluded to in previous updates, the rally has been far from broad-based with ‘stay at home’ and ‘growth’ stocks leading the rebound ahead of their more cyclical and value counterparts. Given the COVID led changes in consumer behaviour and the search for stable and repeatable earnings growth under a low interest rate environment this trend is understood and may have further to run but the relative performance gap is extreme and could close if vaccines are administered swiftly and successfully thereby allowing economies to re-open and mobility to again return. With cash and sovereign bonds looking set to continue to offer only negative real (after inflation) returns for some time to come quality global equites remain a preferred asset class. However, there is no escaping the simple fact that equity markets have rallied strongly and at current prices they should not be viewed as being cheap; many share prices are anticipating better times ahead and therefore without meaningful improvements in the permanent containment of COVID in the coming 3-6 months then equity prices could be set for some short term volatility. Having said this there is no escaping the predominantly risk-friendly backdrop. Namely, central banks are going to keep their feet on the stimulus pedals (both fiscal and monetary), economies should begin to open up and should be met with strong pent-up consumer demand and the general direction of travel for economic data should be positive, albeit from low bases. Ultimately, a favourable climate for risk assets that sadly will not stop some two-way volatility, but should ensure that downside periods are not lasting, rather viewed as buying opportunities – we remain cautiously optimistic.

Longer-dated US government bond yields have been steadily rising since early August but relative to the outlook for a sustained recovery in economic growth conditions next year and for inflation to trend higher, we believe the market remains expensive, particularly based on historic ‘real return’ levels. It appears likely that the 10-year benchmark will breach 1% but we are mindful that the Federal Reserve will only tolerate yields rising sharply if coupled with signs that the economy is on a sustainable path to pre-pandemic levels. If not, further manipulation of the yield curve via quantitative easing measures (i.e. buying longer dated US treasuries) is probable. With interest rates near zero and destined to stay there for some time, the yield curve has steepened in recent months but the difference between two- and ten-year issues still remains some 50 basis points below its ten year average and therefore, not yet close to levels that we would deem sufficiently attractive to consider extending durations. Ultimately, market yields remain extremely low which in turn raises the duration risk exponentially and this is not a favourable mix for longer[1]dated bonds when taking a medium to long-term view – we remain cautiously defensive.

UK sovereign bond yields fell sharply throughout 2020 with all Gilts maturing in six years or less now trading on negative yields. The continued ‘will they, won’t they’ delays on a final Brexit deal together with the spread of a new “mutated” coronavirus strain understandably led to demand for safe[1]haven government bonds. The market is pricing in a bleak picture for the UK economy, suggesting rates will remain lower for longer, something we fully subscribe to. However, whilst UK PLC has clear headwinds, after a circa 11% contraction in 2020 we expect the economy to expand in the year ahead although the timing and pace will be at the mercy of the pandemic and, more importantly, the vaccine deployment. With yields either negative or close to historic lows, our defensive ‘underweight duration’ bias remains – the yield advantage on longer-dated bonds is negligible and vastly outweighed by potential capital downside risk. We expect a more attractive buying opportunity, although this may not present itself until the second half of the year.

Our strategies have retained a moderately overweight allocation to investment grade and high yield corporate credit. However, we are cognisant that these markets have rallied strongly since late March to the extent that spreads on both are now either at or close to pre-pandemic levels. The level of forward-looking optimism, aided by an ongoing search for yield and central bank support justifies these moves. Whilst we do anticipate ongoing demand for these higher yielding markets, further significant upside may be limited from current levels if markets begin to price in diminishing central bank support via quantitative easing. As with all ‘risk’ markets the direction of travel will not be ‘one way’ and whilst we are happy to maintain our current allocations, we will aim to increase at more attractive levels.

The US Dollar weakened in the second half of the year, more than we had anticipated and to the detriment of our overweight strategy. In particular, the currency’s slide against the Euro during this period has been meaningful however it should be noted that the US government bond market has significantly outperformed its German counterpart year-to-date so the relative cost to performance has not been material. Looking ahead, further downside in the US Dollar is very much the ‘consensus’ opinion which, in itself should be a slight concern, particularly given the weakness already experienced this year. Ultimately, we may be forced to reduce the long held overweight strategy but we remain very mindful that the US bond market still enjoys a considerable yield pick-up over virtually all counterparts (circa 1.5% in the case of German ten-year bonds for example) and therefore, allocating to Euro or Yen assets forces our strategies to invest in zero, and more often deeply negative yielding assets.

Sterling had a strong run into year-end thanks to a mix of broad US dollar weakness and positive news on the Brexit trade deal. At current levels it appears much of the good news may be priced-in but we are not discounting further short-terms gains. Years of wrangling over Brexit and the COVID-19 pandemic have taken their toll on the UK economy and whilst we are more optimistic for the year ahead, there is a big mountain to climb to recoup much of the lost output. Interest rates are certainly staying put and, though this is not our base case, speculation remains that the Bank of England may consider taking them negative. Our Sterling International strategies have remained moderately overweight base currency and we will continue with this strategy unless it becomes apparent that the currency has run ahead of economic fundamentals.