Stuart Paterson: What will future hold for global stocks?

it was hard not to recap the extraordinary year

of 2020; most importantly, to provide valuable context for our observations this year, and what to expect on the horizon.

When the global pandemic shocked the world into artificially shutting down its economy, the initial equity market reaction saw a 26 per cent decline in GBP terms within a span of three weeks. This triggered a “warlike” response from governments and central banks around the world, injecting a record amount of liquidity, both in the form of asset purchases and fiscal spending to contain what could have been a downward spiral for risk assets. Subsequently, global equities recovered 42% in GBP terms from their low over the remainder of the year.

Whilst 2020 forced the world to rethink its social priorities, healthcare, government deficits, and, in some instances, our democracies, the year finished with hope, boosted by the vaccine discoveries and spurred on by an ambitious new administration in the US.

Financial markets reflected this hope and,

since last November, they have seen a remarkable rebound in the most cyclically exposed sectors, such as financials, materials and, especially, energy. Having lost as much as 60% of their value from the initial sell-off in 2020, oil stocks have recovered by more than 40% from their trough.

Similarly, those sectors that faced existential threats last year, from travel and leisure to commercial real estate, have participated in this rally as traders closed their bearish bets. Ample liquidity and recovering risk appetite also helped smaller companies outperform the blue chips, with great excitement from retail investors.

Very much like a “war-time” recovery, inflation was top of investors’ minds going into this year. This was evident in the fixed-income market, where government bond yields rose across the world from record low levels in 2020. This has left government and high-grade corporate bonds amongst the worst performers this year, compared to in favour of reflationary assets, from commodities to cyclical equities.

This inflation fear requires the important context of 2020. Macro-economic data often looks at the changes over the same period the year before, and are now lapping the anniversary of the extraordinary troughs seen in 2020. The shutdown and restart of global supply chains has inevitably led to bottlenecks, which stoke price rises – much like how a congestion results from the start-stop nature of traffic. We think this friction is transient, as high prices signal for demand and supply to rebalance. An example is the spike and then collapse of US lumber prices, and the softening of new US housing demand. Central banks seem to agree with us.

While watching inflation manifest, central banks around the world keep their fingers on the pulse of job markets. For example, major

policy-makers from the US Federal Reserve (Fed), the Bank of England and the European Central Bank have advocated patience on policy normalisation, be it via tapering asset purchases or (thinking about) raising interest rates, despite inflation consistently printing above the 2% target.

This patience reflects the slow recovery of the job market and the data distortion from both a low-base effect and governments’ pandemic support, which when exhausted may expose lingering weakness in consumer health. However, with the risk of an over-heating economy and potential asset bubbles (mortgage-backed securities, for instance) the Fed has signalled a higher willingness to intervene. This hawkish shift in tone from the world’s largest central bank has put a brake on reflationary assets.

The outperformance of cyclical sectors

– energy, materials and financials, for instance

– versus the defensive growth companies in technology and healthcare, has partially reversed since June, when the Fed took a more hawkish stance towards inflation. This also coincides with the surge in the Delta variant of Covid, which

has now accounted for most of the new cases around the world. Countries with relatively high vaccination rates will likely not revert to stricter mobility restrictions, capping downside risk for some struggling sectors.

Meanwhile, business and consumer trends that were accelerated by the pandemic, such as digitisation/virtualisation, e-commerce and biotechnologies, are here to stay. This is evident in the latest earnings season, where technology and healthcare companies that enjoyed a strong 2020 continue to beat expectations. Together with a recovery of cyclical companies’ earnings, we see corporate earnings have materially re-based upwards from 2019.

Looking to the remainder of the year, we continue to like the fundamentals of developed market equities, which will likely weather the slow withdrawal of monetary support from major central banks, especially when such withdrawal is conditional on improving macroeconomics.

We continue to stick with our focus on quality companies in client portfolios, favouring businesses that have durable exposure to secular growth stories, strong balance sheets to withstand rising borrowing costs, and the pricing power to pass through inflation. Amongst those, healthcare companies are particularly interesting, with attractive earnings growth potential and undemanding valuation. They enjoy favourable demographic tailwinds, new drug developments, and, as the pandemic has shown, warrant a much higher level of investment and support.

Stuart Paterson is executive director at Julius Baer International Limited.