In this week’s market update: shares give back some recent gains as vaccine and Brexit optimism fades; emerging markets are analysts’ favoured investment for 2021 as activity rises and the dollar slides; and the ECB meets to discuss how to put a lid on the soaring euro.
The remarkable rally in November that took stock and commodity markets to new highs paused for breath this week. US and European indices gave back recent gains as the optimism around Covid vaccines and hopes for a last-minute Brexit deal faded.
The gap between the level of markets and economic reality is starting to concern market watchers such as the Bank for International Settlements, which said this week that daylight had opened up between valuations and persistently uncertain economic conditions.
Having clawed back all the losses incurred in the market rout in the spring, stock markets are in many cases back or above pre-pandemic levels. A year ago, investors were worrying about whether the markets had gone too far too fast in 2019. If markets were too hot at the beginning of the year, then it is hard to see that conditions are any better today with the Covid outbreak still running riot in the US and the economic damage just beginning to be counted there and in Europe.
Valuations have risen in markets like the US to levels that have only been beaten during the peak years of the dot.com bubble 20 years ago. Analysis by Deutsche Bank this week pointed to multiples of earnings rising above those at the peak of the market in 1929 before the Wall Street crash that triggered the Great Depression.
The cyclically adjusted Price-Earnings ratio, which smooths out short term ups and downs in the earnings cycle to deliver a more reliable long-term measure of value, has climbed to 33, roughly twice its long-run average. It is well below the 44 reached in December 1999 but at today’s level high expectations for future growth are baked into prices and the market is vulnerable to a correction.
There are plenty of reasons to be optimistic. A successful vaccination programme has the potential to re-open the shuttered global economy. Renewed travel, eating out and shopping trips are expected to see activity bounce back quickly as the underlying economic infrastructure has not been damaged by the pandemic. The pick-up in activity stands to be boosted, too, by co-ordinated fiscal and monetary policy stimulus. In the US, for example, a $1trn spending boost looks possible before year end.
But the market is currently swinging between this glass half full scenario and a gloomier version which worries about the gap between discovering a viable vaccine and actually delivering it to 7bn people. There are plenty of other concerns too, highlighted by last week’s weaker than expected non-farm payroll employment report and this week’s negative headlines around Brexit.
Negotiations between the UK and EU are, as usual, going right down to the wire. An EU summit on Thursday and Friday looks like being the latest, and perhaps final, deadline to secure a deal before the end of the year cut off at which point trading terms must revert to World Trade Organisation terms in the absence of a deal.
Ahead of that meeting the Prime Minister is heading to Brussels this week for face to face talks to try and break the impasse.
The sticking points have not changed in recent weeks. They remain fishing and state aid provisions, effectively the rules that govern fair competition between the two sides in a post-Brexit world. Both sides clearly want to do a deal, but neither is prepared to be the one to back down at this final stage of the talks. They are playing a dangerous game of poker.
The pound, which has been buoyed by optimistic talk of a late deal, has started to lose its nerve, falling against both the euro and the dollar this week. Adding to the pressure is the Government’s decision to press ahead with two controversial pieces of legislation that breach the terms of the withdrawal agreement signed by Britain and the EU.
Investors have never quite been able to believe that the Government meant it when it said it was prepared to drop out of the EU’s single market and customs union. They thought this was just posturing, part of a negotiating strategy to get a better deal out of the Europeans. Now nobody is quite so sure.
With Brexit arriving on the back of the biggest economic slump in 300 years, the timing of a rift between Britain and its biggest trading partner could hardly be worse. In the circumstances it is unsurprising that the UK stock market has been a major underperformer this year, as it was in the previous three years since the 2016 referendum.
The UK market has the advantage of being cheap but so too do other markets, especially in Asia and Emerging Markets which went into the pandemic first and have come out the other side ahead of Europe and America too.
Emerging markets have moved sideways for a decade while the US market has soared since the financial crisis. This has resulted in one of the biggest and longest periods of underperformance in living memory. Many think that 2021 will be the year of emerging markets as a result.
A key driver of non-US markets, and emerging markets in particular, is the outlook for the dollar which looks to be weak in the months and years ahead, especially if the twin deficits, budget and trade, continue to widen and US interest rates remain at rock bottom.
The dollar has been falling since March while emerging market currencies have risen, boosted by the strength of the Chinese currency, the renminbi. A falling dollar is good for emerging markets which often have debts denominated in the US currency. As it falls, so too does the real value of their liabilities.
The other positive for emerging markets is their exposure to global trade. As it picks up so too do exports and commodity prices to which emerging markets often have a high weighting. Forecasts for company earnings in emerging markets are starting to pick up, suggesting a new positive cycle is unfolding.
The better earnings outlook means that the yawning gap between valuations in the US and many emerging markets, notably in Russia and eastern Europe, is too big to ignore. The average price-earnings ratio in emerging markets is less than 15 against more than 22 in the US. The ratio between the two is the lowest for almost 20 years.
Despite the discrepancy, shares in both regions have risen by the same 45% since the March low.
In other markets, oil has also paused for a breather after a strong rally in November which took the price of Brent crude up to nearly $50 a barrel. Oil prices at a nine-month high gave a boost to the energy sector last week after an agreement between OPEC and Russia eased fears of oversupply. The two agreed to boost oil supply by just 500,000 barrels a day, a quarter of their previously planned expansion.
With developed markets in Europe and the US in the midst of a second wave of infections, demand for travel remains low, reducing the ability of energy markets to absorb much higher production.
Meanwhile other commodities prices have been on a tear as hopes for the world economy getting back to normal have boosted speculative demand for copper and iron ore in particular. The price of iron ore has risen by 56% this year, to its highest level in eight years. The rally this year has been driven by a combination of higher demand from China for the main steel-making ingredient and reduced production forecasts from the likes of Brazil’s Vale.
In the currency markets, the main focus this week is likely to be on the euro which has climbed more than 8% against the dollar this year, rising above $1.20 last week and heading, analysts believe, towards $1.25 in the near future.
The ECB is keen to put a cap on the euro’s strength because it makes the task of pulling the region out of deflation even harder than it already is. Investors expect the ECB to push back against the rising European currency but question whether it can do much to prevent further moves which are driven as much by dollar weakness as euro strength.
The central bank is nevertheless expected to increase its €1.35trn emergency asset purchase programme by another €500bn on Thursday.