The UK equities have continued to struggle in these trying times. UK equities are now the cheapest major market globally and there is a strong argument that a valuation rerating would result in very good returns. However, there would need to be a clear path out of both COVID and Brexit for both domestic and international investors to be comfortable allocating back to the UK.
Mid and small-cap UK companies have fared much better, keeping up with international peers. The bulk of this is down to the differing sector makeup. Although, those more domestically focused companies are still being disproportionately impacted by Brexit- related headwinds, and more recently the prospect of a second wave of COVID infections and restrictions.
The sector makeup of the UK has been a headwind through the selloff and rebound as the investors place an ever-increasing premium on the winners (tech, healthcare) and shun those companies which are likely to struggle in the new environment (retail, banking, energy).
The Asda income tracker for July was released in the quarter. Unsurprisingly, and following on from the prior report, there has been a further deterioration in household discretionary incomes. The outlook remains weak, with likely job losses and potentially higher inflation squeezing spending power. This may be eased to some extent by an improvement in the economy over the coming quarters.
Government schemes such as the “eat out to help out” and incentives to get consumers using other services and bricks and mortar retail has seen a return to spending by consumers, some of whom will have built up surplus income during the lockdown period. However, these incentives and the unwinding of demand will cloud the data over the coming months.
US equities have been strong performers once again as demand for technology-focused shares has continued to be robust. This demand has only started to waver in September as some volatile selling of technology and associated stocks led to a period of underperformance. As is always the case with stretching valuations, calling the top is incredibly challenging. There was no particular catalyst for the selling other than once it began; momentum was taken out of their rise.
Valuations in the US market as a whole remain relatively more expensive than global peers. On an absolute basis, the US market is now clearly at a level objectively considered “expensive”. As previously discussed, some caution is needed when it comes to looking a P/E metrics in the shorter term as the hit to earnings may only be for one year. However, taking this into consideration, the market is now at a level that even if a reasonable best-case scenario were to occur, there appears to be little in the way of upside.
We have an underweight positioning to US equities. The underweight reflects the high premium that US equities trade, both relative to other regions, and on an absolute basis.
European stocks have seen periods of bullishness as investors were encouraged to see that most countries had brought COVID under control and were unwinding lockdown measures. However, this was measured as numerous regions once again reported rises in cases (eg. France, Spain). Given that COVID restrictions are now predominately affecting the services side of the economy, those areas with manufacturing strength have been more robust, which is likely to continue.
Another contributor to the positive sentiment was the announcement of a €750bn EU COVID rescue package which, apart from the size, signalled that there was increasing unity in the EU and Eurozone. The implication is that the potential risks form a Eurozone breakup have been reduced. There has also been speculation that reserve currency managers have been increasingly keen to diversify their holdings out of USD, with the Euro being a key beneficiary.
Resultingly, and considering the sector breakdown is less favorable in the current environment, it is encouraging that European equities have performed in line with global peers.
Japanese equities have lagged very slightly over the fourth quarter, meaning that there has been a small underperformance YTD. However, most Japanese companies have very robust balance sheets with large cash balances, perhaps making them better able to cope with global economic disruption. While the index and national economy remains heavily dependent on the success of the global economy, particularly in manufacturing, it is surprising that given the global recovery in this area, the stock market has not fared as well. A likely explanation is that the relative performance once again has been impacted by the lack of large technology stocks in the Japanese market.
Our inline position to Japan through a passive holding appears comfortable given the above but also acknowledging that the relative valuation of the market to others continues to be somewhat less attractive than it was a year ago.
Asian/ Emerging Market Equities
Asian and emerging markets have outperformed global peers over the quarter; however, the outperformance was weighted to July. Investors have been encouraged that as an asset class, there have been fewer countries severely impacted by COVID, although there are clear examples of where this is not the case (eg. India). The weakening dollar over the quarter has been a tailwind for the region as has a resurgence in export activity.
As previously mentioned in Q3. In the longer term, it appears that the friction between the US and China will continue and there will be an increasing polarisation of the global economy and trade, with countries forced to pick sides.
Government bond yields remain at close to or below zero in most developed markets. Furthermore, this is the case out to 10+ years, creating very flat yield curves. While the issuance of government debt has been at record levels, most of this has been absorbed by central bank buying. It is therefore impossible to assume that current prices are reflective of market forces, as QE programmes leave bonds overshadowed by a large indiscriminate buyer with no profit/risk motive. We remain averse to government bonds as we believe that over the medium to long term they will provide a negative real (and possibly negative absolute) return and are now exposed to a large asymmetric risk, where there appears little capital upside and a realistic possibility of significant capital losses.