February 07th 2021

Investment Outlook February 2021

Old school After a January where commodities and emerging market equities were the best performing asset classes, investors maybe thinking old school investing has returned. Bonds eased lower as inflation concerns appear to be pushing yields higher, albeit yields remain low and unattractive for investors in our view.

Equity markets were generally positive as the prospect of a large fiscal stimulus from President Biden (how consoling does that sound) boosted recovery expectations. However, at the end the month activity became erratic, especially in some segments of the US equity market. Is the rally in the shorts indicating capital misallocation?

The saga of Robinhood retail investors battling against the hedge funds in targeting ‘short’ positions, stretched call/put ratios, high margin debt and speculative capital raisings all seem to point to exuberance. An example of the impact of assault on hedge fund capital is shown below. Over time, companies with the highest proportion of short interest typically underperform by 6.9% annually since 1985.

The long-term underperformance of the heavily shorted companies suggest that the short sellers collectively have good judgment. So, the strong rally of this basket since the pandemic lows of March 2020 is at odds with the long-term track record, but in directional terms in keeping with the patterns seen in previous market troughs.

In part, the strong rally of the stocks with the highest level of shorts (i.e. most despised by the hedge fund community) may be associated with the strong performance of those companies with the weakest balance sheets. When companies with over extended balance sheets meet with recessions and revenues fall, these companies typically either fail or must undergo capital restructuring, often to the detriment of equity holders.

This is one of the reasons we stress balance sheet strength as part of our Capital Discipline Process in selecting direct equities for inclusion in client portfolios.

The rally in those companies with the weakest balance sheet may in turn be associated by the monetary largesse of Central Banks that have poured liquidity into the financial system bailing out good and not-so-companies through the pandemic. Some investors may be lulled into believing the liquidity punchbowl provided by the Federal Reserve will remain spiked forever and the dangers of balance sheet stretch are being hidden by policy makers in search of providing support to the wider economy.

Fiscal dominance Over the past few decades economies have been stimulated by reducing interest rates. Whilst the monetary tap is turned on, investors appear to be willing fiscal authorities to take advantage of low interest rates and bond yields to provide fiscal stimulus to fuel the recovery. The strong focus on the demand side is visible in measures such as direct cash payments to households, job retention schemes (furlough) and unemployment insurance. Thus, the boost to real GDP from each government dollar, pound or euro spent could very well be larger compared to the post-GFC recovery, or least result in less damaging outcomes if governments had stood to one side and left monetary authorities alone to provide support. Earnings drive equities

Over the past few years as bond yields fell, so equity valuations rose. On all traditional measures equities look expensive, reducing the level of potential return over the medium term. Relative to other asset classes, however, equities still appear attractive. In the short-term, valuations don’t drive market returns, especially if the earnings are rising rapidly. The old school recovery is likely to benefit equities as well, as it magnifies the expected spike in earnings growth. Historically earnings growth is especially strong in the expansion phase of the business cycle, which we have just entered. For the MSCI World All Countries Index, earnings growth of roughly 25% is expected. In regions with high operational leverage –Japan and emerging markets – expectations are as high as 36%, which we think is achievable. As a result, earnings growth will be the main driver of equity market returns going forward.

Even in the U.S. equity market which has a higher weighting in non-cyclical recovery companies, earnings are being revised higher. For investors looking forward into 2021 and 2022 estimates for profitability have risen by 5% over the past 6 months. Expectations are that 2021 will see $170 and $198 for 2022.

This revision higher is at odds with the typical path of earnings estimates as shown on the chart below. In most years, analysts revise earnings estimates lower, as over optimistic estimates meet reality and management guidance. However, despite the continued impact of COVID-19 estimates are being revised higher, which is providing a support for equity prices, despite elevated valuations. The estimate revision is being driven by the improvement in the revenue line. In the current quarterly updates of companies 78% of companies are beating estimates of sale to the upside according to Factset data. This is the highest since the data started in 2004.

Inflation temporary Inflation is likely to track higher over coming months as the oil price is currently at $55 per barrel, which is 145% higher than the March 2020 level. As this base effect feeds through so it likely that headline inflation measures will rise, as shown in the chart below.

Lingering excess capacity implies only a modest structural rebound in core CPI. Eurozone core CPI is only 0.2% and remains far below the ECB inflation target. Global core inflation slumped to a record-low of 1.1% last year, reflecting the steep fall in global demand. This slide reflected an unprecedented drop in services price inflation alongside a year of solid goods price increases, aligning with the dramatic sectoral divide in activity. In the three months through January, China’s core CPI has slipped into deflation and US core price gains have fallen to a 1% ar.

Nonetheless, more inflation volatility over the coming months could complicate the forward guidance from Central Banks. However, ECB President Lagarde has already stated that “any kind of tightening at the moment would be very unwarranted”. We would agree as globally, the sharp down-and-up swing in oil prices last year is set to generate noise in year- ago comparisons.

Potential China tightening risk China’s GDP grew 2.3% last year, making it the only major economy to see its output expand. The latest economic indicators for China’s manufacturing cycle indicate that the country is losing some momentum in industrial activity, though it is still expanding. The official PMI fell back to 51.3 in January from 51.9 in December.

The combination of several COVID-19 lockdowns and a moderation in export orders as the rest of world’s recovery is delayed is the probable cause of the deceleration. Although Chinese stimulus, measured by total social financing, may well have peaked, As the Chinese economy gets onto a stronger footing, Chinese policymakers are increasingly paying attention to financial stability risks emanating from high leverage even though inflation remains subdued.

A tightening stance would also strengthen the yuan even more, potentially weakening the external competitiveness of the Chinese export sector. Any tightening by policymakers may require investor to reassess the current positive stance towards Emerging Market equities.

IMPORTANT INFORMATION

Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 10th February 2021 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content.

The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results.

Nothing in this document is intended to be, or should be construed as, regulated advice. Reliance should not be placed on the information contained within this document when taking individual investment or strategic decisions.

Any advisory services we provide will be subject to a formal Engagement Letter signed by both parties. Any Investment Management services we provide will be subject to a formal Investment Management Agreement, which will include an agreed mandate.

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