While the Christmas break may feel like a distant memory, and 2021 finds us all yet again in a lockdown, a reminder that our outlook for 2021 is broadly positive as economies return to normality against a backdrop of a vaccine rollout. We should remember, however, that a lot of good news and hope is already priced into market levels so this could be a year where the economic recovery catches up with the recovery we have already seen in markets.
So, where to start? Usually the Christmas period is a time of year where it all goes a bit quiet and I’m struggling to find anything of note to comment on in our daily team meeting. This year, there were no such problems. We have seen equity markets push further onwards, helped by the removal of a number of tail risks that dominated headlines in the run up to Christmas and despite the ongoing, and worsening in many regions Covid-19 pandemic, which has resulted in further restrictions being imposed across many western economies.
The first tail risk to be removed was that of a ‘no-deal’ end to the Brexit transition thanks to the UK and EU reaching agreement on a basic trade deal on Christmas Eve, which came into effect on 1 January. For the whole of December it felt like we were in ‘last minute’ talks, with several deadlines broken and both UK and EU political leaders suggesting the most likely outcome was ‘no-deal’. The fact neither side broke off talks highlighted that neither the UK nor the EU wanted such an outcome, but the brinkmanship from both sides meant that ‘no deal’ remained on the table until it became clear that the key sticking points around a ‘level playing field’, fisheries and governance had been resolved just before Christmas Eve. The consensus in financial markets remained that a deal would be reached and that what was taking place was just political brinkmanship ahead of an ultimate compromise. As Christmas, approached Sterling volatility picked up as concerns grew that time was running out, but on Christmas Eve both sides confirmed an agreement had been reached. The deal was rapidly approved by the UK Parliament when it was recalled between Christmas and New Year and given preliminary approval by the EU meaning the deal takes effect with scrutiny by the European Parliament to take place in the coming months. The UK-EU trade and co-operation agreement seeks to govern the two sides as they separate and is unique in the sense that trade deals are usually about bringing two economies closer, not regulating how far they can diverge. This is a very skinny trade deal that secures tariff-free and quota-free access for goods, but little else. It does very little for the service sector, which makes up 80% of the UK economy. The deal also means Brexit will be ‘never ending’ in the sense that the trade agreement has multiple governance, review and termination clauses and is subject to automatic review every five years, as well as annual fishing negotiations once the 5½ year transition on fisheries comes to an end. All the same, the key concerns about Brexit but will likely fall out of the headlines, and financial markets will move on, now that the tail risk of a cliff-edge at the end of the transition period has been removed. As for the economic reality of what is in effect a very hard Brexit, the immediate impact is masked by the consequences of the pandemic, though it is already clear that the end of frictionless trade is causing headaches for some cross-border traders. Over the longer term it will be impossible to put exact numbers on the economic growth foregone by the UK choosing to diverge from a trading bloc that it had been part of for decades.
Moving on to US politics and again there has been a lot going on. From a financial markets’ perspective, two things stand out – the stimulus package (removing another tail risk) and the ‘blue wave’ outcome from the runoff for two Senate seats in Georgia. From a political perspective, the fallout from the disorder in Washington last week stoked by President Trump’s continued efforts to undermine the election outcome is yet to fully play out. With Joe Biden due to be inaugurated as President next week, Trump is once again subject to impeachment proceedings, with a single charge of ‘incitement of insurrection’. The process will likely extend beyond Trump’s tenure in the White House, and will still need Republicans in the Senate to abandon their support in order to achieve the two-thirds majority needed to secure a conviction. The bipartisan deal on a fiscal stimulus package passed through Congress in the days leading up to Christmas, but was delayed being implemented after President Trump called the Covid Relief Bill “a disgrace”, calling on Congress to increase the $600 direct payment to individuals to $2000, as well as calling for increased tax breaks for corporate lunches (!). The Bill was eventually signed into law, despite Trump’s protests and also included a wider package to fund federal spending for the next 9 months, meaning a potential post-Christmas government ‘shutdown’ was averted.
The stimulus package is seen as a stopgap measure, with further measures to come once President-elect Biden takes office. The President-elect spoke yesterday of his intention to put forward a $1.9 trillion stimulus package, with additional payments to individuals of $1400, an increase and extension of unemployment insurance and significant additional spending on Covid related care and vaccination programmes. Biden’s ability to implement policy became a lot easier earlier this month after the runoff in Georgia for two Senate seats saw the Democrats win both seats, meaning that the Senate is now divided down the middle with 50 Democrats and 50 Republicans. However, the Vice-President will hold the casting vote, meaning that the Democrats (just) have control of the Senate, and with their existing majority in the House it means that President Biden will, for the next two years at least, have Congress on his side. The reaction to this so called ‘blue wave’ in financial markets was for the cyclical and value names to outperform, with some of the mega cap tech names struggling relatively. With the Democrats having more scope to implement policy, the expectation is for more fiscal spending which presents upside risks to economic growth. However, the ‘reflation trade’ and potentially higher growth also raises the prospects for tighter monetary policy. Despite continued language from Federal Reserve members that monetary tightening will not happen any time soon, we have begun to see a repricing in government bond yields – nothing like a taper tantrum but notable all the same. The market mood for now appears to be focused more on the benefits of higher economic growth than on higher taxation and regulation particularly in the tech sector, and while US equities may have lagged some other indices in the past fortnight, they still closed last week at all-time highs.
The Covid-19 pandemic continues to dominate the news headlines even though the increasing case numbers and renewed lockdown appear to have only momentarily impacted the momentum in equity markets. Since my last update, the UK has evolved from government policy set to allow gatherings over several days at Christmas reduced to a single day, and in the aftermath of Christmas back to a lockdown, including the closure of schools. The spread of a more virulent strain of the coronavirus has led to a huge spike in case numbers in the UK, with daily cases topping 60,000 at the start of the week – this is sadly now feeding into mortalities with warnings that the peak stress on the healthcare system is still ahead of us. Across Europe we have seen the reintroduction or extension of lockdowns and in the US, stay at home orders. Japan is also rolling out new restrictions as case numbers accelerate. The news on the vaccine remains encouraging, though there is clearly some frustration at the speed of rollout in some places. We have also seen positive signs of reducing case numbers in Israel, which having now vaccinated 24% of their population should be a useful guide as to how vaccinations will start to make a difference. Sadly, the reality in the short term is once again a significant amount of economic activity is on hold, and while there is still a path out of this pandemic, restrictions are likely to be in place through the spring of this year, and quite possible well beyond in terms of travel. We are now starting to see new case numbers in the UK begin to level off as the lockdown reduces transmission, but it is clear that a lockdown, or at least severe restrictions will likely be required for an extended period to come.
The news around Covid and the extended economic impact does not alter our base case that we will see a return to economic ‘normality’ over the course of the year, but as we argued in the webinar, we have some dark months to get through first with large sections of the economy closed or operating well below capacity. For the moment, financial markets have continued in the main to disregard the short-term concerns in favour of focusing on the vaccine (and stimulus) fuelled recovery. However, given current equity market levels and the strong recent run, we would not be surprised if a pause in the momentum were to take place. We have slightly reduced our equity exposure this week, taking short index futures positions across the portfolios in order to take a little risk off the table. We still think we can make further progress but think that we can put money to work at slightly more attractive levels than we are seeing right now. There is still a potent mix of fiscal and monetary support, combined with an optimistic mood around the economic recovery to come, but we do see some markets as looking ‘frothy’ and believe that some caution in the short term is prudent.