In this week’s market update: there’s plenty for investors to watch out for as Rishi Sunak’s second Budget is staged against a nervous, inflationary backdrop for stock markets.
Investors will be looking in two different directions this week. In both cases somewhat nervously. The main news focus here in the UK will be Rishi Sunak’s second Budget. His first came just a few weeks into his tenure as Chancellor of the Exchequer a year ago as the pandemic took hold and a Conservative finance minister was forced into a series of very un-Conservative measures to support the economy.
Sunak’s baptism of fire was well-received as he held his nose and opened the financial taps. Public sector borrowing could be close to £400bn this year, blowing a massive hole in the public finances that the Chancellor’s predecessors had worked to rebuild after the financial crisis with 10 years of now largely discredited austerity politics.
The young Chancellor was acting against his budget balancing instincts, but he realised quickly that supporting the economy through last year’s fiscal heart attack was his first priority. Regaining a reputation for fiscal prudence could wait for another day.
The question now is whether, as vaccinations allow a tentative re-opening of the economy, that day has arrived. The consensus seems to be, not quite yet. While there is a lot of talk about raising taxes, most people expect the focus this week to once again be on shoring up the economy, protecting jobs and providing a bridge to better times in the second half of 2021 and beyond.
The Chancellor’s announcement of a new ‘tax day’ on 23 March, in which the Treasury will package up a collection of tax-related consultations and reviews points to a separation of the ‘bad news’ of expected fiscal consolidation, perhaps starting later this year, from the ‘good news’ of further stimulus measures and support schemes.
For investors, the key things to watch out for on Wednesday are:
- First, the economic forecasts and current state of the economy. The hole in the public finances will be gargantuan but maybe a bit less than feared. Perhaps a £350bn deficit against November’s forecast of £394bn. Growth should also be a bit better than expected. After the worst downturn in 300 years last year, we should see the best growth in around 50 years this time.
- Second, any tax rises to repair the damage. The Chancellor is talking ominously about ‘levelling’ with the public about the need to repair the damage caused by heavy pandemic spending. Debt stands at close to £2trn or 100% of GDP. A small rise in corporation tax from the current 19% is odds on favourite. It would still be well below the OECD average. Other almost certain measures will include a freezing of allowances and thresholds for income tax. Also in focus, but with longer odds of anything actually being announced, are pension contribution tax relief and Capital Gains Tax.
- Third, an extension of current job protection schemes. The furlough programme, as well as business rates relief for retail and hospitality and local authority grants are all likely to be extended until the end of June when, according to the government’s proposed re-opening timetable, we should finally emerge from the current restrictions.
- Fourth, the housing market. There have been hints of an extension to a stamp duty holiday, again until the end of June. And government guarantees to increase the availability of 95% mortgages.
- Finally, the environment. Expect everything to be presented through a build back better, environmental lens. Look out for talk about a new national investment bank and so-called green gilts.
If this is roughly how the Budget looks then markets should take it in their stride. A bigger corporation tax hike, or higher personal taxation measures might unsettle UK shares, but these will probably be left until later this month.
Investors may be worried about the impact of tax measures on their personal finances but the key question as far as the markets are concerned is last week’s mini inflation scare and the dramatic backing up of bond yields it prompted.
Investors with longer memories were reminded of earlier bond-market-fuelled market wobbles. In 2013, the so-called Taper Tantrum saw markets fall sharply after the then Federal Reserve chair Ben Bernanke mused publicly about the timing of a winding down of the quantitative easing programme that had stabilised markets since the financial crisis.
Bonds are supposed to be boring. When they are not, investors always sit up and take notice because significant moves in bond yields can indicate big moves are afoot more generally in financial markets. The rise in the 10-year Treasury bond yield from 0.9% at the end of last year to over 1.6% last week may not sound a big deal but investors are seeing it as a straw in the wind that the current extraordinary fiscal and monetary stimulus measures risk stoking uncontrolled inflation in due course.
Something similar happened in 1994 when an unexpected series of interest rate hikes by the Federal Reserve unsettled markets, prompting Bill Clinton’s economic adviser James Carville to talk in a much-quoted phrase about the bond market’s ability to ‘intimidate everyone’.
Stock markets certainly looked intimidated last Thursday as the S&P 500 fell by 2.5% and the Nasdaq was down by 3.5%. Markets in Asia followed suit with the high-flying Japanese market off by 4%. Nasdaq was hard hit because rising bond yields are particularly bad news for the technology growth shares which have led the market higher in recent years. Much of their value is represented by hopes for future earnings growth and how much investors are prepared to pay for that growth is determined in part by bond yields today. If these are low, investors are relaxed about waiting for future growth to arrive; if they are higher, investors have more to lose by waiting and prices adjust accordingly.
Rising rates have already taken the edge off the outperformance of growth shares. And given the importance of this part of the market to the overall index level, further erosion of the growth stock advantage is starting to ring alarm bells for the market as a whole. The outperformance of growth over value in the first six months of the pandemic has now been completely unwound in the subsequent half year - a dramatic reversal of fortunes.
An interesting indicator of this rotation has been the failure of companies unveiling positive earnings surprises in the latest results season to benefit. Some of the biggest Covid beneficiaries have actually seen their shares drop despite delivering better than expected results. Apple and Facebook, for example, both beat estimates by about 20% but their shares slid by 7% in the two days following the announcement. Investors have shifted their attention away from results to how they believe companies will fare in a more positive cyclical operating environment, and to how much of that is currently priced in…or not.
The really interesting question now is how relaxed central banks remain about the rise in real, inflation-adjusted yields. The authorities are keen for nominal yields to remain below the expected level of inflation because this allows the economy to grow faster than the level of outstanding debts and so reduces the debt burden in real terms over time. This is relatively less painful than lower spending or higher taxes - even if inflation is really just a hidden, or stealth, form of taxation.
In theory, the Fed can halt the rise in real yields by capping bond yields, buying up bonds in sufficient quantities to keep their yields low. It is what the US did during the second world war to fund its military spending and it is what the Japanese have been doing more recently. It is called yield curve control. Many experts expect this to start happening again soon in the US.
The risk then for markets is what happens when inflation is allowed to run hot for a while and perhaps beyond the power of the authorities to control it, as happened in the 1970s. When inflation rises above a Goldilocks range of between 2 and 4%, valuation multiples start to fall as investors become more nervous about the real value of their investments reducing over time.
This can become an insidious, and partially invisible drain on investors. Between 1975 and 1982, stock markets looked like they were rising. But in real, inflation-adjusted terms they were simply moving sideways. In inflationary times your money has to work hard just to stand still.
An equal concern for investors, and for their financial advisors, is what happens if equities and bonds no longer offset each other as they have in recent years. If bonds rise when equities all then a balanced portfolio can provide a smooth ride for investors. This is the thinking behind so-called 60/40 portfolios that mix shares and bonds, perhaps according to an investor’s age. If the two asset classes move in the same direction, then investors will need to find better hedges than bonds - perhaps cash. Alternatively, as in the 1970s, commodities, including gold, can perform well in an inflationary environment.