State Of The World

“One of the key developments over June has been markets challenging the regime change thesis.  The rally in longer-dated bonds, and the rotation back into growth equities, actually started well ahead of the 16 June Federal Reserve (Fed) meeting, and may have been a response to perceptions we have now seen, the peak in earnings upgrades, activity surprise and the inventory squeeze.  It may also have reflected some scepticism about regime change, which was then heightened by the Fed appearing to advance the timing of their first rate hike.  This saw the (US yield) curve flatten significantly.”  ASR Research.

 

 

State Of The World

“One of the key developments over June has been markets challenging the regime change thesis.  The rally in longer-dated bonds, and the rotation back into growth equities, actually started well ahead of the 16 June Federal Reserve (Fed) meeting, and may have been a response to perceptions we have now seen, the peak in earnings upgrades, activity surprise and the inventory squeeze.  It may also have reflected some scepticism about regime change, which was then heightened by the Fed appearing to advance the timing of their first rate hike.  This saw the (US yield) curve flatten significantly.”  ASR Research.

“Students of bubbles know two things:  (1) they can last far longer than reason suggests, and (2) they always end in massive financial losses for most participants.  There is still an opportunity for investors holding egregiously overvalued stocks, bonds and real estate to exit before the curtain closes on this current chapter in financial folly.  With the Fed and other Central Banks terrified of pulling the plug in justifiable fear of an adverse market reaction, the bubble is likely to continue for a while.”  Michael Levitt, The Credit Strategist.

“One of the most important components for financial conditions are real rates.  There is a lot of focus on the Fed’s normalisation path up ahead, and as nominal rates rise while inflation expectations become a bit more restrained, real rates actually rise and dampen the investment outlook.  Just the confirmation that tapering is going to be on the agenda has begun to move real rates higher:  between May and June of this year, the US real rate increased by 50bp.”  Geoffrey Yu, BNY Mellon.

Since the start of the year, we have seen stock markets predominantly move upwards as a result of the “reflation narrative”.  Simply put, as the vaccines led to economies reopening, this led to a recovery in economic activity that saw company earnings and profits exceed expectations.  At the same time, and in contrast to the response after 2008, we have seen in the US and elsewhere massive fiscal support.  This has seen the unemployment rate lower than anyone initially thought when lockdowns were enacted, and aggregate savings exceed forecasts.  Central Banks have continued to provide extraordinary support to complement Government spending, largely by buying all the new debt Governments are issuing to fund their largesse.  It was an overwhelming response to a once in a hundred year event.

Now, however, markets are likely to confound observers in a fashion just like the incredible recovery we saw in equity indices 12 months ago, whilst we had no vaccine and lockdowns were in full effect, by beginning to worry about an economic slowdown or policy mistake.  As ASR Research note above, it appears now could be “as good as it gets”.  Economic data for the US in particular are showing signs of peaking and rolling over, the so-called second derivative, which highlights things have incrementally stopped getting better has become the focus.  As a stock market acts as discount mechanism for future profit growth expectations, the initial question being asked now is should we expect growth to be as strong in a year’s time as the growth we are observing now is?  Furthermore, will we see fiscal stimulus end sooner rather than later – before the economy is judged to be able to stand on its own two feet?  And, has the US Central Bank (the Fed) this past June laid the groundwork for reversing its monetary policy support for the US economy?  We think the answer to each of these questions is critical for the future return profile for risk assets, over the balance of this year and beyond.  What will influence future returns is how investors interpret subsequent corporate earnings, economic data, Government spending and Central Bank action and, until there is an established consensus, it is likely to be a period of increased volatility.

At this point, it must be stressed that we still cannot ignore the risks presented by COVID-19 in general, and new variants in particular.  The evidence so far suggests high vaccination rates reduces the ongoing pressure on hospital admissions and reduces deaths, but there is an awful lot to do before global herd immunity is achieved.  We expect 50% of the global population to be vaccinated with a first dose in November, and that 60% to 90% of people in all of the major economies will have some degree of immunity to COVID-19 by the end of 2021.  This means we would surmise that fears over future lockdowns, the pace of recovering consumer confidence and how quickly developed World countries return to February 2020 levels of employment to weigh on market expectations at times.  However, as we have seen with the US economy, it has recovered sufficiently to return to its pre-February 2020 trend line of Gross Domestic Product growth with 8.5million less workers, which may point towards the global economy transitioning into a new regime.

At the time of our last publication, the focus on the explosive pace of the recovery was leading to worries about inflation and the risks of a 1970s price spiral.  These fears were being aided and abetted by Central Banks that were only going to move to quell inflation reactively, rather than in tune with the prior orthodoxy of the past 40 years, which had been to proactively stop inflation before it becomes entrenched in consumer expectations by raising interest rates.  A combination of two things has happened since this time to significantly question the prospect of high inflation occurring.  Firstly, commodity prices (aside from oil) have all fallen, which could be due to the maxim that the best cure for high prices is high prices, or that the US economic reopening has seen demand for goods fall and demand for services replace it.  Secondly, in a surprising move in June, the Fed effectively removed the risk that inflation would run out of control in the US by indicating it would act proactively after all, despite it being less than a year into managing its new symmetric inflation target regime, which saw a drastic move down in market derived inflation expectation measures.

There is a market truism that you should not “fight the Fed” i.e. take an investment position that runs counter to their intended monetary policy.  As the clock ran down towards the end of the second quarter and, following June’s Fed monetary policy meeting, we saw this truism play out across markets.  The US Government Treasury bond market yield curve flattened (meaning that the gap between yields on the longest and shortest-dated bonds has grown much narrower), while bond yields themselves have fallen substantially.  That directly implies a belief in lower inflation, and a less powerful economy that does not need higher rates to rein it in.

There is an alternative view regarding the above market re-pricing, following the Fed pronouncements around inflation, as the move down in US Treasury yields did not start from the date of their 16 June meeting, but yields had actually begun falling several weeks beforehand.  Why does this matter?  It seems that the collective memory of the prior status quo ante is the markets expectation for our future.  This would mean that Government bond yields drop towards zero, inflation falls back towards zero and in such a low growth World, where companies have limited pricing power, then investors will gravitate back towards the technology monopolies.  Although this could prove to be the outcome, we are not so convinced.  The conviction we have embarked on a “new normal” economic path is dominated by the re-emergence of fiscal policy on an unprecedented scale outside of war time in the US and in other countries.  This dynamic change is being aided and abetted by Central Banks that are buying sufficient Government bonds from the market, that it neutralises all new bond issuance to cover the cost of furlough, stimulus checks etc.

It is likely the pandemic has proven such an exogenous shock to the economy that it has accelerated innovation and efficiency gains, which together are a catalyst for a strong capital expenditure cycle.  The pandemic has also been successful in rekindling inflation concerns and the key to whether this is “transitory” or “permanent” inflation will only manifest itself over the balance of the year.  If US inflation were to average around 4% for the year, then the decline in US Government bond yields below 1.5% is wrong.

For the period that Whitefoord has been managing money on behalf of Clients, there has existed a well-established negative correlation between the return on Government bonds and the return on equities.  This means in a balanced portfolio, if bonds have a “bad day” your stocks should be up and vice versa.  Inflation can overturn that and move the correlation between the two assets into a positive direction, meaning both bonds and stocks can lose money at the same time.  This is why, after the high inflation period of the 1970s, Central Banks were tasked with keeping inflation low at all costs.  If that inflation target mandate has altered, then at the very least, it introduces uncertainty into the future relationship between bonds and stocks.

In such circumstances, we judge it prudent to hold your bonds primarily in index-linked Government issues together with high yielding bonds and those in Emerging Markets, which have a higher coupon to mitigate some of the inflation risk, together with redemption dates not that far into the future.  Gold retains a place in such a period of uncertainty alongside the bonds.  For equities, right now the choice of growth versus value companies is more nuanced.  If, as seems probable, company earnings momentum exceeds forecasts and we are embarking on a new capital expenditure cycle, then most sectors should have constituents that can benefit and grow their earnings.  But, geographical positioning is likely important now, remembering that Europe and Asia lag the US reopening timeline, but are catching up fast vaccination wise, whilst also having similar fiscal and monetary tailwinds to support an embryonic recovery and in such circumstances, could offer better opportunities than the US now.