Market Commentary - Q1 2021
Q1 2021 was marked in the UK, and the US which continues to set the tone for world markets, by cautious optimism that the vaccine rollout will work, and that economies will restart. Concern about how (or even if) the debt burden will be coped with has been at a low level.
“Value” stocks (broadly defined as those with visible shorter-term earnings) have outperformed “growth” stocks, on the basis that a) many are direct beneficiaries of a conventional cyclical recovery and b) that a normalisation or even a partial normalisation of interest rates must penalise the valuation of growth companies with more distant prospects to make money. This duration risk has of course mechanically penalised the bond markets, albeit central banks continue to repress rates through various forms of quantitative easing, and it is logical that it should affect the implicit discount rate that the market applies to equities. As can be seen, that normalisation has not yet had a massive effect:
Over the last year, the FTSE has performed poorly, compared with the US markets (which exceeded their pre-pandemic levels in mid-2020 - the FTSE still has not got back there), and also compared with AIM. Its relative performance has flattened out this year:
The thing about the pandemic was that it was in firms’ and governments’ risk registers, but just not taken seriously. It is not that humans cannot worry about things they have not experienced- having been brought up in the fear of the Bomb I can testify that is not the case. But we do tend to discount problems that we believe are solved. Like financial crises (ahead of 2007-8), which Gordon Brown assured us were not an issue. Indeed, my then boss at Societe Generale in 2007 elicited a laugh from the London staff by observing that we had been wasting time on a Bank of England mandated SARS exercise when we should have been worrying about financial instability. Sick chickens I think was his description. But he did assure us that there was nothing to worry about as regarded derivative pricing…
Like armies that endlessly re-fight the last war, we shall spend the future with a Cold War level of spending against pandemics. The government has for example just announced a new £15bn framework agreement for testing over the next four years. Vaccine development is clearly now a priority rather than a Cinderella area of life sciences. The markets remain interested in who will benefit, but we are no longer seeing the astronomical rises in share prices for companies just because they are mentioned, the Vox markets Covid index has stopped rising, and we will have to be selective as to who really benefits.
Elsewhere in life sciences, there will continue to be interesting opportunities, and the UK is a rich source of primary research. As you may see in our quoted report, we have seen good moves in companies involved in the emerging field of the microbiome (Skinbiotherapeutics), in liquid biopsies (Angle) and sexual health (Futura), and many others. There are some very interesting companies working in imagine, an area LGB has been involved in since its early days.
So what else can we worry about and how should we react?
Inflation is an interesting conundrum, and if you live in the UK you now have to be a certain age to remember it. Here is the last 17 years (with the Bank of England’s 2% target in bold). But if you go back to the ‘70s you can find 20% rates in the U, and a time when 5% inflation felt pretty modest.
There is clearly huge surplus capacity in the main western economies, and the sorts of goods that remain poorly represented in inflation indices (data processing power, broadband capacity, media choice) have seen huge deflation. In the UK there has been a lot of argument over the years about whether the inflation statistics have caught housing cost inflation adequately. On the other hand, we are starting to see shortages for certain goods, exacerbated by political dislocations. At a very high level, the continued outperformance of China and other Asian economies will make the West have to compete harder for scarce goods. The tension between the US and China represents a threat to certain supplies (rare-earth metals notably). Increased consciousness of the ethical dimension of supply chains will also – quite rightly – start choking off some of the more exploitative sources of cheap goods. The closure of the Suez Canal for a week led to some overwrought discussion of how damaging it would be. In 1967 the Suez Canal was shut for seven years as a result of the Six Days War. That certainly had a measurable effect on trade between some countries. Should we worry about a week’s blockage and consequent disruption? Not so much. For a very long-term study on the differential effects of inflation on different asset classes, this paper is interesting.
What we should definitely assume is that longer duration bonds, and particularly government bonds, are a questionable investment here. The repression of rates through QE and otherwise is a cost to savers, but we have surely now seen the trough of interest rates with the brief period of sub-zero coupons in some markets. In so far as rates normalise, the price risk for longer-dated paper is mechanically very high. Government (and investment grade) bonds are also supported in price (and repressed in yield) by pension solvency rules and the perverse way that indexation works in the bond market, as well as banks reserve requirements. There is value away from here, in private and undated debt.
What else can we worry about? Climate change will soon resume its pre-pandemic salience. There is a shortage of hydrogen economy stocks, and as large companies attempt to greenwash their businesses we shall no doubt see some of them disappear into conventional energy, utility or engineering companies. We shall continue to look for fuel cell plays, and there will be opportunities in suppliers into the hydrogen economy as specialist engineers and others seek to capitalise on the enormous investments that will have to be made to change the shape of our energy consumption.
Agriculture is a massive source of CO2 emissions, but most of the companies active in work on decarbonisation are at venture level. Agronomics Ltd, a quoted investment vehicle in this area, now trades on over three times the historic costs of its investments. We shall be alert for other ways into investing here. Biome Technologies plc has some interesting exposure to compostable material for food packaging and forestry.
Cybersecurity was the dog that didn’t bark in the night during lockdown. Companies had to find ways of securing working from home but delayed other projects. The dangers are still very much out there and state-sponsored actors have been part of this. Whilst the Darktrace IPO is proving controversial for governance reasons, there are many smaller quoted companies in the sector, and the field is ripe for consolidation. We have seen in digital transformation how worthwhile a roll-up vehicle can be (look at The Panoply plc) – maybe we will see an imitator in cyber?
Lastly, if you really want something to worry about, then US-China and Russia-Ukraine tensions both have the potential to get worse. Russia has already annexed part of Ukraine, and knows that the EU at least is not going to do anything very concrete to stop an escalation – the Germans are too keen to press on with the Nordstream gas pipeline. Poor US-Turkey relations make NATO intervention difficult. But a hot war in the Donbass would inevitably call forth more severe and disruptive sanctions and potentially affect European energy supplies. It is hard to believe that the equity markets would not react badly.