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AJ Bell: Why the FTSE 100 is warming to an economic upturn

Please see below for one of AJ Bell’s latest investment articles, received by us yesterday 18/04/2021:

As the UK starts to emerge from its latest (and hopefully final) lockdown, the FTSE 100 already trades above the levels reached just before the pandemic first made its presence felt in China and Southern Europe in early 2020.

There can be no finer example of how financial markets are forward-looking, discounting mechanisms which seek to price in future events before they happen. Yet they are not right all the time. No-one, but no-one, owns a crystal ball (or at least one that works) and if markets really were that prescient, then there would never be major sell-offs or upward surges, as no-one would ever be surprised by anything.

What the advisers and clients must therefore do, in order, is assess the facts as they are known, determine the current consensus about what will happen and – by looking at valuation – decide whether the risks are to the upside or downside. Therefore, they must look at the broad range of possibilities concerning what may happen, what could be the biggest surprises and their potential impact so they can decide whether the potential upside rewards outweigh the downside risks over their preferred time horizon.

In sum, the best fund managers are not necromancers or chancers trying to guess the future. They are experts at judging probabilities and act according to the cold maths of valuation, be that measured by earnings, cash flow or yield. It may not take much good news to boost a market that has fallen sharply to price in negative events (it may even just take the absence of fresh bad news), while it may not take much bad news to jolt a market if it has made big gains.

The FTSE 100 bottomed in late March 2020 at 4,994, long before the worst news about the pandemic and its toll on lives and the economy became known. After a near-40% gain in the UK’s headline index over the past year, advisers and clients must once more assess the balance of probabilities so they can decide whether the index has further to run or not and a good place to start is earnings forecasts.

New highs

At face value, it does seem odd that the FTSE 100 is trading above its pre-pandemic levels, even if the number of daily new COVID-19 cases is back to where it was last March and last September, and the vaccination programme continues apace. The economic outlook is still uncertain: the effects upon the behaviour of corporations and consumers alike are yet to reveal themselves and other parts of the globe are less advanced in their race to inoculate their populations.

But it does make sense if you think that the consensus earnings forecasts for the FTSE 100 are going to be accurate. An aggregate of the estimates made for each member of the index suggests that the FTSE 100’s total pre-tax profit will be £178 billion in 2021 and £205 billion in 2022.

FTSE 100 is forecast to make record pre-tax profit in 2022

Those figures exceed the £166 billion made in 2019, before the pandemic hit home. Moreover, if the 2022 forecast is attained, then that would represent a new all-time high for annual earnings, surpassing the £199 billion made in 2011.

In this context, it is not too hard to see why the FTSE 100 is trading where it is, or even make a case for further gains, since the index trades below its May 2018 zenith of 7,779 even though record profits are expected for 2022.

Advisers and clients must therefore decide whether the forecasts are reliable, too optimistic or too pessimistic and what must happen for analysts to be off-beam (which they usually are, owing to the absence of that crystal ball).

Heavy metal

To do this, advisers and clients need to parse the FTSE 100’s earnings mix. Roughly 60% of forecast profits come from just three sectors: mining (now the single biggest earner), financials, and oil and gas.

Just three sectors are expected to generate around 60% of FTSE 100 earnings in 2021 and 2022

In some ways, this makes it easy for advisers and clients to judge the upside and downside potential: in crude terms, the stronger the economic recovery the better, so far as the FTSE 100 is concerned as the index’s key industries offer huge gearing into GDP growth. The opposite also applies. A weak recovery (or heaven forbid an unexpected double-dip) would be potentially a nasty surprise.

A breakdown of forecast earnings growth makes this picture clearer still. Analysts think that the FTSE 100’s aggregate pre-tax profit will rise by £75.1 billion this year and by a further £27.1 billion in 2022. Miners and oils are expected to generate two thirds of that between them in 2021. Oils, consumer discretionary and financials are forecast to provide four fifths of the expected profit uplift in 2022.

Just three sectors are expected to generate more than 75% of forecast earnings growth in 2021 and 2022

Rising commodity prices and steepening yield curves would therefore be a good sign; falling and flattening ones would not. Those advisers and clients who buy into the narrative that inflation is coming, after being largely dormant for 40 years, will therefore feel right at home in the UK. Those who still fear debt-ridden deflation may be tempted to steer clear and seek their fortunes elsewhere.

Please continue to utilise these blogs and expert insights to keep your own holistic view of the market up to date.

Keep safe and well.

Paul Green DipFA

19/04/2021

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Legal & General: Our Asset Allocation team’s key beliefs

Please see below for Legal and General’s latest Asset Allocation Team’s Key Beliefs article received by us the afternoon of 25/01/2021:

Bubble trouble?

Never have more people searched for the term ‘stock market bubble’ on Google. Data stretching back to 2004 show that January 2021 is set to eclipse January 2018, when searches for the term both preceded and followed a 10% drop in the S&P 500 over nine trading days. As we have highlighted before, investor optimism is pretty well inflated and, while most sentiment indicators don’t look stretched, many are elevated.

Burst case scenario

Not everyone is optimistic, though. One scholar of market bubbles, Jeremy Grantham, opened his new outlook: “The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble.” Grantham has a good track record in predicting the moments when bubbles burst, so should we be worried? We think the famed investor may be right but, as he concedes, we believe the market could still run a lot further. Our own bubble index shows that the probability of a market bubble has indeed been rising. In fact, it is now the highest it has been since 2008.

What has driven this? We have seen an increase in capital raising through IPOs and SPACs, some of which echo the tech bubble of the late 1990s. US retail investor activity has also taken off, with easier access through investment platforms and, for some, new money to play with from stimulus cheques. However, we are just emerging from the COVID-driven economic recession. This means many macroeconomic indicators have improved, policy is supportive, and there is plenty more cash on the side lines ready to be deployed, regardless of further fiscal stimulus.

So while the market is definitely reminiscent of a bubble forming, it could easily still get much stronger from here. We therefore believe it’s too early to call a bubble now.

The moderates yield

If you weren’t able to watch any of the US presidential inauguration, I recommend viewing US National Youth Poet Laureate Amanda Gorman’s recital of “The Hill We Climb”, a powerful and gritty poem of hope for the future of the US, from a self-proclaimed presidential candidate for 2036.

In the more immediate future, the most relevant aspect of the new Biden administration to financial markets will be the prospect of more fiscal stimulus. The central case is for another virus relief package worth $1 trillion to be passed in the coming months, with an additional $1 trillion recovery package potentially following later. The quicker the economy recovers, of course, the smaller later packages will be.

Politically, though, we see the path of least resistance actually being for more fiscal spending rather than less. With a razor-thin majority, power accrues to the moderates, which means only consensus policies can pass. We expect it will be easier to build such a consensus on extra spending (giving things away) than on extra revenues (taking things away). While Democratic moderates have supported virus relief and the current package so far, several are not on record as supporting Biden’s tax proposals. Finally, voters don’t appear to care as much about deficits anymore, so senators probably won’t either.

Treasury yields could be the place where changing fiscal dynamics are priced, and indeed US yields have risen more than others in recent weeks after the Georgia runoffs, but as it stands we are comfortable with an overall neutral position on duration. In fact, we prefer US markets to UK gilts, which have only seen more modest yield rises despite the so-far successful vaccine rollout and expectations for a fiscally conservative budget.

Flexible recipe for fixed income

Multi-asset portfolios are like giant cakes, baked with multiple ingredients. We have decided to add a new ingredient to our cake: Chinese bonds. Technically it’s not new, as they are a growing part of emerging-market bond allocations in portfolios, but we have moved to an explicitly positive view.

We believe Chinese bonds add a lot of diversification to our fixed income holdings as China hums to a slightly different economic tune from the rest of the world, with a different monetary policy framework too. Historically, Chinese bonds have had a low correlation to other bonds. Their yields are relatively high, and we are particularly interested in bonds that could continue to provide protection in macro downturns as we believe many traditional bond markets will struggle to provide the defence they offered in the past.

This is just one of the steps we have been taking in portfolios to try to manage investor outcomes in a low interest-rate environment, with greater roles for non-traditional fixed income assets as well as defensive currencies and other strategies.

Regularly ‘picking the brains’ of investment managers and experts by reading articles like these can help update your own view of the markets and current global affairs.

Please keep reading these blogs to keep your view of the market well informed and up to date.

Stay safe and well

Paul Green 26/01/2021

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Market predictions and investment resolutions for 2021

Please see below for Invesco’s article on Market Predictions for the year ahead, received by us yesterday 06/01/2020:

Happy New Year! No one wants a year in review for 2020, but here is what I learned from the past year: History may not repeat itself, but it sure does rhyme. What we learned from 2020 is a repeat of the lesson we learned from the global financial crisis (GFC): Central banks are very powerful. They can’t cure viruses and they can’t create jobs, but they can boost confidence and move markets — a lot. That is the big similarity 2020 had with 2009: Central bank intervention mattered, especially by benefiting risk assets.

When I think of the New Year, I think of predictions and resolutions. And so today, I provide you with a little of both.

My New Year’s predictions

1. US-China relations may get warmer. There seem to be two factions emerging among Biden loyalists: “reformists” who want to push China aggressively on key issues and check its power, and “restorationists” who want to restore US-China relations to where they were in the Obama administration. I believe Biden will do what he typically does: land somewhere in the middle. I don’t expect US-China relations to return to what they were pre-Trump. However, I do expect the relationship between the two countries to improve and normalize. In particular, I expect more predictability and less volatility. While Biden may not unwind tariffs immediately, I do expect him to unwind the Trump administration tariffs after a “study” of their impact (which has obviously been negative for parts of the US economy, especially agriculture). The Biden administration will likely be aggressive on specific issues with China and pursue those issues multilaterally — but I expect that to occur within the context of a broader US-Sino relationship that is more cordial because the fortunes of many US businesses are tied to China. The Chinese economy is on pace to soon overtake that of the US, with the timeline expedited due to COVID, which gives China growing leverage. In fact, the Centre for Economics and Business Research recently released its forecast that China will overtake the United States by 2028 as the world’s largest economy, which is five years earlier than previously estimated due to the two countries’ very different recoveries from the pandemic.1 In addition, China has already begun to signal that it would like improved relations with the US. China’s Foreign Minister Wang Yi said in a recent interview with the South China Morning Post that both the US and China have been negatively impacted by the deterioration in their relationship over the past several years, and that US-China relations have come to a “new crossroads” with a “new window of hope” opening.2

2. Developed countries may have a better recovery than they did post-GFC. As COVID-19 vaccines are broadly distributed, I expect the economic recovery to be far more robust and inclusive than the economic recovery coming out of the global financial crisis. I believe the services industry will rebound with greater intensity, benefiting many lower income workers. That doesn’t mean that there won’t be more glitches in distribution — I fully expect there to be. And there will likely be more pandemic-related headwinds, such as the development of worse strains of the virus. However, once a substantial portion of the population is inoculated, I expect the economic recovery to be powerful. 

3. Oil may rise. Given my expectation for a strong economic recovery in 2021 as vaccines are distributed, I also expect demand for oil to increase significantly. I believe this will lead to a substantial increase in the price of West Texas Intermediate crude oil — even if we see a ramp up in oil production.

4. Bitcoin may fall. I know there is a lot of excitement over Bitcoin, but it’s starting to feel a bit like Tulipmania. Bitcoin rose more than 300% in 2020, with much of the gains made in the last few months of the year.3 I continue to believe gold is a far better choice for diversification into “hard assets” and as a hedge against geopolitical risk. Bitcoin might continue to run for a while this year, but I expect it to be volatile and to ultimately disappoint, as it has in the past after strong rallies.

5. The S&P 500 Index may have another double-digit return in 2021. With vaccine distribution beginning, a robust economic recovery anticipated in the not-too-distant future, as well as extraordinary accommodation from the Federal Reserve, I expect a continuation of the stock rally we saw in 2020, albeit with drops and pauses along the way. Better-than-expected corporate earnings should also help.

My New Year’s resolutions

1. Stay invested and well diversified. While I feel very confident about risk assets in 2021, that doesn’t mean there won’t be volatility and sell-offs in the coming year. I believe having adequate exposure to stocks, fixed income, and alternative asset classes is key to building a portfolio that may withstand volatility.

2. Look to Asia’s emerging markets. My outlook is especially bright for the emerging markets countries that have managed the pandemic well, such as China and Korea. These economies have a head start on the robust vaccine-fueled economic recovery that I expect in 2021.

3. Don’t overlook tech. While the economic rebound may result in strong performance by cyclical stocks in sectors such as energy and consumer discretionary, I don’t necessarily expect tech stocks to underperform. I continue to favor adequate exposure to the technology sector, as I believe many tech stocks may continue to benefit from trends that accelerated during the pandemic.

Although nothing is guaranteed for the future as proven by the year 2020, expert insight and opinion like this is a good way of seeing how actions and news developing worldwide could have an impact on the investment markets, and thus highlights good topics for discussion.

Please utilise blogs like these to aid your own informed opinions on what may lie ahead for the markets, but I reiterate that nothing is guaranteed for the future.   

Keep safe and well and all the best for 2021.

Kind Regards

Paul Green

07/01/2021