The recovery continues to pick up speed, particularly in the US and the UK where both nations have successfully vaccinated a majority of the population. The International Monetary Policy (IMF) have raised global Gross Domestic Product (GDP) growth forecasts by 0.8% to 6% for 2021. The Q1 2021 GDP release from the US, was an annualised 6.4% and with plenty of dry powder still available for US consumers we could see even higher GDP growth for the rest of 2021. Retail sales in both the UK and the US were strong over the last month growing 9.8% and 5.4% respectively. Yet, whilst vaccines have allowed certain countries to resume many interrupted services, recent tragic developments in India are a stark reminder of the great battle that many emerging markets still face. In fact, global daily cases reached a new peak level this month, crossing the highs at the end of last year. In the latest IMF Financial Stability Report for this quarter, attention was drawn towards the build-up in debt amongst EU corporates. A dominant feature of the pandemic response in the EU has been liquidity support to firms in the form of loan moratoria and government guaranteed loans. These efforts helped to avert widespread insolvencies last year at the height of the economic shutdown. As of Q4 2020, C$471bn of loans were under moratoria and C$500bn of loans remain under the Public Guarantee Scheme. Italy and Spain have been the biggest users of the scheme with businesses receiving government backed credit worth 8% and 9% of GDP respectively. However, the short-term liquidity support has left firms more indebted and exposed to a pullback in government support. As we move into the second quarter of 2021 many of these support programs will come to a gradual end. In a paper published by the European Systemic Risk Board at the end of this month, several risks were highlighted. Primarily, if government support were pulled too quickly ‘in a worst-case scenario, the postponed insolvencies would suddenly materialise and trigger a recessionary dynamic, potentially causing further insolvencies.’ Yet, there is certainly a level of insolvency that is both healthy and necessary for a strong recovery. It will be up to governments and their national banking systems to pick the winners and losers from the pandemic. If capital continues to be allocated to non-viable ‘zombie’ firms, this will weaken the creative destruction process that is vital in raising productivity and long-term growth.
Population decline a structural headwind for China
Having ended 2020 as the fastest growing major economy, China’s first quarter GDP data indicates the beginning of a slowdown. Yes, real GDP growth for Q1 relative to last year was a record 18.3%, but this is exaggerated by the enormous contraction from the initial shock. Real GDP grew only 0.6% from the last quarter, one of the slowest quarterly rates on record and less than half the consensus estimate. This is partly a result of Chinese policymakers resuming their fight against excessive levels of corporate debt, particularly in the property sector. Earlier in the month, the PBoC had instructed major lenders to limit their credit supply to last year’s levels. As expected, total social financing, a broad measure of lending to the domestic private sector grew by 12%, the lowest level since April of last year. Annual growth in M2 money supply has continued to fall and is now 9.4%, lower than the Eurozone (9.5%) and much lower than the US (24%).
Perhaps more troubling for Chinese policymakers is that the latest nationwide census is expected to confirm the first population decline since the Great Famine in 1960-61. Births in 2020 were reported to have been 15% lower than in 2019. The demographic story for China was already troubling before Covid-19, a result of the disastrous one-child policy, which remained in place for decades. Yet the pandemic has brought forward the possibility of a declining population years before anyone had expected. Researchers within the PBoC published a paper earlier in the month urging authorities to remove all birth control policies that still exist in the country and encourage childbirth. They pointed to the economic disadvantage that would result from a declining population relative to their competitors. From 2019 to 2050, the UN forecast China’s population to decline by 2.2%, while the US will increase by 15%.
China is one of many countries that have experienced a sharp fall in births after the pandemic. Among the East Asian nations (with already weak population trend growth) births fell 23% in Taiwan, 6.3% in South Korea and 14% in Japan. In Europe, births fell by 22% in Italy, 20% in Spain and 13% in France. Whilst the latest national data is not yet out for the US, several states have reported similar double-digit declines. Lower population growth of course has dire consequences for economic growth and in turn asset prices. Unless there is an increase in productivity growth (which has remained elusive for the last 20 years at least) a shrinking labour force necessarily results in lower economic growth.
Earnings rebound already priced in?
Turning to markets, a decline in U.S. Treasury yields and improving corporate earnings provided support to equities. In the U.S., around 87% of S&P 500 companies have beaten estimates for the first quarter, with just under one-fifth having reported.
Volatility in financial markets hit their lowest levels since the pandemic hit stock and bond prices last year, as investors bet on a successful reopening trade and optimism on a strong earnings recovery. The Vix index, which measures implied volatility on S&P 500 index options, has dropped below its long-term average of 20 ending the month at around 17.6. Whilst volatility measures remained subdued, the change in corporate prospects since the discovery of vaccines has meant investors have returned to banking, travel, energy and hospitality sectors with lockdown winners relinquishing market leadership.
Equity market valuations continue to operate at lofty levels. The market P/E ratio, as determined by the MSCI AC World Index, remains elevated at 29x and Tobin’s Q, the ratio of total stock market capitalisation to the total replacement value of the assets in its companies, is at an all-time high. One argument justifying equity market valuations is that the bond market is also historically expensive and when this is considered, equities don’t seem so expensive. Bonds were at their most expensive during the worst of last year’s Covid shutdown, with the decline in yields supportive of growth equities. However, given the sharp rise in bond yields and climbing equity valuations the earnings yield argument has weakened considerably. Despite the move in bond yields, we remain of the view that longer duration bonds continue to be expensive preferring to position ourselves at the shorter end of the curve where interest rate risk is lower.
Investors remain on alert for signs that the Fed will consider reducing its $120 billion monthly bond purchases earlier than anticipated. Such concerns came to the fore when the Bank of Canada became the first G7 central bank to scale back its pandemic-era bond purchases by C $1 billion a month to C $3 billion. The move from the Bank of Canada prompted the ECB to highlight the obvious. That is such tapering would be premature for the Eurozone given the delay in rolling out the vaccine although some progress has been made of late.
After the worst quarterly return since 1980 the U.S. Treasury market has seen yields tighten despite the U.S. expecting stellar economic growth over 2021. The benchmark 10-year yield fell to as low as 1.56%, rallying by 19bps before widening to end the month at 1.64%. Much of the decline in the U.S. 10 year has been attributed to demand from overseas investors.
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