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Monthly Wrap: January 2021

Over the December quarter and into January, markets seemed to ignore negative Coronavirus developments and economic data to focus on the positives – from the prospect of herd immunity through immunisations, to more fiscal stimulus in the US. Read more in George Lin’s latest update.

       Written by George Lin
Senior Investment Manager | Colonial First State

Last quarter, the announcement of vaccine approvals and vaccination programs kick-started a reflation trend (that is, price growth supported by fiscal and monetary policy) – one that continued into the new year. Key share indices reported strong gains during this time, but the strong performance of higher-risk assets has contrasted with the deteriorating pandemic situation in the US and Europe. Economic data has also been somewhat disappointing for several economies – driven, in part, by some governments’ social-distancing measures in response to Coronavirus. Nonetheless, financial markets seemed to ignore the negatives. And by quarter’s end, Australian shares rose 13.8% while the Australian Dollar (AUD) traded at 77.2 US cents – for the most part, continuing this positive momentum into the month of January.

Key developments

Coronavirus accelerated in some parts of the world

New waves of Coronavirus accelerated during the December quarter, particularly across Western Europe and the US. As the number of new cases surged, the UK and several European countries introduced more severe social-distancing measures that were similar to those imposed in early 2020. Since then, the tide seems to have turned – at least for parts of the world. In both Western Europe and the US, daily new cases reached a peak in early January and have since declined.


Another negative development was the discovery – and subsequent spread – of new, mutated strains of the virus from the UK and South Africa. The UK strain is believed to be significantly more infectious and more deadly than the original variant. The South African strain is also more infectious and more resistant to vaccines, and also seems to have a stronger effect on younger people.

New restrictions meant economic data lost momentum

Global economic data began losing steam in December, as industry sectors more reliant on face-to-face contact were impacted by social restrictions. This is reflected in the divergence between the global manufacturing and services sectors. For example, while the Manufacturing Purchasing Managers’ Index (PMI) continued pointing to a healthy expansion, the Services PMI fell – particularly in Europe, where the level (firmly anchored below 50) points to a contraction in the sector.

 

Source: Factset
Source: Factset

As many European countries introduced more restrictions in December, economists have revised down their forecasts for the region’s economic growth. Consensus expectations are that several European economies will have suffered a “double-dip” recession for the December quarter – with Gross Domestic Product (GDP) growth ranging from a mild -0.9% in Germany to a more severe -4.8% in France. However, forecasters also expect European economies to recover about half their GDP losses for the March quarter as cases peak and as social-distancing measures are relaxed.

 

Table 1: Consensus European quarterly GDP growth (Source: Factset)
  December quarter 2020 March quarter 2021
Germany -0.9% 0.5%
France -4.8% 2.0%
Italy -3.0% 1.5%
Spain -3.6% 1.4%

While the US economy seems to have weathered the recent escalation in Coronavirus cases better than Europe, that doesn’t make it immune to economic setbacks. For instance, the level of non-farm employment fell by 140,000 in December – ending the country’s run of seven consecutive monthly rises. Retail trade also fell by an unexpected 0.6%, the first monthly fall since April 2020. Higher frequency economic data suggests that while the US economy still grew over the December quarter, the pace of the economic recovery has slowed significantly compared to the September quarter.


In comparison to our developed peers, Australia has benefitted from the government’s containment of the pandemic over the past few months. While there have been small-scale clusters of active cases in a number of capital cities (Sydney, for instance), lockdowns in Australia have been localised and limited. Australian retail trade rose by an impressive 7.1% in November, the second consecutive monthly rise. The level of employment also increased by 90,000 in November with a 70,000 rise in full-time roles, while the unemployment rate fell to 6.83% after reaching a peak of 7.44% in June.

Source: Factset

For financial markets, Coronavirus negatives were just short-term noise

Markets largely treated Coronavirus developments as short-term noise, focusing instead on vaccination programs. Indeed, a number of vaccines were approved over the December quarter, with several developed economies quickly commencing ambitious programs to vaccinate their populations – including the US, the UK, Europe, Canada, Israel, and Singapore. The number of doses manufactured, delivered and administered is impressive. In the US alone, 44.4 million doses were manufactured and distributed, while 23.5 million doses were administered as at 26 January this year – a little more than a month since the program started. However, it must be emphasised that with the exception of Israel, the proportion of the population which has been vaccinated is still comparatively small and is far lower than the threshold of 60%–70%, which experts believe is required to achieve herd immunity.

Table 2: Vaccination by country as at 26 January 2021* (Source: Our World In Data)
Country Doses (per 100 of population)
Israel 46.7
United States 7.1
Canada 2.2
Germany 2.3
France 1.6
Italy 2.5
United Kingdom 10.8

The start of immunisation programs kick-started a significant reflationary trend in markets. While this trend has faced some challenges from rising Coronavirus cases, concerns about new virus variants, and political volatility seen in the US in January, it has remained largely on track. In particular, the US Senate elections in Georgia (where the Democrats won a narrow two-seat majority) as well as President Biden’s US$1.9 trillion fiscal stimulus proposal furthered the momentum in markets. While the proposal has yet to be passed and the eventual package will likely be smaller than the initial number, markets are still boosted by the belief that US fiscal policy will remain supportive in 2021 and, if the need should arise, that further stimuli will be provided.

Higher-risk assets including shares, credit, commodities and the AUD all performed strongly over the December quarter and into January. Among the main share markets, the US market stood out once again. Hong Kong’s Hang Seng Index, which is dominated by Chinese stocks, also recorded a strong rise during this time. This has been driven by a combination of the strong economic recovery in China and an inflow of Chinese capital into the Hong Kong share markets as more Chinese stocks relocate their listings from New York to Hong Kong. Australia’s All Ordinaries Index has been another beneficiary of this reflation, driven by the recovery in global manufacturing activity and strong commodity prices. The Iron Ore spot price rose to an all-time high and the AUD, which traded at a low of USD 0.575 in March 2020, surged to a high of 77.7 US cents at the end of the December quarter. By the end of January, this declined somewhat to 76.7 US cents.

 

Table 3: Performance of major share indices (Source: Factset)
  All Ords Hang Seng S&P 500 NASDAQ Euro STOXX
Dec quarter 13.8% 8.2% 8.2% 15.4% 12.4%
Jan 2021 0.3% 5.2% -1.1% 1.4% -1.4%
Source: Factset
Source: Factset

Forward-looking views

At this stage, we believe reflation will still be the dominant theme in 2021. However, there are two key risks that could potentially lead to a correction in asset prices:


The first risk is that markets’ total confidence that key developed economies will achieve herd immunity by the end of 2021 may turn out to be too optimistic. Such confidence has allowed markets to “look through” the sharp surge in new cases over the past three months and focus on a normalisation of the level of economy activities, which will allow corporate earnings to recover sufficiently to justify expensive valuation. A weakening of conviction on the expected timing of herd immunity has the potential to produce a significant market correction. While it is difficult to forecast the path of the pandemic, there are several material risks in the path to herd immunity:

  1. The challenges in manufacturing. Given a global population of 7.8 billion, even the target 2021 production of 11 billion doses is insufficient to immunise the world population. Further, vaccine manufacturers may not be able to achieve their ambitious 2021 production targets due to potential shortages of raw material or problems with production processes (especially given two vaccines are based on mRNA technology, which has not previously been used in mass production). For example, AstraZeneca announced that due to production issues in its European factory, it has reduced its supply of vaccines to Europe.1
  2. The challenges in distributing and administering vaccines. It is well known that the two mRNA-based vaccines require cold storage transport and storage facilities, which are difficult to establish and maintain – especially in developing economies. Equally important is the availability of medical equipment at vaccination locations – syringes, swabs, medical gloves and so on. Shortfalls in that equipment can slow down the pace of vaccination.
  3. The challenges new Coronavirus strains pose to the efficacy of vaccines. While there are no scientific conclusions as yet, the consensus is that approved vaccines are equally effective against the UK variant while the South African variant may be more resistant to vaccines. Note that this doesn’t necessarily render vaccines useless but may mean the herd immunity threshold is higher (say, between 80%–90% instead of 60%–70%). This could mean new vaccines and massive vaccination programs may need to be developed on a regular basis.


The second risk is the surge in share prices over the past few months,
which has pushed valuations in several major share markets (as measured by the trailing and forward price-to-earnings ratio) firmly into ‘expensive’ territory. In particular, both the S&P 500 and the NASDAQ are trading at or close to their most expensive valuations. To some extent, more expensive valuations can be justified by the extremely low level of bond yields and the expectation that earnings will recover in 2021. Further, the US share market benefits from having greater exposure to technology stocks, which have better growth prospects. However, the difference between the earning yield of shares versus bond yields, a proxy of investor-expected returns from owning risky assets (shares) over the returns of lower-risk assets (bonds), has declined sharply. While this doesn’t necessarily signal an imminent share market correction, it does suggest markets may not be pricing in some downside risks.

In the meantime, our team will continue closely monitoring market developments and keep our investors up to date on the latest. Visit our market updates page for news, insights and more.

 

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