In this week’s market update: China’s recovery continues, if slightly slower than expected; markets focus on fiscal stimulus hopes after the US Presidential election; will that lead to a rotation from growth to value; and the latest on the last-minute Brexit negotiations.
The last three months of this year were always going to be interesting. And the main market drivers are indeed starting to come to a head. Top of the agenda are: the differentiated recovery from the pandemic, with China in the lead; market hopes that a big fiscal stimulus will follow the US Presidential election; the possibility that this will lead to a watershed moment for markets, as growth rotates to value; and let’s not forget Brexit, much as we might wish to.
Starting then with China. As expected, third quarter GDP grew by a solid 4.9%, almost up with expectations of around 5%. That compares with the massive 6.8% fall in output in the first quarter and the 3.2% recovery between April and June as China emerged first from the pandemic.
Recovery in China has been fuelled by a state-sponsored industrial boom. Production grew by 6.9% in September, back to pre-pandemic growth levels. That was twice as fast as retail sales expanded in the same period, although there are signs that the consumption side of the economy is picking up pace. Sales were 3.3% higher, better than the 0.5% growth in August and that followed seven consecutive months of falling retail sales.
China’s overall growth rate is now moving back towards the 6% level achieved last year and this year as a whole it is likely to be the only major economy that registers an expansion. By the first quarter of 2021 when the comparisons are easier, growth should be well back into double digits for a short period.
The main market implications of China’s recovery are in the currency markets where the yuan has rallied by nearly 4% this year and in commodities where the country is the world’s biggest buyer of many metals.
Stock markets are also picking up on the good news, with the value of shares in China recently surpassing $10trn for the first time.
Over in America, the market is less focused on growth today than on expected growth in the near future. Investors are looking forward to an expected big fiscal stimulus after the election, enabled by a supportive Federal Reserve keeping interest rates and so bond yields low.
The likelihood of this double whammy of stimulus has risen alongside expectations that there will be a so-called blue wave victory for the Democrats in both the White House and the Senate. The Democrats already control the House of Representatives, so this would give them control across Congress and the Presidency. Such a sweep would enable the implementation of a policy agenda that a divided Capitol Hill tends to prevent.
The market is right to focus on the next phase of stimulus because the initial measures to support American businesses and individuals through the early stages of the pandemic are started to wane.
The exact form of relief - tax cuts or New Deal style spending commitments is unclear, but there could be a combination of both which would provide a powerful boost to the economy, even as corporate profits are already emerging better than expected in the third quarter earnings season.
The key question for investors is whether or not this leads to the fabled rotation from growth stocks to value which has long been talked about but failed to show up. Such a rotation would mark a big shift not just for value and growth but between financial assets and real assets (commodities could do relatively well) and between bonds and shares (the long bond bull market would be over if yields starting to rise on the back of accelerating economic growth and rising inflation fears).
The reason why people are getting so interested in this potential rotation is that it has been such a long time coming. Growth has outperformed value with only short-lived and ultimately aborted rotations ever since the financial crisis. That’s a much longer period of dominance than anyone can remember. The pendulum usually swings from growth to value and back again within three or four years. This would be a major regime change.
So, it’s worth reminding ourselves why growth has done so much better than value and defensives so much better than cyclical shares. It’s all about growth or the lack of it, the long-run decline in bond yields and a divide in the returns different industries have been able to achieve in recent years.
The decline in bond yields has been running for nearly 40 years now but it accelerated after the financial crisis and has taken yields down to levels not seen ever, or at least in the 800 or so years that some kind of relevant data has existed.
That has reflected another long-term decline in growth expectations. The West has followed Japan into a period of stagnation, with low inflation expectations for a variety of demographic, macro-economic and technological reasons that I haven’t got time to go into now.
Thirdly, there has been a massive divergence between the ability of capital-lite, platform businesses benefiting from network effects to drive higher returns on equity and earnings than other less favoured businesses. In fact, strip out tech stocks and there has been almost no growth in profitability since the financial crisis.
If anyone asks you why the UK market has underperformed the US, well there is your answer.
So, what have these factors combined to create in stock market terms. Well, the lack of growth and the low yields used to calculate the value of earnings out into the future (the discount rate in the jargon) have given investors a huge incentive to invest in those companies promising to deliver long-term sustainable growth.
They have been prepared to pay up for that growth and the higher the expected growth rate the higher the multiple of earnings they have been prepared to pay. Growth companies are growing faster and they are more highly-rated. That’s a potent combination.
So, what might change this imbalance? Well, self-evidently the reverse of the three conditions that created the environment for outperformance by growth stocks. If the rate of economic growth were to pick up, alongside inflation expectations and rising bond yields then investors would be less incentivised to pay through the nose for growth and the low multiples of value stocks would seem more compelling.
And what might create the growth. Well the fiscal stimulus already mentioned and just as importantly the discovery of a vaccine and the return to normal life. All the underperforming sectors, hospitality and leisure, commodities, airlines would look much more attractive than the expensive work-from-home beneficiaries, healthcare stocks and consumer staples companies.
The third big event in this final quarter of 2020 is, of course, Brexit. So what’s going on here? As is usually the case in negotiations between the UK and EU, it is going down to the wire with somewhat theatrical high-stakes brinksmanship. Last week, the UK threw down the gauntlet to the EU, saying the talks were effectively over because the European side was not negotiating in good faith.
What looked like an act of pique by the UK may actually have been a mistake by the EU which gave the British the opportunity to look like the aggrieved party. There was some pretty rapid backpedalling by the EU, blaming a ‘misunderstanding’ and even French President Macron conceded that EU access to UK waters might have to be less ‘ambitious’ in future.
So, the talks have moved on from technical discussions to the final straight where it is all about political will. Compromises may now all have to come in one go to avoid the impression that one side or the other is giving too amuch away. And that, in turn, means that the concessions could all come in a rush at the very last minute.
We are almost at that point, because if everything is to be ratified by all 27 remaining EU states, agreement has to be reached by the middle of November. And what are the markets saying? Well the pound rallied yesterday to $1.30 where it traded last week before the latest stand-off. That suggests that investors think some kind of a deal is the most likely option.
So, it’s all go on lots of fronts. Meanwhile, earnings season is in full swing now. This week tech takes over from the banks, with Netflix and Tesla in the spotlight. There’s a sprinkling of car makers too and commodities in the shape of Antofagasta and Anglo American.
On the economic front, the UK is in focus, with inflation tomorrow and retail sales on Friday.