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A rotation in equity markets starts to emerge



“Ready for take-off” was the instant market judgment for a beleaguered airline industry on news of a breakthrough in the development of a Covid-19 vaccine.

A 15 per cent plus surge in the US shares of United Airlines, Delta Air Lines and American Airlines on Monday was bettered by British Airways parent International Airlines Group jumping 25 per cent. Ruling the sector roost for one-day price surges was Rolls-Royce, with the UK jet engine maker up 44 per cent. 

Airlines along with energy, finance, real estate, retail and hospitality are among the sectors hit hardest by Covid-19. The arrival of good news duly triggered a classic surge in their value from very cheap levels, but this week’s “vaccine pop” still leaves them trading well down on the year.

Widespread deployment of a vaccine will take time and not likely reach critical mass until mid-2021. In the interim, many countries are experiencing a rising number of infections and social restrictions heading into the northern hemisphere winter.

In market terms, near-term anxiety and additional pressure on economic activity over the coming months will compete with the natural tendency among investors to look ahead.

That will manifest itself in a debate over whether the first tangible sign of life beyond the pandemic represents a catalyst that triggers a temporary or sustained shift in global equity leadership across sectors and regions.

Bar chart of MSCI All World sector indices (% change) showing The rotation towards pandemic laggards

For investors, successful equity performance has consisted for a long time of owning popular technology names that offer growth potential and cash flow generation far ahead of the rest of the share market.

Given the dominance of tech within the US market, Wall Street has duly run up the scoreboard compared with other parts of the world where companies and sectors more exposed to the economic cycle dominate equity benchmarks.

Long-term investors have been vocal that such a sharp divergence between share market sectors and regions represented a spring waiting to snap back. That was certainly the case when news of the vaccine broke on Monday.

From here, the merits of a sustainable rotation of investor holdings of stocks and sectors depends considerably on the extent of the anticipated economic recovery next year.

Yes, a rough few months loom, but arguably 2021 looks brighter when you combine the promise of Covid-19 vaccines with the existing stimulus from governments and central banks. A vaccine on the way will help companies plan ahead, leading to greater business investment across sectors and the economy. 

Line chart of Indices in local currency, Nov 13 2019 = 100 showing Global rivals narrow some of the gap with US tech stocks

Another tailwind for cyclical stocks and sectors is that, after such a grim year, the 2021 earnings of these companies should look better by comparison. In contrast, big tech stocks have a higher bar in terms of surpassing earnings expectations after this year’s gains.

Rising long-dated government bond yields from stronger economic fundamentals will also weaken the appeal of paying a premium for growth companies and help sustain a rotation towards other areas of the equity market.

“The growth names that have carried markets to this point remain attractive on a three-year view, but now are likely to take a back seat as near-term year-over-year comparisons will be more difficult for them,” argued Stephen Auth, chief investment officer for equities at Federated Hermes.

In global terms, an economic recovery should boost the relative performance of equity markets in Europe, Japan and the UK, which are far more reliant on the performance of cyclical companies. The FTSE All World equity index, excluding the S&P 500, is back in positive territory for the year and has rallied nearly 11 per cent so far this month thanks to gains in those markets.

The UK’s FTSE 100 represents a “global cyclical bellwether”, given that almost three-quarters of the total revenue of the benchmark’s constituents is international, according to research firm TS Lombard. “With the vaccine signalling rotation into cyclicals, the UK market is set for outperformance,” it said.

However, a rotation in equity markets as the pandemic fades is likely to represent a tactical, rather than a secular, shift within equities. A more sustained move requires more growth and more inflationary pressure. Small-cap and cyclical stocks need greater pricing power that helps boost their earnings. 

That may come in time, but investors also note that over a longer period, many tech companies will retain superior earnings growth prospects. And while tech companies are sometimes disruptive forces, they also can be considered defensive investments. Strong cash flow and low debt is a hallmark of quality and this appeals during periods of market turmoil.

“Tech has such a superior growth rate, and it also has defensive qualities within a portfolio that provides diversification benefits,” observed Jim Paulsen, chief investment strategist at the Leuthold Group. “Tech will underperform, it will not crater. Over a 12 to 36 month horizon, tech looks good to me.”

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Financial bubbles also lead to golden ages of productive growth




Sir Alastair Morton had a volcanic temper. I know this because a story I wrote in the early 1990s questioning whether Eurotunnel’s shares were worth anything triggered an eruption from the company’s then boss. Calls were made, voices raised, resignations demanded. 

Thankfully, I kept my job. Eurotunnel’s equity was also soon crushed under a mountain of debt. Nevertheless, the company was refinanced and the project completed. I raised a glass to Morton’s ferocious determination on a Eurostar train to Paris a decade later.

With hindsight, Eurotunnel was a classic example of a productive bubble in miniature. Amid great euphoria about the wonders of sub-Channel travel, capital was sucked into financing a great enterprise of unknown worth.

Sadly, Eurotunnel’s earliest backers were not among its financial beneficiaries. But the infrastructure was built and, pandemics aside, it provides a wonderful service and makes a return. It was a lesson on how markets habitually guess the right direction of travel, even if they misjudge the speed and scale of value creation.

That is worth thinking about as we worry whether our overinflated markets are about to burst. Will something productive emerge from this bubble? Or will it just be a question of apportioning losses? “All productive bubbles generate a lot of waste. The question is what they leave behind,” says Bill Janeway, the veteran investor.

Fuelled by cheap money and fevered imaginations, funds have been pouring into exotic investments typical of a late-stage bull market. Many commentators have drawn comparisons between the tech bubble of 2000 and the environmental, social and governance frenzy of today. Some $347bn flowed into ESG investment funds last year and a record $490bn of ESG bonds were issued. 

Last month, Nicolai Tangen, the head of Norway’s $1.3tn sovereign wealth fund, said that investors had been right to back tech companies in the late 1990s — even if valuations went too high — just as they were right to back ESG stocks today. “What is happening in the green shift is extremely important and real,” Tangen said. “But to what extent stock prices reflect it correctly is another question.”

If the past is any guide to the future, we can hope that this proves to be a productive bubble, whatever short-term financial carnage may ensue.

In her book Technological Revolutions and Financial Capital, the economist Carlota Perez argues that financial excesses and productivity explosions are “interrelated and interdependent”. In fact, past market bubbles were often the mechanisms by which unproven technologies were funded and diffused — even if “brilliant successes and innovations” shared the stage with “great manias and outrageous swindles”.

In Perez’s reckoning, this cycle has occurred five times in the past 250 years: during the Industrial Revolution beginning in the 1770s, the steam and railway revolution in the 1820s, the electricity revolution in the 1870s, the oil, car and mass production revolution in the 1900s and the information technology revolution in the 1970s. 

Each of these revolutions was accompanied by bursts of wild financial speculation and followed by a golden age of productivity increases: the Victorian boom in Britain, the Roaring Twenties in the US, les trente glorieuses in postwar France, for example.

When I spoke with Perez, she guessed we were about halfway through our latest technological revolution, moving from a phase of narrow installation of new technologies such as artificial intelligence, electric vehicles, 3D printing and vertical farms to one of mass deployment.

Whether we will subsequently enter a golden age of productivity, however, will depend on creating new institutions to manage this technological transformation and green transition, and pursuing the right economic policies.

To achieve “smart, green, fair and global” economic growth, Perez argues the top priority should be to transform our taxation system, cutting the burden on labour and long-term investment returns, and further shifting it on to materials, transport and dirty energy.

“We need economic growth but we need to change the nature of economic growth,” she says. “We have to radically change relative cost structures to make it more expensive to do the wrong thing and cheaper to do the right thing.”

Albeit with excessive enthusiasm, financial markets have bet on a greener future and begun funding the technologies needed to bring it to life. But, just as in previous technological revolutions, politicians must now play their part in shaping a productive result.

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US tech stocks fall as government bond sell-off resumes




A sell-off in US government bonds intensified on Wednesday, sending technology stocks sharply lower for a second straight day.

The yield on the 10-year US Treasury bond, which acts as a benchmark for global borrowing costs, climbed to nearly 1.5 per cent at one point. It later settled around 1.47 per cent, up nearly 0.08 percentage points on the day.

Treasury trading has been particularly volatile for a week now — 10-year yields briefly eclipsed 1.6 per cent last Thursday — but the rise in yields has been picking up pace since the start of the year and the moves have begun weighing heavily on US stocks.

This has been especially true for high-growth technology companies whose valuations have been underpinned by low rates. The tech-focused Nasdaq Composite index was down 2.7 per cent on Wednesday, on top of a 1.7 per cent drop the day before.

The broader S&P 500 fell by 1.3 per cent.

The US Senate has begun considering President Joe Biden’s $1.9tn stimulus package, with analysts predicting that the enormous amount of fiscal spending will boost not only economic growth but also consumer prices. The five-year break-even rate — a measure of investors’ medium-term inflation expectations — hit 2.5 per cent on Wednesday for the first time since 2008.

Inflation makes bonds less attractive by eroding the value of their income payments.

“I would expect US Treasuries to continue selling off,” said Didier Borowski, head of global views at fund manager Amundi. “There is clearly a big stimulus package coming and I expect a further US infrastructure plan to pass Congress by the end of the year.”

Mark Holman, chief executive of TwentyFour Asset Management, said he could see 10-year yields eventually trading around 1.75 per cent as the economic recovery gains traction later this year.

“It will be a very strong second half,” he said.

Line chart of Five-year break-even rate (%) showing US medium-term inflation expectations hit 13-year high

Elsewhere, the yield on 10-year UK gilts rose more than 0.09 percentage points to 0.78 per cent, propelled by expectations of a rise in government borrowing and spending following the UK Budget.

Sovereign bonds also sold off across the eurozone, with the yield on Germany’s equivalent benchmark note rising more than 0.06 percentage points to minus 0.29 per cent. This was an example of “contagion” that was not justified “by the economic fundamentals of the eurozone”, Borowski said, where the rollout of coronavirus vaccines in the eurozone has been slower than in the US and UK.

The tumult in global government bond markets partly reflects bets by some traders that the US Federal Reserve will be pushed into tightening monetary policy sooner than expected, influencing the costs of doing business for companies worldwide, although the world’s most powerful central bank has been vocal that it has no immediate plans to do so.

Lael Brainard, a Fed governor, said on Tuesday evening that the ructions in US government bond markets had “caught my eye”. In comments reported by Bloomberg she said it would take “some time” for the central bank to wind down the $120bn-plus of monthly asset purchases it has carried out since last March.

After a series of record highs for global equities as recently as last month, stocks were “priced for perfection” and “very sensitive” to interest rate expectations that determine how investors value companies’ future cash flows, said Tancredi Cordero, chief executive of investment strategy boutique Kuros Associates.

Europe’s Stoxx 600 equity index closed down 0.1 per cent, after early gains evaporated. The UK’s FTSE 100 rose 0.9 per cent, boosted by economic support measures in the Budget speech.

The mid-cap FTSE 250 index, which is more skewed towards the UK economy than the internationally focused FTSE 100, ended the session 1.2 per cent higher.

Brent crude oil prices gained 2 per cent at $64.04 a barrel.

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UK listings/Spacs: the crown duals




City-boosting proposals are not enough to offset lack of EU financial services trade deal

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