By Tim Sharp, Hottinger & Co.
As we started the New Year the reflation trade was already underway with commodities and resources stocks showing a strong performance and the 10-year US Treasury yield rising back above 1%. Markets were happy that the Presidential Election in November had not resulted in a “blue wave”. However, by Inauguration Day the Democrats’ sweep as a result of the Georgia Senate elections was instead seen as the path to higher stimulus due to the seriousness of the escalation of the pandemic taking centre stage. Banks are still supporting financial markets, government fiscal stimulus continues to support economies in lockdown, and the roll-out of the vaccinations can be viewed as a third stimulus, shortening the path back to normality.
Albeit slightly dimmed due to uncertainty, the light is now visible at the end of the tunnel. With continuing high levels of stimulus and evidence that the majority of investors share very similar expectations for the coming year, it is of little surprise that the return of inflation has emerged as the main risk to the central scenario. The threat of another “taper tantrum” as in 2013 could affect risk assets negatively, so the biggest risk for governments and central bankers is that any change in policy that feels like a tightening of conditions could trigger a surge in Treasury yields. A more aggressive rise in 10-year US Treasury yields to 1.5%, or even 2% in the medium term, could see investors become more nervous, while an orderly rise in yields due to a mild rise in inflation could still see risk assets thrive.
Our original thesis, that the reopening of economies would see risk assets continue to perform during the first half of the year before absolute valuations become relevant, is being challenged by the continued lockdown of major economies under the weight of new, more virulent strains of Covid-19. The first week of the year saw the beginnings of a New Year rally, with the MSCI World gaining 2.5% before the weight of the pandemic came to bear. Renewed global lockdown measures will have probably suppressed the economic recovery trade, and the optimism of investors towards a return to a semblance of normality is slipping, as the realisation of the here and now is brought sharply into focus. The question now is whether the recovery will be affected by further delays or whether the pent-up demand from consumers unable to spend will be just as strong but over a shorter time period. Absolute Strategy Research (ASR) has raised their US growth forecast for the year this week from 3.5% to 7%, based on the stimulus package being proposed by the Biden administration, and Global nominal GDP to grow around 8%ii.
We are currently in the middle of fourth quarter earnings reporting and so far, the results have been very encouraging. Bank Julius Baer report that S&P500 earnings have come in well ahead of expectations both in strength and breadth. The bank now expects Q4 will show a decline of 2% year-on-year vs. -8.8% at the beginning of the earnings period, and guidance for the first quarter suggests 82% will guide ahead of market expectations vs. a historical average of 33%[i]. This chimes with December manufacturing PMI’s also looking strong, including new orders and prices paid, although services indices remain weak. Earnings surprises to the upside will give further confidence to investors that 2021 overall will be a favourable climate for risk assets despite the impatience currently on display. IBES global twelve months forward earnings are now forecast to rise 26%, and ASR also suggest a central forecast for global earnings-per-share of 25% year-on-year in 2021[ii]. Most developed equity market indices have fallen off in the second half of the month. The NASDAQ Composite clung to positive territory, up 1.4%[iii] on the month, the S&P500 was down 1.1% and the UK FTSE All-Share and German Dax finished down 0.9% and 2.1% respectively. Asian markets have fared better as they have dealt with the third Covid-19 wave more effectively. The Korean KOSPI Index was up 3.6% in January, the Nikkei 225 Index +0.8%, and the Shanghai Composite Index +0.2%.
We still believe that the environment favours equity risk on a relative basis and absolute valuations will be overlooked until major economies have re-opened. The main challenge for multi-asset investors as to how to off-set equity risk and volatility becomes more acute as valuations are further stretched. The traditional 60 / 40 portfolio has never been more questioned not just because of equity growth, but the inability of government bonds to hedge performance risk due to their own expensive valuations. The situation is arguably different in each developed economy depending on the Central Bank view on the use of negative rates. In Europe, negative rates have been a well-used monetary tool leaving 10-Year German Bund yields currently at -0.51% offering questionable support to investors anxious of equity valuations. In the US, the Federal Reserve has been adamant that negative rates are not appropriate, even under intense pressure from President Trump in 2020, meaning that while the zero bound is unlikely to be penetrated ten-year yields of 1% also offer little protection to investors. In the UK, Bank of England governor Andrew Bailey has refused to rule out the use of negative rates, but with 10-year Gilt yields at 0.33% the level of plausible protection is still low. Therefore, allocating effectively away from government bonds in order to offset potential equity volatility may need ingenuity and an understanding of the alternative asset space.
From a macroeconomic perspective, the Covid-19 pandemic has the potential to see the 2020’s evolve much differently than the 2010’s. The long and sophisticated supply chains that have developed through globalisation have proven fragile in the face of a pandemic, encouraging many companies to shorten or onshore their manufacturing processes, potentially raising costs and adding to the upward pressure on inflation. The result of QE has clearly bolstered financial markets with questionable effect on the real economy, whereas the switch from monetary to fiscal policy will inject funds directly into the real economy again adding to the long-term upside pressure on inflation. Finally, we enter the 2020’s with much higher debt levels as companies and governments make use of cheap debt, leaving government debt levels in most developed nations at levels unprecedented during peace time. One of the ways of reducing debt is to inflate it away, and some recent central bank policies suggest that inflation may be allowed to run above trend creating negative real interest rates in the longer term. Real assets have also started the year mixed with Gold challenged by real interest rates and a stronger dollar down 2.7%[iv], Brent crude oil is up 7.9%, while a broad basket of commodities is 2.6% to the better.
Preliminary discussions into allocating to Alternatives at the expense of government and investment grade corporate bond exposure, has covered Macro Fund strategies, capital protected structured products, and managed futures or CTA’s (Commodity Trading Accounts). The inflation protection offered by real assets has caused us to increase our direct commodities exposure already, but managed futures potentially offer further protection against volatility, and astute Macro funds managers have historically offered downside protection during equity bear markets. While government bonds may still offer an element of diversification there is less protection available when equities are under pressure, and they are vulnerable to a potential pickup in inflation risk. Therefore, it is becoming more important for us to consider how effective a strategy current asset allocation is at mitigating equity market downside risk and the options that are available.
[i] Bank Julius Baer, THE WIRE – Europe Bell, January 26, 2021
[ii] Absolute Strategy Research, Bonds at Risk as Policy Goes “Big”, January 28, 2021
[iii] Asset pricing and performance data sourced from Bloomberg
[iv] January 2021, Gold – XAUUSD:CUR, Brent crude – CO1:COM, Commodities – BCOMTR:IND
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