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From considering vaccine setbacks and the impact of Brexit to whether tech is a winning trade again and Biden reshapes America
Thursday 17 Dec 2020 Author: Daniel Coatsworth

One cannot help feeling more optimistic about 2021 after the year we’ve just experienced. Everyone would agree that it’s been a testing time and hopefully we’re past the worst.

Yes, there are still plenty of hurdles to clear. The pandemic continues to rage, unemployment levels are worrying, the true impact of Brexit is still unknown, and there are plenty of other factors to cause trouble.

But a vaccine has become a reality and the stock market is forward-looking in nature, so the focus is much on economic recovery and getting life back to normal.

The stock market recovery since March’s crash has been very impressive and hopefully investors will have still made money this year despite the negative backdrop. Here’s hoping for another year of success on the market.

To help you understand the opportunities and the threats for markets and make better informed investment decisions, this article addresses 10 important questions relevant to anyone wanting to invest in 2021.

1. WILL UK EQUITIES REGAIN APPEAL WITH INVESTORS GLOBALLY?

At the time of writing, another deadline has passed without any progress on a definitive trade deal between the UK and the European Union from 1 January.

The pound has been remarkably strong, pushing against the top of its trading range going back to 2018, so progress towards a deal – or at least avoiding a ‘no deal’ outcome – could see it breaking out into new territory which would give domestic stocks a lift.

At the moment, pre-tax earnings for the FTSE 100 are seen reaching £166 billion next year, which is significantly better than this year but is still slightly less than the index generated in 2017, according to figures compiled by AJ Bell investment director Russ Mould.

However, more than 40% of pre-tax earnings are forecast to come from miners and financials, so a situation with sluggish recovery and interest rates staying lower for longer would be unfavourable.

Failure to agree a definitive trade deal could see the pound drop sharply. Analysts at Morgan Stanley believe a ‘no-deal’ Brexit outcome would represent a shock to markets which could potentially cause the FTSE 250 index to drop between 6% and 10%.

Morgan Stanley also sees shares of UK banks falling 10% to 20% in a ‘no deal’ scenario, as it raises the chances of the Bank of England cutting interest rates into negative territory. Insurance, real estate and housebuilding stocks would also be at risk according to analysts.

On the plus side, the pace of takeovers is picking up with foreign buyers taking advantage of depressed UK market valuations. A UK/EU trade deal could lead to even more takeover activity as companies would have more certainty over the lay of the land.

Luke Newman, a portfolio manager at Janus Henderson, says feedback from lawyers and advisers is that a lot of takeover research has been done and targets identified.

‘The message we’re getting is that there is a real desire to see Brexit resolved first, even though UK assets could rise in value after a deal. The takeover work has been done and, once there is certainty on what the UK has in store for the next five to 15 years, we could see a wave of inbound interest for UK companies.’

Richard Colwell, head of UK equities at Columbia Threadneedle, also agrees that M&A is big theme. He says: ‘Why are assets like security company G4S (GFS) being bid for? There is a lot of cash burning a hole in people’s pockets, and prize assets are available because the investment community continues to be too bearish on the intrinsic value of UK stocks.’

2. WILL THE VALUE INVESTING STYLE REMAIN IN FASHION?

Despite many false dawns over the last few years the arrival of not one but three effective vaccines proved to be the catalyst that brought the value investing style back into fashion.

This saw investors rotate from paying high multiples for companies that could deliver growth in tough times to paying lower multiples for companies whose previously weaker growth prospects have now improved because of vaccines hopefully reviving economies around  the world.

The question now faced by value and growth investors alike is for how long can value remain in vogue given its prior extreme period of underperformance?

For starters, there needs to be a strong global economic recovery because investors will only remain committed to value stocks if they offer higher earnings growth.

US investment bank Morgan Stanley is in the strong recovery camp saying, ‘this global recovery is sustainable, synchronous and supported by policy, following much of the normal post-recession playbook.’

For Morgan Stanley this translates into 25% to 30% earnings growth for global equities and favours rotating into cyclicals and small caps over owning defensives and large cap shares.

Value stocks tend to deliver higher earnings growth in the early part of economic recovery as they are more operationally and financially geared. This means that revenue growth translates into disproportionately higher profit growth.

However, poor quality companies can be at risk when the economy recovers as they often underestimate the extra demand for cash as working capital requirements balloon higher.

An important factor supporting value stocks is rising inflation because it can provide cover for lifting prices which also amplifies profit growth.

Rising inflation expectations normally show up first in the bond markets. While it’s true that bond yields have gone up in recent weeks as prices have gone down, they are still low with 10-year UK Government gilts yielding 0.27%.

In addition, BlackRock notes the central banks have committed to maintaining low rates even in the face of rising inflation which should keep interest rates anchored.

The risk for value investors is that the huge debt burden taken on to fight the pandemic will hinder growth and keep economies ‘below potential’ for much longer than expected.

WHAT SHOULD INVESTORS DO UNDER THESE CIRCUMSTANCES?

BUY: Henderson Opportunities Trust (HOT)

Managed by James Henderson and Laura Foll, Henderson Opportunities Trust (HOT), trades on a 14% discount to net asset value, whereas many other value funds now trade at a premium.

It has delivered 17.7% NAV growth over the last three months, comfortably outperforming the Morningstar category return of 15.95%.

The longer-term performance has been excellent with an average annual 10-year return of 10.9% compared with 6.6% for the category benchmark.

We like the smaller company bias and diversified mix of exposure to value sectors such as industrial and financials which should perform well in a cyclical upturn.

3. IS THE MARKET TOO OPTIMISTIC OVER THE PACE OF THE VACCINE ROLL-OUT?

The performance of the economy and the markets next year is partly in the hands of the pharmaceutical groups, logistics networks and national health systems who are preparing a very large immunisation programme for Covid-19.

The market has already reacted positively to the development of a vaccine in hope of a return to normality in 2021.

However, rolling out the vaccine across the globe will be a huge effort and could well be uneven, meaning travel restrictions between countries could be in place for some time yet. All of us, investors included, may need to be patient but there is a risk of sentiment souring if the promised escape from the coronavirus crisis doesn’t transpire in the spring.

Another stumbling block is the take-up of the vaccine. Shore Capital health analyst Adam Barker says: ‘Communication will have to be very clear, with some surveys in the US (for example) suggesting that 20% to 60% of Americans wouldn’t accept a Covid-19 vaccine, given concerns that “corners have been cut” on safety.’

Therefore investors racing to own travel and leisure stocks, for example, need to consider that we might not all be racing off abroad on our summer holidays in 2021 and so earnings could miss expectations (or forecasts may be downgraded during the year) for certain companies dependent on widespread movement of individuals.

4. HAVE CORPORATE DEFAULT RATES ALREADY PEAKED?

It might seem surprising given the economic damage caused by the pandemic, but fewer companies in the US have defaulted than expected a few months ago. Defaults refer to companies failing to make interest payments on their debts.

Agencies that provide credit research and investment banking analysts were predicting the default rate for high yield debts to surpass the 14.7% peak seen in the global financial crisis of 2007/2008.

Since September 2020 the increase in defaults has slowed after reaching a level much lower than the old peak, at around 8.5%.

The reason can be pinned on the move by the US Federal Reserve in late March to include investment grade (highest quality credit) bonds as part of its quantitative easing programme. This effectively ‘backstopped risk’ and opened the door for a massive deluge of corporate bond issuance.

Janus Henderson bond managers John Pattullo and Jenna Barnard make the case that the corporate credit market now faces a benign default outlook. They believe companies will prioritise deleveraging and balance sheet repair over spending on new investment projects.

However, Bank of America notes that increased issuance has pushed leverage as measured by net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) to a record 6.2 times, implying that default rates may stay elevated for longer.

5. WHAT DIFFERENCE WILL JOE BIDEN MAKE?

Joe Biden’s victory in the US presidential election has been broadly welcomed by investors. Markets like certainty and Biden provides that, not just through the result but also his clearly defined agenda for the next four years.

He plans tougher action against the tech giants, higher corporate taxes and a lot more investment in infrastructure and clean energy, set to be a boon for construction firms as well as renewable energy stocks and funds.

Some of the appointments he has made to his Cabinet have significance to US and global shares, particularly hiring of former US Federal Reserve chair Janet Yellen as Treasury Secretary. Yellen’s time at the Fed was marked by accommodative monetary policy, i.e. increasing the money supply to boost the economy when growth is slowing. This raises the chance of interest rates staying lower for longer and further increases the appeal of stocks to investors, despite US companies’ profit margins set to be squeezed by higher taxes.

Tensions with China should be eased, though not removed, through Biden’s policies. He believes the best way to deal with China is through forming coalitions with allies and partners, not imposing unilateral tariffs.

But the important factor that could be key in determining the efficacy of Biden’s presidency is January’s runoff elections in Georgia, which will effectively decide who takes control of the Senate.

The Democrats hold the House of Representatives and if they can wrestle control of the Senate from the Republicans, this will provide a clear path for Biden to get his policies through Congress. But if the Republicans keep control of the Senate, expect the same kind of gridlock we’ve seen in recent months in trying to get a stimulus deal done.

6. HOW QUICKLY CAN THE UK START ON ITS BIG ESG PUSH?

Last month the UK Government published a plan for a green industrial revolution, and if the latest projections from the Met Office are correct the plan can’t come soon enough.

Even if global emissions are reduced dramatically, says the Met Office, within 20 years the average coldest day in the UK is likely to be zero Celsius compared with -4.3 Celsius over the past 30 years. The average hottest day in London could be 40 Celsius compared with 32 Celsius in the past.

The two highest-profile planks of the Government’s plan are a ban on sales of internal combustion engine cars by 2040, 10 years earlier than expected, and a quadrupling of offshore wind capacity to 40GW by 2030. While these deadlines are some way off, a lot of work is required to hit those goals.

The key to widespread public adoption of electric vehicles has moved from ‘range anxiety’ to cost. The main cost in an electric vehicle is the battery. A decade ago, batteries cost $1,000/ kWh while today they cost $150-200/kWh: the holy grail is $100/kWh, and we could get there this year.

The plan to decarbonize our energy supply with offshore wind requires billions of pounds of upgrades to our manufacturing, ports and the electricity transmission network. Private, ‘sustainable’ investment is likely to take the lead, and any signs of action in 2021 could further increase market interest in all things ESG.

7. WHAT IS THE OUTLOOK FOR PROPERTY INVESTMENTS?

Both globally and in the UK, there has been real polarisation in the property market in the wake of Covid-19, meaning investors could have either made or lost a lot of money in the space.

Valuations of retail properties have slumped this year, logistics assets have soared, and offices have sat somewhere between the two as assessments are made about the long-term impact of the pandemic on working from home. Schroders’ head of UK real estate investment Nick Montgomery expects this polarisation to begin to reduce in 2021.

There is one big reason why real estate as an asset class could attract investors in 2021: income. Therefore, real estate stocks or funds in more stable parts of the markets and not trading on premium valuations could be in demand.

‘The monetary policy response to the Covid-19 crisis has further repressed traditional sources of income such as government bonds and has lowered real yields to rock-bottom levels,’ says asset manager Fidelity.

‘Real estate is attractive in such an environment and remains popular with income-seeking investors despite being less liquid than other asset classes.’

If the accommodative policies adopted by central banks are matched with a strong recovery from the coronavirus crisis there is also a chance that inflation could increase – as a ‘real’ asset property tends to be a good hedge against rising prices.

WHAT SHOULD INVESTORS DO UNDER THESE CIRCUMSTANCES?

BUY: Schroder Real Estate Investment Trust (SRE)

 

One of the features of real estate investing in 2020 has been the divergence in fortunes between different types of property and the resulting outperformance of specialist funds in areas like logistics, healthcare facilities and social housing.

We think this will gradually reverse in 2021, making generalist products more attractive. In this context Schroder Real Estate’s 35% discount to net asset value looks compelling, backed by its focus on ‘Winning Cities’.

The portfolio has been punished in part for its 23.2% exposure to retail. But it is important to make the distinction between seemingly doomed shopping centres and high streets and the mixed use and convenience retail sites which the REIT owns.

8. ARE EMERGING MARKETS SET TO SHINE?

‘One thing is clear: emerging markets will lead the economic recovery in 2021, propelled by China and supported by a weaker US dollar,’ insists Pictet Asset Management’s chief strategist Luca Paolini, among the cohort of experts backing emerging markets to outperform in 2021 as vaccines help drive global recovery.

The combination of a Joe Biden presidency and a potential Republican Senate is seen as positive for emerging markets, as it should result in reduced trade uncertainty and a less disruptive foreign policy from America.

Paolini believes emerging market local currency bonds should fare well in 2021, being one of the few fixed income assets yielding above 4%. Adding to their investment appeal is the prospect of a strong rally in emerging market currencies – which should unfold as the global economy recovers and as trade tensions ease.

Invesco argues emerging markets is ‘still the sovereign space with the best potential’ for 2021, with emerging markets real estate and emerging markets bonds among its best-in-class assets based on projected 2021 returns.

In terms of regional preferences, ‘no matter which asset class we consider, there is a preference among the team for EM assets, with China featuring prominently,’ adds Invesco.

Templeton Emerging Markets Investment Trust’s (TEM) Chetan Sehgal concedes global supply chains have come under pressure to diversify away from a perceived excess dependence on China. And yet most countries are still trading with China and ‘supply chains won’t change overnight, even if countries want to make a transition due to Covid-19 or other reasons’.

Invesco’s Mike Shiao believes 2021 will be another fruitful year for Chinese equities, ‘supported not only by higher visibility surrounding the growth outlook but also by an increase in allocation to the asset class’. The creation of China indices excluding other emerging markets might be a theme to watch out for next year.

Elsewhere within emerging markets, Brazil is up against it in terms of the virus, but this massive country still offers tremendous opportunities for investors given its demographic profile and abundance of natural resources, while high-quality India stocks are among the opportunities identified by Invesco’s William Lam.

WHAT SHOULD INVESTORS DO UNDER THESE CIRCUMSTANCES?

BUY: Fidelity Emerging Markets (B9SMK77)

We like Fidelity Emerging Markets (B9SMK77) fund which has beaten the MSCI Emerging Markets benchmark index on a one, three, five and 10-year basis.

Nick Price has managed the fund since 2009 and the focus is on high growth stocks. Price and co-manager Amit Goel benefit from access to significant resources within Fidelity including regional EM portfolio managers and a large team of equity analysts based on the ground.

9. WHAT COULD HAPPEN IN THE COMMODITIES MARKET?

Gold has been the standout performer in the commodities space for most of 2020 thanks to the pandemic, but has tailed off towards the end of the year as optimism over an economic recovery rises thanks to the successful development and roll-out of coronavirus vaccines, diminishing the need for such safe-haven assets.

In theory if the stock market rises in 2021 gold should go down. However, investment bank Goldman Sachs sees gold hitting $2,300 an ounce next year, up from around $1,850 currently, and the shiny metal does have some factors in its favour.

The US dollar is set to remain weak next year as action from the US Federal Reserve to support liquidity means there’s excess greenbacks in the financial system, with further stimulus on the way.

These supply and demand factors imply the dollar is set to weaken further. That will boost the appeal of gold. In addition, consumer spending is set to ramp up as people spend cash they saved in lockdown, which is likely to spur inflation and see gold regain its tag as an inflation-hedge.

And while there is rising optimism over economic prospects next year, there is still a large degree of uncertainty over the pace of the recovery, something which should provide a base level of price support for gold.

Three other metals to watch are copper, iron ore and nickel. Copper and iron ore are intrinsically linked to the health of the global economy and the prices of both have been on a tear in the past month as activity around the world picks up again.

China is the largest consumer of both metals, and there is an expectation for China’s economic growth in 2021 to be unusually fast. As for nickel, the metal has increasingly been key in the production of electric vehicles, and as this transportation market continues to gather pace the price of nickel is expected to improve accordingly.

WHAT SHOULD INVESTORS DO UNDER THESE CIRCUMSTANCES?

BUY: Antofagasta (ANTO)

A good way to get exposure to copper is via Chilean miner Antofagasta (ANTO), one of the top 10 biggest copper producers in the world.

Antofagasta is considered by analysts at investment bank Jefferies as the lowest risk play on the copper price and has consistently been able to avoid some of the operational issues which have dogged other miners.

The company has a strong track record of increasing production and keeping costs under control, making it better than many of its peers in being able to capture the upside from rising copper prices.

10. WILL TECH BE A WINNING TRADE AGAIN IN 2021?

Investors have been piling into technology stocks this year in huge volumes and it has been a winning trade during the pandemic. In 21 trading days during the teeth of the coronavirus sell-off tech stocks lost 30%, based on the tech-heavy Nasdaq Composite. Over the following nine months this index rallied more than 80%, hitting a new all-time high of 12,582.77 on 8 December.

Tech always splits opinion, but investment experts widely agree that pandemic-enforced work-from-home has accelerated structural shifts that were already in play. Digital adoption jumped five years during 2020, according to consultant McKinsey, including cloud computing, online shopping and digital payment volumes.

It is becoming increasingly difficult to find industries not looking at tech solutions to stay competitive, increase growth or simply survive. Banks, healthcare, manufacturing, energy, education, media and entertainment – the list goes on. Real productivity gains have been won and ‘we may find it hard to go back,’ says Peel Hunt’s head of research, Charles Hall.

The tech space is seen maintaining its strengths in 2021 by leveraging accelerated trends and offering growth amid rock-bottom yields, believes BlackRock. ‘The sector boasts the highest profit margins in the global equity universe,’ says Sarah Thompson, part of BlackRock’s Global Allocation team.

‘As in previous years, the technology sector is unique in boasting net cash,’ points out Polar Capital fund manager Ben Rogoff.

But the tech space is still mixed so investors can’t pick anything and expect to profit. ‘Tech businesses do not automatically generate good returns: they have to earn them,’ says Stephen Yiu of Blue Whale Capital.

The pandemic has also accelerated ‘winner takes all’ dynamics that have led a handful of tech giants to dominate equity market index performance. Between them, Google-owner Alphabet, Amazon, Apple, Facebook and Microsoft are worth more than a quarter of the S&P 500’s value.

‘We see potential for leadership within the sector to broaden to a wider set of beneficiaries across different themes, including 5G connectivity, while software and semiconductors could lead the charge, as they face fewer regulatory risks and enjoy long-term growth trends,’ says BlackRock.

Despite this year’s run-up in valuations, experts see tech stocks as having structural tailwinds, not just for 2021, but far into the future.

ASSETS TO OWN IN 2021

In November, Invesco produced a list of three scenarios for 2021 and the assets to own in each situation. Since it was published we’ve had the first vaccine approved and started to be administered in the UK, therefore we have chosen to ignore Invesco’s ‘double dip’ scenario which was based on the premise that there would be no vaccine in 2021.

The other two scenarios are presented below. The second one (base case) is still credible even though it calls for a vaccine to be rolled out from 2021. While vaccines are already being deployed in 2020, we do not expect wide scale roll-out until next year, so Invesco’s scenario overview still applies.

The key thing that separates the two scenarios is the scale of the US stimulus package which had still not been decided as Shares went to press.


‘V’ for vaccine

Description: Early vaccine approval, large US fiscal boost, relative normality before end-2021.

Preferred assets: Real estate, equities (inc. value, banks, travel and leisure, basic resources), industrial commodities.

Preferred regions: Europe (including UK), emerging markets (especially non-Asia).

Base case

Description: Vaccines rolled out in mid-2021, moderate US fiscal boost, relative normality during 2022 H1.

Preferred assets: Real estate, equities (inc. growth, price momentum, financial services, REITs), industrial commodities, high yield credit.

Preferred regions: US, emerging markets (especially Asia).

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