Despite the virus taking a turn for the worse in the fourth quarter and renewed containment measures being required, equity markets continued to rally due to vaccine progress, positive US election and Brexit developments and further monetary and fiscal policy support. The announcement of effective vaccines in November proved especially helpful to equities and triggered a notable change in market leadership towards previously out of favour companies and sectors. This enabled the UK market to finish a difficult year with a strong quarter. Most international equity markets ended the year achieving good gains whilst government and corporate bonds extended their gains with further modest progress over the quarter.
The fourth quarter of 2020 saw a resurgence in Covid-19 cases in many countries, including the economic heavyweights of the US and Europe. Governments were forced to implement new lockdown measures to control the spread of the virus and the strong economic recovery from the depths of the initial lockdown period lost momentum. The tighter restrictions will primarily impact the service sector and delay the global recovery, but manufacturing and trade data has proved more resilient than in the initial lockdowns.
Some parts of the world have been more successful at controlling the virus, such as China where infections have remained low and their economy has seen a significant return towards normality. With sustained economic reopening without triggering a new wave of the virus proving to be a challenge for many countries, the key escape route has become successful vaccines. The announcements of effective vaccines from Pfizer, Moderna and AstraZeneca/Oxford and the beginning of their rollout also gave a significant shot in the arm to investor confidence.
The quarter saw significant political events, with well-received developments in both the US elections and Brexit negotiations. Whilst Donald Trump had delivered some market friendly policies such as tax cuts and deregulation, investors welcomed the prospects for a less confrontational presidency under Joe Biden and increased government spending. Although it was widely expected that a last minute Brexit compromise would be reached, the risks of a damaging no-deal had hung over UK markets in recent years and there was relief when this was avoided. The deal itself was still a relatively hard Brexit with a lack of progress on some important areas such as financial services, but it still enabled sterling to recover over the final quarter and for UK equities to regain some of their lost ground.
Government and central bank fiscal and monetary policy measures have continued to provide crucial support to economies and markets until conditions normalise, and further measures were announced in the quarter. These included a new US pandemic relief plan, progress on the European Union’s recovery fund and seven-year budget and further asset purchase plans from the major central banks.
The first ten months of 2020 had seen a strong difference in performance between equities that were perceived Covid-19 winners such as technology related companies and those that had been hard hit by the virus such as banks, energy and travel & leisure companies. The November vaccine announcements led to a significant momentum change and reversal in market leadership, with the previous laggards rallying strongly and reducing but by no means eliminating the 2020 performance gap.
Alongside the improved sentiment from progress on the Brexit deal, this trend was beneficial for the UK equity market which has few technology companies but a larger than average exposure to the more value and cyclical sectors. A fourth quarter gain of 12.6% reduced 2020 losses for the FTSE All-Share index to 9.8%, with small and medium sized companies outperforming the larger company FTSE 100 index.
International equity markets also had a strong final quarter, although the strength of sterling limited gains for UK based investors to 8.4% (13.0% in local currencies). Despite the significant impact of the pandemic on global economies and companies, this third consecutive quarterly gain meant that international equities achieved an excellent 2020 return of 14.3% in sterling terms. Asia Pacific ex-Japan and Emerging Markets saw the best Q4 returns whilst the technology heavy US market led the way in 2020 with gains of over 17%.
Despite hopes for a vaccine inspired economic recovery, central bank bond buying and indications that interest rates would be kept very low for the next few years meant bond yields remained extremely low throughout the quarter. UK gilts gained 0.6% for the period, taking their 2020 return to 8.3%. The pro-risk backdrop supported credit markets and corporate bonds saw gains of 3.1% for the quarter and 7.8% for the year.
The commercial property market has seen pockets of strength in areas like industrial and warehousing, but further weakness in the retail and leisure sectors and growing concerns over the future demand for office space resulted in forecast overall losses of around 3% in 2020.
With the Bank of England having cut the UK interest rate to a record low of just 0.1%, returns from cash deposits remain exceptionally low and well below the level of inflation.
An extraordinary year saw markets get off to a strong start before being significantly hit by an unexpected global pandemic followed by a remarkable rally from the March lows fuelled by massive monetary and fiscal stimulus and vaccine hopes. It may seem that with many global markets now at or near all-time highs they have become detached from the real economy, but it is important to remember that financial markets are forward looking and an end to the pandemic should trigger a multi-year economic recovery.
Providing there are no significant unanticipated shifts in the virus, the vaccine rollout proves effective and central banks and governments continue to provide significant support until conditions normalise, then markets are likely to continue to look through any further negative news on virus cases and economic lockdowns and focus on the expected recovery.
Short-term economic forecasts have been reduced in many countries as tighter lockdowns have been implemented, but the unleashing of pent-up demand from consumers and businesses as economies reopen once the virus is under control should see a period of sustained above trend growth. Hopefully virus containment measures will be successful and this would help sentiment, but realistically it looks like the vaccine will be the key catalyst in much of Europe and North America to enable reopening and mid-year should have seen significant progress on that front.
Monetary policy has been a key policy tool in recent years, but the newly utilised combination of both monetary and fiscal policy working together has been a powerful support for markets. Many countries have seen significant increases in their debt positions following the extensive support packages that they have provided, but it is widely expected that this support will continue until the economic recovery is embedded and high debt levels will be tolerated for the foreseeable future. This abundance of liquidity has seen interest rates and bond yields in many countries move down to around 0%.
Political developments have also been supportive, with both the US and Europe set to deliver increased fiscal spending. In the US, the election of Joe Biden and a Democrat controlled Congress should see significant further spending to support the economy, boost infrastructure and develop the green agenda. Europe also has ambitious plans to use its substantial recovery fund, which is seen as an important sign of European unity and a commitment to more aggressive policy measures.
Whilst the Brexit deal is still viewed by many as negative for the UK economy and significant elements such as financial services remain to be agreed, the removal of the ‘no-deal’ risk has lifted some of the investor gloom that has hung over the UK market since the 2016 referendum. Sterling was seen as especially vulnerable to a bad outcome but has seen some strength in recent weeks especially against the weakening US dollar.
Brexit has certainly been one factor behind the UK equity market being out of favour with global investors in recent years, but it has also suffered from a worse than average impact from Covid-19 and a sector mix that was poorly placed for recent trends that had favoured areas such as technology. This has left the UK market on a historically large valuation discount to global equities and with an economic recovery in sight the change of market leadership towards more value and cyclical companies should favour the UK market. The UK is also seeing the earliest vaccine rollout of the major nations and there are growing signs of an uptick in merger and acquisition activity as buyers recognise the relative valuation attractions of the UK.
Many companies, especially in areas more impacted by lockdown measures, saw lower profits and reduced dividend payouts in 2020, but overall declines were better than initially feared and forecasts for 2021 and 2022 are for a significant recovery as conditions normalise. With such strong financial support from authorities we have not seen the usual impacts from a normal deep recession and companies and consumers look well placed to increase their spending when conditions allow, as we have already seen in the likes of China.
With interest rates and government bond yields close to 0%, equities offer significantly higher levels of income and these low discount rates also support higher equity valuations. This has been especially true of higher growth largely technology related companies in recent years, but with an economic recovery set to lead to profit growth in other more cyclical or ‘value’ sectors of the market the recent market rally has broadened out and this has the potential to continue.
In a normal recovery from an economic downturn it would usually be expected that there would be an increase in inflation, interest rates and bond yields and as well as being a challenge to fixed income investors that could also remove the support equities have received from low yields and cheap borrowing costs and impact their valuations. Some uptick in short-term inflation is likely but there are mixed opinions as to whether we will see a sustained increase. The heavy levels of government debt issuance could also put some pressure on bond markets, but central banks have committed to continue their substantial asset purchases to help keep the cost of debt low for the foreseeable future to support the recovery. Whilst this should help keep short-term interest rates and bond yields low, yields on longer-term bonds may begin to rise and in aggregate the return prospects for government bonds continue to look poor.
With prospects for an economic recovery, fixed income investors have migrated towards higher risk bonds which offer superior income such as investment grade and high yield corporate bonds and emerging market debt. The additional yield on these bonds over and above equivalent gilt yields have narrowed significantly from the elevated levels seen last year but are still seen as offering the best risk-adjusted return potential within fixed income assets.
There is some debate within the Bank of England as to whether UK interest rates should be cut to 0% or even move negative, but the outlook for interest rates is that they will stay very low over the next few years, so for savers the returns on cash deposits will continue to struggle to match the levels of inflation being seen.
In conclusion, whilst investors will still focus on the path of the virus and the extent of lockdown requirements, markets will look through these short-term difficulties if central banks and governments continue to provide extensive policy support and the vaccine rollout looks set to enable a return towards normality later this year. With many equities now at above average valuations there is little room for disappointment, but the economic environment should be supportive and their relative growth potential and income attractions compare favourably to extremely low interest rates and bond yields. Government bonds have again proved their worth as safe-haven investments in difficult times, but the lack of yield now limits their attractions and corporate bonds are preferred within fixed income. Equities continue to see periods of heightened volatility, but they remain our preferred asset class and investors with suitable risk appetites should retain confidence in their longer-term attractions as part of appropriately balanced portfolios.