Macro update: February 2021
Welcome to our monthly macro update. Here we provide an overview of our current market views, and our recommendations for strategic portfolio positioning.
Companies take advantage of cheap capital
With equity markets buoyant and borrowing costs low by any standard, we are in a great environment for corporates to raise capital – and we are starting to see this play out. Companies raise capital predominantly through issuing shares or borrowing from investors, and in January 2021 alone we saw companies raise $92bn globally in equity offerings, over double the level in January 2020 as shown in the chart below. High levels of issuance is also being seen in debt markets, most notably within high yield. As we have said before, cheap borrowing costs means more corporate projects are viable, which in turn should be accretive to earnings and ultimately benefit shareholders. All of this reinforces our preference for listed equities as the major driver of returns over 2021.
But we still wrestle with the question of whether equity valuations can continue to inflate from their current high levels. From a price to earnings (P/E) perspective we saw a meaningful rise in 2020 from c.20x to c.32x, which was predominantly a function of ‘multiple expansion’ where the price increased at a faster rate than earnings. What this misses, however, is the impact that the largest (and most expensive) companies have on headline numbers; on an equal weighted basis valuations are less extreme. Equally, we can’t forget that we have record low bond yields. Bond yields are an important influence on stock prices, and the largest (most expensive) companies have been notable beneficiaries.
As more corporate projects are undertaken, it is feasible that increased earnings begin to take over as the driver of returns. In practice, this means share prices can rise without companies looking more ‘expensive’ in a traditional sense, e.g. from a P/E perspective, valuations are unchanged providing prices increase in line with earnings growth. Given the strong P/E expansion we saw in 2020, this may prove to be a more sustainable way for company value to continue growing, and against this backdrop we continue to advocate a higher equity allocation.
Year to date global equity issuance
Source: Bloomberg as of 02/2021
Snapshot of views
We have been talking for some time about the benefits of low borrowing costs, and we are now seeing companies act. Debt issuance has been significant throughout January, while over twice as much equity has been raised year to date compared to the same point in 2020. This action is supportive of our preference for listed equities, which we set out in detail last month. But we still anticipate volatility in the first half of 2021. Being dynamic around this will be key, as will making use of a wide investment toolkit, with tools like structured equity being important for managing risk.
Given the considerable spread compression in credit markets, there is now minimal compensation for potential defaults and downgrades. Stimulus has been effective in supporting credit markets but has also done a remarkable job in maintaining the finances of the US consumer, with US household savings at their highest levels since World War II. The deployment of pent up demand could cause a private sector boom and put short term pressure on inflation, but we still view a sustained rise in prices as unlikely given levels of unemployment and the deflationary pressures discussed last month.
Volatility is making structured equity attractive
Whilst the current environment is supportive for equities over the medium term, we do expect to see short term volatility. So, how are we taking this into account? Well firstly, where we have discretion, we are being dynamic within equities, and secondly, we are being selective about the exposure we do take. But there is another important tool we can use – structured equity. For those of you who are less familiar with the concept of structured equity, it is a tool which allows us to “shape” the returns we get from equity markets. For instance, adding greater downside protection in return for sacrificing some equity upside. It ultimately allows us to access equity markets in a more risk-managed way.
Reflecting on 2020, structured equity was key in managing downside risk, and had we been restricted to traditional assets, we would not have advocated increasing equity exposure to anywhere near the same degree. It remains an essential part of our investment toolkit, and recent market volatility has presented us with attractively priced opportunities. For example, in January 2021 it was possible to purchase an equity structure with cash + 8% upside, and downside protection up to 20%. This presents an interesting comparison with more traditional assets; for instance, high yield credit valuations look increasingly challenging. From current spread levels, equity structures present better value than high yield(considering respective levels of potential downside) and we have been rotating capital to reflect that.
Structured equity payoff profile on US equity
Source: River and Mercantile, 04/02/2021
Could pent up consumer demand lead to a private sector boom?
US household savings are at their highest levels since World War II, despite considerably higher unemployment compared to pre-COVID 19 levels. Today, if consumers spent half of their excess savings then US consumption would rise over 7%, potentially driving a private sector boom. With the US passing a meaningful milestone of more vaccinations than total cases, household savings are getting ever closer to being deployed. Most likely this will be evident in the travel and leisure sector where pent up demand is most apparent. But what impact could this have on inflation? To answer this, we should look at China which has been a useful leading indicator throughout the pandemic.
China’s GDP grew over 2% in 2020 (one of very few nations to achieve positive growth) yet we have not witnessed a material pickup in inflation despite stimulus measures. This reinforces our point last month that it is difficult to see a sustained uptick in inflation without stronger employment data. This takes time, and with meaningful deflationary pressures coming from technology improving productivity, there remain questions over whether policymakers can manufacture the inflation required to lower stimulus and raise interest rates. Most likely we anticipate a short-term pick up in inflation followed by a return to the moderate levels we are currently witnessing.
US household savings
Source: Bloomberg as of 02/02/2021
 MSCI All Country World Index Price to Earning Ratio End of 2019 vs End of 2020
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