FOURcast: December 2020
Welcome to our monthly macro update, the FOURcast. Much like a weather forecast, it provides a guide to what we think may be coming, and how to position portfolios to prepare for the future climate.
Cyclical rotation – can it continue?
As discussed last month, we have been introducing a cyclical bias into equity portfolios to position for an economic recovery. The anticipated cyclical rotation came to fruition in November with economically sensitive companies outperforming as vaccine trials proved successful (Figure 1). The pressing question for investors is now how long this rotation can last. While typical growth and quality sectors have dominated equity markets over the past decade, we believe current circumstances support cyclical sectors. We expect to see increased capital expenditure driven by record low borrowing costs, and elevated consumer spending due to pent up demand and lower household debt. These factors all point to sustained strength in the Consumer Discretionary, Industrial, Financial and Material sectors.
While there now appears to be light at the end of the tunnel, we are cognisant of further short-term volatility amidst rising US COVID-19 cases and the unprecedented scale of vaccine distribution. With further US fiscal support unlikely until early next year, the path to stronger economic output may still be bumpy. Consequently, we remain selective within our cyclical allocation, focusing on companies with higher quality and ESG characteristics.
Sector performance: November cyclical rotation
Figure 1. Source: Bloomberg, 30 November 2020
Snapshot of views
The announcement of a highly effective COVID-19 vaccine is signalling some light at the end of the tunnel. The positive development saw a rotation towards cyclical and value-oriented sectors, reversing the trend seen through much of the year so far (Figure 1). Looking forward to 2021, we anticipate an economic recovery led by capital expenditure and consumer spending, supported by continued stimulus; as a result, we continue to favour cyclical sectors. As COVID-19 and US election headwinds show some signs of fading, we foresee further upside for equities. Expected credit returns continue to look muted, at least at a broad index level. As a result, we remain neutral risk assets but with an increasing preference for equities over credit.
Despite high valuations and recent underperformance, we remain positive on the Technology sector. The sector’s role in economic growth should not be underappreciated, positioning technology companies to benefit from a capital expenditure-led recovery focused on digital productivity. 2020 has accelerated digital adoption globally, but there is still a long way to go in this transition.
Positive outlook for equities relative to credit
As equity indices hit record highs in November, investors considered whether there is further upside for the asset class. As discussed in previous FOURcasts, valuations should be seen in context of stimulus, driving down bond yields and making future company profits more valuable. These low borrowing costs also present a large incentive for corporate activity which we expect to benefit shareholders. Notably, US dividend yields now exceed government bond yields, with the disparity growing throughout the pandemic to its widest this century. Equities would need to be c.28% behind inflation (assuming 2% inflation) in order to give the same return as government bonds (Figure 2). Whilst this is not inconceivable, we view this as highly unlikely.
Nominal yield (left) and Cumulative real return (right)
Figure 2. Source: Bloomberg, River and Mercantile, 2 December 2020. Equity cumulative return assumes equity prices grow with inflation and dividend yield remains constant with government bonds held to maturity
Furthermore, unlike in previous rounds of quantitative easing, current monetary policy has been matched with record fiscal spending. In practice, this provides a mechanism for policy to reach consumers and is beneficial for long term growth, as are continued low borrowing costs. Look no further than Japan, where major stimulus is boosting an economy that has been stagnant for some time.
The above factors, alongside US election and long-term COVID-19 risks moderating, provide equities with a supportive environment. As a result, we are advocates of steadily increasing equity exposure whilst trimming other risk assets, keeping overall risk exposure neutral. As stated last month, credit exposure should be selective, highlighted by our preference for opportunistic mandates – a theme that is continuing to work well.
We remain positive on the technology sector
Technology stocks have been the main beneficiaries of the pandemic due to the acceleration of digitalisation. Investors have favoured agile, asset-light business models with resilient revenues; this is in many ways synonymous with technology companies. Their assets are often largely intangible, e.g. intellectual property, rather than tangible assets such as manufacturing equipment. This helps explain the outperformance of tech-heavy US indices which have an increasing proportion of intangible assets (Figure 3). But whilst valuations appear high, this viewpoint fails to appreciate the extent to which technology is driving productivity and consequently economic growth. The unfolding capital expenditure expansion will undoubtedly focus on technology efficiencies which in turn support job growth, increased productivity and lower inflation.
It is also notable that while digital is just 9% of US GDP, it has contributed 32% of US GDP growth over the past 14 years. We expect the importance of technology to global growth to continue and provide further share price appreciation in the coming months and years.
Nominal Tangible assets vs intangible assets for S&P 500 assets ($tn)
Figure 3. Source: Bloomberg, 2 December 2020
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