November 2021 | The Monthly View

What we liked

• The Westpac-Melbourne Institute Index of Consumer Sentiment decreased by 1.5% to 104.6 in October from 106.2 in September. Despite both Sydney and Melbourne remaining in lock down throughout the last month consumers are relatively upbeat. At 104.6 there continues to be a clear majority of optimists nationally.
• Australia’s two largest states, N.S.W. and Victoria, emerged from COVID induced lockdowns. Early signs from retail sales and job advertisements has seen a pick-up on the back of this.
• Despite a negative headline number of -0.4% for durable goods orders in the U.S. it did beat expectations of a -1% drop. Additionally, Capital goods orders non-defence ex-air was +0.8% vs +0.5% expected, showing underlying strength in the numbers. This data is an important indicator of business confidence as spend on large ticket items is a strong barometer of corporate America’s confidence in the sustainability of economic growth.
• US retail sales for the month increased by 0.7%, against the Dow Jones estimate for a decline of 0.2%. Compared with a year ago, sales were up 13.9% on the headline number. Adding to the positive tone the increase came during a month when the government ended the enhanced benefits it had been providing during the Covid-19 pandemic and against forecasts that growth would slow in the third quarter due to the delta variant spread.
• Euro area 3Q GDP grew by 2.2%Q in 3Q21, at a slightly higher pace than the previous quarter and than consensus expected, suggesting that supply bottlenecks were more than compensated by still surging demand, especially in the services sector.
• China retail sales beat expectations, rising 4.4% in September from a year ago. This compares to expectations of 3.3% growth. This is an encouraging development as reverses recent consumer weakness and indicates the domestic consumer is in good shape.
• Japan’s elections see the incumbent LDP and coalition partner Komeito securing 293 seats out of 465, retaining a stable majority in the Diet. This is expected to see a substantial fiscal policy finalised in September supporting the Japanese economy.

What we didn’t

• Australia’s unemployment rate rose 0.1% in September to 4.6%, reflecting the labour market damage inflicted by lockdowns across New South Wales and Victoria. A rebound is expected as Australia’s two largest states emerge from lockdown in October.
• US gross domestic product (GDP) which measures the value of goods and services produced by the economy, grew 2% in the third quarter from the same period a year ago. That initial reading marked a sharp slowdown from the second quarter when GDP adjusted for inflation grew 6.7%. The third-quarter headline number also fell short of many analysts already curbed expectations.
• Eurozone industrial production fell in August due to supply-chain bottlenecks and slowing global trade. Output from factories, mines and utilities across the single-currency area in August fell 1.6% from the previous month.
• Euro area PMI’s disappointed as the service sector slowed significantly which brought the composite PMI to a six-month low of 54.3 in October from 56.2 in September. Despite the slowdown the readings remains in expansionary territory (a reading above 50 indicates expansion).
• Euro area retail sales, a proxy for consumer demand, in the 19 countries sharing the euro rose 0.3% month-on-month in August and were unchanged from a year earlier. While a positive growth figure it was below the expected 0.8% monthly gain and a 0.4% year-on-year increase.
• China’s third-quarter GDP grew a disappointing 4.9% as industrial activity rose less than expected in September. That missed expectations for a 5.2% expansion, according to analysts polled by Reuters.
• Chinese manufacturing PMI fell to 49.2 in October from 49.6 in September. The biggest impact came from the sudden stoppage in electricity generators in some locations, which brought to a total halt electricity supply for factories as well as for households.

Base Case

Our view of the most likely scenario for markets over the coming months, for which our portfolios are currently positioned.
72% Probability

While the speed of the economic improvement is expected to be continue to be adversely affected by supply chain disruption, economic demand and activity is anticipated to remain at elevated levels.

Globally, central bankers will look to continue their accommodative policy stance, but markets will begin to question the sustainability of this level of support as economies show strong growth and inflationary pressures build. This may create increased volatility over the coming months. On the fiscal front governments have indicated they are willing and able to step up with spending to support their economies. Such policies are expected to be maintained globally as governments look to sustain employment and wage growth, as well as supporting long-term social objectives such as carbon reduction and social inequality. Political wrangling over the size and make-up of such government spending, particularly in the U.S., is likely and may create uncertainty and bouts of market volatility.

Risks remain. Those we view as most prominent include increased China and Australia/U.S. trade tensions, greater slowdown in the Chinese economy than is currently expected, faster than expected increases in government bond yields (due to inflationary pressures building), a further increase of COVID-cases across different regions pressuring health systems, continued high levels of supply chain disruptions and stimulus packages that underwhelm expectations.

This scenario is likely to see us maintain a constructive medium-term view on growth assets, using any volatility to increase exposure to growth assets. Capital preservation will be targeted through appropriate company and sector allocations. Overall asset allocation will retain a bias to growth assets.

Bear Case

Our worst-case scenario for the coming months, which we are prepared to position for should conditions deteriorate.
13% Probability

Global consumer demand for goods and services falls further than expected as the expected pick up from pent up demand does not eventuate. Rather the consumer remains apprehensive once the direct-to-consumer fiscal support from governments begin to wane. Additionally, supply chain issues remain as do inflationary pressures. In this environment we observe slowing growth while higher inflation levels place pressure on Central Banks to begin withdrawing monetary support.

This scenario may see central bank stimulus and fiscal support from governments as lacking the required potency to maintain economic support and provide further improvement in consumer confidence.  Additionally, a premature withdrawal or reduction of central bank liquidity could derail financial markets which have become accustomed to liquidity support. Any failure of governments across the globe to extend or further stimulate their economies through fiscal spending would further erode confidence. This may cause consumer confidence and spending to fall as government support is not easily replaced with gainful employment income. Such a scenario would likely see a level of dislocation in financial markets across the spectrum.

An emerging risk is rising government bond yields. The disruption of supply chains and high input costs is expected to place upward pressure on bond yields, particularly if judged to be more sustainable. While considered unlikely, an unexpectedly swift acceleration of bond yields from current levels could see valuation compression in financial markets as well as adversely impacting economic activity. This would be more pronounced in high valuation stocks and company’s unable to exercise pricing power in such an environment.

Left-field events such as a rapid escalation in geo-political tensions (especially between the US and China) or a significant or systemic corporate default (especially due to over-indebtedness in an environment of rising bond yields) could see a liquidation of risk assets in a compressed period of time. This risk appears to be most acute in China following recent delays in scheduled bond payments from domestic property developers.

Above scenarios will see us take a more defensive position and reduce equity exposures replacing them with defensive assets, such as cash. The accelerating bond yield scenario would require a more nuanced shift toward companies and sectors that would be the greatest beneficiaries of such a move. The overall focus will remain on capital preservation.

Bull case

Our most optimistic view for markets over the coming months.

15% Probability

Economies across the developed world continue to exhibit strong economic growth. Substantial fiscal support from governments would combine with high cash levels on household and corporate balance sheets to sustain the speed of the global economic recovery. In the event central banks maintain measures aimed at supressing interest rates, we would expect this to further fuel asset appreciation, while any extension of these accommodative policies would further accelerate the expected upward re-rating of asset values.

Such a market dynamic would see substantial improvement in economic activity globally, particularly in service-oriented businesses that will benefit from social re-opening. This would occur as pent-up demand from business and consumers combine with massive government and central bank stimulus measures to create a potent environment for risk assets. Sectors expected to benefit most in this environment are those leveraged most to economic activity, in many cases these are the same companies that were most adversely affected by the COVID-19 induced lock downs.

This scenario would be cheered by financial markets as a combination of monetary and fiscal stimulus act to fuel demand for growth assets in a low to negative real interest rate environment. We would act by reducing our cash levels further and adding to the growth asset allocation at the expense of cash and other defensive assets.

Stock in Focus

Lloyds Bank plc is a British retail and commercial bank with branches across England and Wales. It has traditionally been considered one of the “Big Four” clearing banks. Lloyds Bank is the largest retail bank in Britain, and has an extensive network of branches and ATMs in England and Wales (as well as an arrangement for its customers to be serviced by Bank of Scotland branches in Scotland, Halifax branches in Northern Ireland and vice versa) and offers 24-hour telephone and online banking services. As of 2020 it had 17.4 million personal customers and small business accounts.

Our View

There are a number of attributes that attract us to the near-to-medium term prospects of Lloyds:

• Leverage to U.K economy – LLOY has ~20% of U.K housing mortgage market share, the largest in the U.K. Mortgage demand has been resilient in the face of economic challenges with demand up 7% vs. the same month in 2019. We expect growth to continue and this should lead to further upgrades for the business.
• Earnings Growth – LLOY most recent result saw management upgrade guidance on margins as they were able to keep costs in check as income rose. This dynamic is expected to result in enhanced profitability as economic activity in the U.K improves and upward pressure on bond yields persists.
• Strong Balance Sheet – LLOY last reported a capital adequacy ratio of 16.7%, which is higher than required by regulators. This along with strong loss provisioning being released from their balance sheet should see significant capital management in the form of share buyback and increased dividends. We expect this to reflect positively on the company’s share price.

History

Lloyds Bank was founded in 1765 in the city of Birmingham. It began when John Taylor, a button maker, and Sampson Lloyd, an iron producer joined forces. They started a bank called Taylors and Lloyds. Based in the centre of the town, the bank served manufacturers and merchants.

From a single office, the bank operated for over 100 years. It was during the period when Birmingham was becoming a powerhouse of the Industrial Revolution. In 1852, the Taylors dropped out of the business. The bank became Lloyds & Company, and in 1865 it became a ‘limited’ concern.

The need for more capital saw Lloyds expand, and a board of directors appointed. Some were prominent citizens. It included Joseph Chamberlain who was later to become the Mayor of Birmingham. During the next 50 years, Lloyds expanded and took over 200 smaller enterprises. By the 1880s the bank decided to make a foray into London, the hub of banking.

Joining Barclays Bank, Lloyds settled in Lombard Street when it took over Barnetts, Hoares and Co. The bank first used the famous Black Horse symbol at this time. Another, important company included in the Lloyds takeover push was Twinings Bank. In 1893, Lloyds took over Herries, Farquhar & Co. It was a business that had introduced the concept of the traveller’s cheque.

Lloyds continued to expand in the twentieth century. It expanded both in the UK, and it slowly began to make inroads into the overseas markets. Like other banks, Lloyds started to employ more women staff during the period of the first world war. Additionally, there was a gradual change over to mechanisation. This was instead of all the accounting completed in handwritten ledgers.

One of the largest takeovers that Lloyds embarked upon was in 1918 when it took over the Capital and Counties Bank. This move meant that Lloyds had an extra 473 branches giving it a more than 50% increase in branches. At this point, it became part of the ‘big five’ banks of the UK.

Starting out in Paris and Le Havre, in 1911 Lloyds began its foray into the foreign markets. Its overseas operations later became known as Lloyds Bank Europe. Lloyds also established branches in Argentina, Brazil and South Africa. Lloyd saw these as emerging countries with excellent opportunities due to the wealth of minerals people mined and extracted.

Today it remains one of the U.K’s largest banks with around 20% of the mortgage market.