For Auld Lang Syne

As we approach the peak of the festive period, there will only be very few among us ruing the passing of 2020.  Whilst many of us will have had more challenging years in our lives individually than the one about to pass, the aggregate physical, mental and financial burden endured through this year across every corner of the globe is unsurpassed in most of our lifetimes.  Yet, it has also shown the resilience of the human condition.  The year has brought tragedy on a huge scale, but it has brought innovation and invention to counter a substantially worse outcome if Covid-19 had been left to work its way through society unchecked.  Less than a year after the discovery of this novel virus, we have one effective vaccine already being rolled out, and two more likely to follow in the coming weeks.  That is an extraordinary achievement.  In our own industry banks, insurers, asset managers and platforms transitioned to a virtual working environment en masse virtually overnight without any material drop in service levels.  Central banks ensured the world’s financial plumbing kept working; supermarkets and food manufacturers kept the population fed.

The recent surge in cases, combined with a new variant of the virus that is potentially significantly more infectious, gives further cause for concern.  However, so long as the vaccines remain effective against this new strain, what we face now is a footrace between transmission of the disease and the roll out of vaccine to the most vulnerable.  If medicine wins that race, we can start to look forward to some form of normality returning in the Spring.  If it does not, the evidence of the past year suggests that summer months will give us a natural opportunity to catch up.  Whilst it is sobering to recognise that, even after ten months of fighting the disease, the worst of the pandemic may not yet be past us, from a time perspective we are almost certainly closer to the end than the start of the medical crisis.

All of this leaves looking forward to 2021 a somewhat bittersweet experience.  There is genuine nervousness over what the next couple of months might hold, yet the prospect of longer, sunnier days spent with our family and friends and unencumbered by proximity restrictions feels like halcyon days compared to where we are and where we have been.

There is something of a symmetry between this perspective and that pertaining to the economic outlook.  The direct economic impacts of the post-Christmas lockdown in the UK are unlikely to be as deep as in March and April.  Construction and manufacturing are likely to continue through the winter – even as case numbers grow – as it is increasingly clear that households, hospitality and higher education are the main vectors for transmission.  Set against that, there is likely to be greater synchronicity of the lockdowns that do come in across the globe.  Particularly in the United States, where the early pandemic was unevenly spread as metropolitan areas bore the brunt of initial infection, whilst more rural states were less affected.  With the disease endemic across the whole country, preventative actions are likely to be much more widespread; particularly as the new Administration will want to demonstrate its bona fides early on.

Yet, as the vaccine programme allows societies to reopen fully, we are going to face a fairly unique scenario of emerging from an economic downturn with households (and to a lesser extent, companies) having stronger balance sheets and liquidity than when they went into the downturn.  The speed and scale of household deleveraging this year has been unprecedented.  The official figure for the household savings ratio in the UK in the second quarter was more than 27%.  The highest recorded level before that was 14% in 1993.  Even in the third quarter, when the economy opened up to greater levels of consumer activity, the ratio had only fallen back to 17%.  Similarly, (and with the obvious exception of the travel and hospitality sectors) businesses entered 2020 in good financial shape.  This allowed them to access significant swathes of liquidity in March and April as a protection against what might happen later in the year.  In general, the corporate sector traded much better through the remainder than feared, leaving much of that liquidity surplus to immediate requirements.

As a result, we have observed that investment spend across most sectors has held up well this year.  Indeed, the enforced changes to working practices across many industries has opened up hitherto unconsidered areas for cost saving and efficiency improvements.  Virtually every business we have spoken to expects to keep some future savings in its travel budgets as “Zoom” becomes the default meeting option for many.  Further, service companies are all reassessing their property needs with greater flexibility to work from home going forward.

All of this is set against a backdrop of ultra-lax fiscal and monetary policy.  It is obvious that the scale of government support cannot continue at current rates indefinitely.  However, there is a rare consensus in agreeing that heightened fiscal support should not be withdrawn precipitously.  In particular, health, education and training budgets will need semi-permanent increases to deal with the aftermath of the crisis; particularly for both ends of the age spectrum who have been most affected by this year’s events.

Central bankers also have no intention of turning off the monetary taps any time soon.  Through the years of the great financial crisis, there was a hawkish element within decision makers wary of the future inflationary consequences of their actions further down the line.  These voices have all been silenced at the current time.  Future price inflation is far from the biggest risk facing society at large, and monetary authorities are not going to act pre-emptively to halt rising prices.  At this stage, the downsides to rising inflation and pretty much limited to bond valuations.

Rising inflation might seem like a very remote risk in the short term, yet there are signs that it could be closer that we might think.  It has been difficult to draw meaningful conclusions from wage data this year given the distortions in calculating base effects and the deep intervention in terms of the Job Retention Scheme.  However, it does appear that on a true like for like basis (i.e. employees that have remained in employment and are fully utilised by their employer) we have seen meaningful wage increases this year.  As consumer expenditure opens up in the Spring or Summer, this could produce more intense pressure on wages than we have seen for many years.

All of this presumes, of course, no devastating impact from a No Deal Brexit outcome.  Everyone reading this piece with have their own view on how the next two weeks will pan out; and at this stage it would appear that no-one’s view is any more legitimate that any others’.  For what it is worth, our view is that the negotiations will go “deep” (and perhaps even past 31st December), but a deal will be done.  The mood music has changed in recent days, at it suggests that the two parties are closer on the remaining outstanding issues.

We have always been clear that, in our opinion, Brexit is a sub optimal economic outcome to remaining within the EU.  That remains the case.  However, we would concede that basics of the deal as we understand it probably add up to a better than expected outcome for the UK.  The UK will retain quota and tariff free access to the single market for goods, without making payments to the European Parliament, accepting judgement from the ECJ, nor being bound by free movement of people.  Services are not included in the deal, but services trade less on price and more on value added factors, and the idea of a free European market in services has always been something of a myth (try acting as a pharmacist in Germany, for example).  Yes, there will be non-tariff barriers to trade, but technology and innovation will ease these over time.

There remains a risk of a complete No-Deal outcome.  We have had a taste of the short term costs of such a result over the past few days, but – again – business will adapt and move on.  Brexit is sub-optimal in our opinion, but the UK economy will adapt and grow over any sensible investment horizon.

From an investment perspective, this year could prove a watershed in many ways.  The relatively severe economic impact of the Covid-19 crisis and fears over the country’s relationship with its largest trading partner have left the UK equity market in general – and its domestic equities in particular – sitting at a valuation discount to international peers.  In 2021 that discount will be justified, or it will be unwound as the world normalises.  Further, for over thirty years, there has been a net selling of UK equity assets by institutional investors.  As the UK transitions to its new economic model, we may see a broader re-appraisal of UK equities as an asset class.  If inflation becomes more meaningful, we may well also see a reversal of bond flows as its 20-year bull market tops out.

If nothing else, 2021 will be intriguing.  It could be a banner year.  It could be desperate.  However, it is in the nature of equity investors to believe in better times ahead.  History, by and large, backs that perspective up.  In the meantime, may we wish all our friends a very Merry Christmas.  We have not seen anywhere near enough of each other this year.  Let’s put that to rights soon.

Written by Glen Nimmo