Melville Douglas Focused Monthly Commentary
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Melville Douglas
Focused
Monthly Commentary
/ February 2021
Valuation concerns resurface
The new year began with a succession of new highs for global
stock markets. The impetus was the Democratic Party’s surprise
wins in the Georgia senatorial run-off elections that enabled
control of the Senate. The Biden Administration now has more
scope to push through heftier fiscal spending programs. The
rollout of COVID vaccination programs across the globe further
Bernard Drotschie
stoked “look-through-the-crisis” confidence. However, as the
/ Chief Investment Officer
month progressed, this initial optimism dissipated on concerns
about more infectious (and potentially vaccine resistant) COVID
viral strains. Not even stronger than expected economic data,
a very strong outcome from the Q4 2020 earnings season or
assurance from Janet Yellen (the newly appointed US Treasury
Secretary) and Federal Reserve Chair Jerome Powell that more
stimulus was on the way to safeguard the economy from “a
longer, more painful recession now – and long-term scarring
of the economy later”, could stem some short term weakness.
With the deployment of vaccines and inoculations gathering
momentum and policy makers steadfast in pulling the global
economy out of the pandemic hole, investors can look forward
to a much stronger growth environment in the second half of
the year, but the reality is that not all asset prices will benefit
equally, as much of the good news is already reflected in many
valuations.
PRICE-TO-EARNINGS (NEXT 12 MONTHS)
US
World
Europe
EM
Japan
Source: FactSet
More fiscal support on the way.
Investors will take comfort from Joe Biden’s inauguration as the 46th president of the United States. With a Democratic
sweep now a reality after the Georgia Senate run off, President Biden has the majority (albeit at a very slim margin)
support in Congress and his new administration is pushing for a further $1.9 trillion fiscal stimulus package (over and
above the $900bn approved in December). Whilst the actual figure and timing remain up for debate, the economy is
set to receive more assistance, albeit to the detriment of rapidly rising debt levels. These amounts are significant even
for a $20trn economy. The funds have been earmarked to support those that have been worst hit by the pandemic and
to rebuild the economy with a focus on infrastructure investment.
The US government’s debt has ballooned to well over 100% of GDP as a result of the crisis and this will at some point
have to be addressed by policy makers, but evidently not in the near term given that the overarching objective is to
first pull the economy out of the claws of the pandemic. The good news for now at least is that the cost of financing the
increased debt for western world countries has become almost insignificant given the historically low interest rates.
Roll over risk (re-financing risk) has become a non-event for governments given that their central banks stand ready to
provide the necessary support. Further out there will have to be higher taxes to reduce debt but again the immediate
focus is to deal with the severe economic effects of COVID-19 rather than halt any lasting recovery before it has begun.
Signs of exuberance surfacing
Focus has rightfully shifted to lofty and in some cases
outright “bubble” like valuations (generally described
as price rises not justified by fundamentals) in certain
sectors such as solar power and electric vehicles; think
Tesla Motors whose share price has increased by a factor
of eight during the past year. The increased involvement
of US retail investors in pushing valuations higher has
also started to raise alarm bells as cheap financing and
easy access to online trading and derivative platforms
has resulted in increasing speculative behaviour,
Call option Buys minus Sells by smaller investors,
something which can easily unravel should share
mn contracts (lhs)
prices sharply decline or when (ultimately) liquidity is
Nasdaq, rhs
withdrawn from financial markets.
Source: JPMorgan
Increased involvement of US retail investors in pushing
valuations higher has started to raise alarm bells.
Through various social and trading platforms such as Reddit, ordinary retail
investors have recently been targeting and buying certain small cap stocks
such as GameStop which have been shorted (strategy which allows investors
to profit from lower share prices, but can be very expensive when share prices
increase) by long/short hedge funds. This has resulted in significant losses
for the hedge funds involved as they were forced to “cover” their positions,
by buying back shares at higher prices. Because these strategies are usually
funded with debt, hedge funds have no option but to sell their long positions in
equities to cover realised losses and de-leverage. These events coupled with
profit taking by the retail investors resulted in weakness in equity markets
during the last few trading days of the month.
The example above is not unique in nature but does highlight the potential for
more volatility ahead and, at the same time, serves as a good illustration of
some of the unintended consequences of very cheap money, which instead
of being deployed in the real economy to create employment is finding its
way into short term speculative investment bets. For now, regulators will
most likely intervene to restrict this sort of behaviour by market participants,
before the Federal Reserve is forced to respond with tighter monetary policy
(higher interest rates) to prevent this “bubble-like” behaviour from spreading
more widely.
TESLA - SHARE PRICE MSCI EARNINGS YIELD vs US 10Y GOVERNMENT BOND
Tesla’s share price looks extreme. US 10Y Government Bond Yield (lhs)
Source: FactSet MSCI Earnings Yield (rhs)
Positive correlation between equity valuations and the risk-free interest rate.
Source: FactSet
There is no doubt that valuations for risk assets are expensive by historical
standards when viewed in isolation, something we have alluded to previously,
but it is also equally important to understand that this has been a function
of extremely loose monetary policy and a much-improved growth outlook as
the global vaccination program and fiscal support are stepped up a notch.
Risk assets have also benefited from a quicker than expected recovery, with
economic data and company earnings consistently printing well ahead of
consensus estimates. Few would have modelled a +4% year-on-year growth
rate in earnings per share for the S&P500 in Q4 2020. The average (median)
company is on track to hit +10% growth, a 2-year high and the fastest
since Q3 2018 which benefited from the corporate tax cut. More widely, the
International Monetary Fund (IMF) recently raised its 2021 global growth
estimate to 5.5% – a level that would match 2007 as the best in four decades
of data.
The fact is that many companies outside of the hospitality and leisure
industries have adopted a “don’t let a good crisis go to waste” approach
and have successfully been adapting their businesses to a new and more
challenging environment with the assistance of technology. So, while
valuations have adjusted to a lower-for-longer interest rate environment and
with the alternatives of cash and bonds being so unattractive, we have been
following a two-prong approach. The first of which is to continue backing
management teams of companies with secular and structural growth drivers
supported by strong balance sheets, which makes them more defensive
during an economic downcycle and allows them to grow market share.
Secondly, to ensure that the shares that we are invested in provide enough
margin of safety from a valuation perspective for long term investors, even
in the event of a market correction. Interest rates will normalise again and
so too will valuations for risk assets. We can’t be exactly sure when this will
happen given that the US Federal Reserve (FOMC), along with many other
central banks, are adamant that monetary conditions will remain ‘ultra-loose’
for the foreseeable future, but we do expect lower returns and perhaps more
volatility in future and have positioned portfolios accordingly.
Conclusion
The outlook for the global economy remains favourable. Accommodative monetary and fiscal policies, high
savings ratios by households combined with pent up demand and normalisation in mobility as vaccines are
deployed bode well for growth momentum in the second half of the year. Forward looking indicators, the
oil price and industrial metal prices are all pointing to stronger growth and valuations of risk assets have
followed suit, providing investors with attractive returns since markets reached their lows in March 2020.
While fundamentals look set to continue to improve as the global economy re-opens again investors should
temper near term return expectations given elevated valuations. Asset prices have in some cases run
ahead of fundamentals and ideally require a period of consolidation. That doesn’t mean that a correction
is in the offing but does suggest that returns will be lower in the future and that investors need to be more
selective and circumspect when making investment decisions.
Market Performance % / as at 31 January 2021 EQUITIES JANUARY YTD 12 MONTHS Global FTSE All World TR Net (Sterling) -0.90% -0.90% 12.15% FTSE All World TR Net (US Dollar) -0.45% -0.45% 16.83% UK FTSE All-Share TR -0.81% -0.81% -7.55% US S&P 500 TR -1.01% -1.01% 17.25% Europe Dow Jones Euro STOXX TR -1.37% -1.37% 0.61% FIXED INCOME JANUARY YTD 12 MONTHS Bloomberg Barclays Series - E UK Govt 1-10 Yr Bond Index -0.44% -0.44% 1.73% Bloomberg Barclays Series - E US Govt 1-10 Yr Bond Index -0.24% -0.24% 4.03% JP Morgan Global Government Bond (Sterling) -1.80% -1.80% 2.06% JP Morgan Global Government Bond (US Dollar) -1.35% -1.35% 6.32% Iboxx Sterling Corporates Total Return Index -1.07% -1.07% 4.50% Iboxx US Dollar Corporates Total Return Index -1.07% -1.07% 6.06% CURRENCY vs. STERLING JANUARY YTD 12 MONTHS US Dollar -0.37% -0.37% -3.71% Euro -1.16% -1.16% 5.40% Yen -1.73% -1.73% -0.30% CURRENCY vs. US DOLLAR JANUARY YTD 12 MONTHS Euro -0.76% -0.76% 9.46% Yen -1.34% -1.34% 3.55% Source: FTSE International Limited (“FTSE”) © FTSE 2013. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and / or FTSE ratings vest in FTSE and / or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and / or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.
Asset Classes Equities
Equities Overweight Consumer Discretionary Overweight
Fixed Income Underweight Consumer Staples Neutral
Cash Plus Overweight Energy Underweight
Financials Neutral
Healthcare Overweight
Fixed Income Industrials Neutral
G7 Government Underweight Information Technology Overweight
Index-Linked (US Government) Overweight Materials Neutral
Investment Grade - Supranational Overweight Communications Services Neutral
Investment Grade - Corporate Slight Overweight Utilities Neutral
High Yield - Corporate Overweight Real Estate Underweight
Currencies / Interest Rates
RECOMMENDATION - INTEREST RATES
Current Direction
US Dollar Overweight 0.25%
Sterling Neutral 0.10%
Euro Underweight 0.00%
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