March 2021 - Monthly House Views
The Great Rate Debate
The investing world has been aflutter over the first quarter as it digests the possibility of renewed inflation. Some consider this a paradigm shift in markets which for years have experienced anaemic levels of price rises. Indeed, for most of the period since the Great Financial Crisis, the spectre of deflation has been the overarching concern for major central banks.
This potential sea change has several supports. One, while neither quantitative easing (QE) nor deficit spending are novel, the sheer scale of the programs today certainly is. Most notably, the newly elected Biden administration in the US recently pushed through a $1.9 trillion stimulus package on top of the $900 billion support bill passed in late December – together, a staggering 13.4% of GDP. The Federal Reserve is doing its part, continuing its purchases of $120 billion in bonds each month. The US is hardly alone. In the UK, the budget deficit is on par to be 16.9% of GDP in 2020-21 and 10.3% next year, levels akin to those during World War II. The European Central Bank has clearly stated it is monitoring bond yield increases closely and remains committed to “accommodative” financial conditions.
Two, money supply has shot up dramatically, particularly in the US. In previous editions of QE, nothing on this scale occurred because much of the liquidity stayed on bank balance sheets. Therefore, the money multiplier remained low amid muted demand for loans. Fiscal spending was much smaller too, relatively speaking. Today, a much larger proportion of spending is going straight to households via direct payments: In the immediate wake of the pandemic, $1,200 cheques were sent out as part of a massive relief package. A second stimulus payment of $600 was sent to most US adults late in 2020. Now, $1,400 are being remitted to all but the richest Americans. This is unprecedented.
Three, with a rapid ramp-up in vaccinations in most developed countries, expectations are that a surge of spending will occur once restrictions on mobility are lifted later in the year, particularly in the services sector. Economists fear that unleashed consumer spending will overheat the global economic recovery and stoke the inflationary pressures fomented by huge government spending and monetary excess.
For these (and other) reasons, inflation expectations have surged from the historical lows witnessed in the throes of the pandemic last year. This has market implications. For one, investors have been tolerant of higher equity valuations given the extremely low or negative base rates set by central banks. Presumably, if inflation continues to rise, central banks are forced to tame it by raising those base rates, thereby calling into question historically high prices for stocks when compared to earnings.
Perhaps more importantly, inflation fears have driven yields on government bonds around the world sharply higher (i.e. investors should demand more yield when inflation expectations rise if they want to receive the same inflation-adjusted income). In the US, the yield on 10-year Treasuries has jumped from 91 basis points (bps) at end-2020 to over 1.6% now; UK gilts have gone from 20 bps to 80 bps; and German bunds from -57 bps to -34 bps. This has caused direct losses for holders of these bonds. However, it also makes government bonds more attractive, assuming yields don’t keep rising, and partly erodes the relative attractiveness of equities, which has been one of the important pillars supporting risk assets for many years.
However, markets may well have got ahead of themselves regarding inflation expectations. While we recognise the above factors, there are important mitigants, most importantly the existence of gaping output gaps. These include high levels of unemployment: US employers now report 10 million fewer jobs than before the pandemic and US unemployment is at 6.3% vs. 3.5% last year. Wide swathes of the public are dependent on cash flows from the government simply to stay afloat; this is where the stimulus is largely targeted. It is also worth bearing in mind that there is much more slack in the system now than in the pre-pandemic period where inflation remained muted even as unemployment was at record lows. In addition, there is huge underutilised capacity for office and retail real estate.
Therefore, a rise in actual inflation would presumably not be rapid given this huge excess capacity that must be worked through first. Let’s not forget that actual inflation remains very muted at present in most of the West; and in China – on track to becomes the world’s single biggest economy – year-on-year core consumer prices rose by 0% in February.
The high level of unemployment at present is important as sustained and structural inflation is often linked with wage growth, for which there is little current pressure. Long-term structural trends such as aging and inequality remain entrenched too – older, richer people tend to save more and spend less. These factors should keep medium and long-term inflation under control, which will eventually stabilise the bond market.
We do accept that prices may start to rise in the short-term as a result from pent-up demand once economies go through post-vaccination bonanzas and subsequent increases in money velocity. However, this should be transitory, not structural. Moreover, this spending surge should lead to robust economic growth and earnings, and higher employment, which is beneficial to corporates by increasing sales and profits while allowing for maintained margins – this helps support the case for equities and risk assets.
Moreover, we take central bankers at their word that they have little intention to raise rates until pre-pandemic level of unemployment and economic activity are firmly in hand. It is much more likely they act to curb the increase in yields – buying long-dated bonds as part of ongoing QE programs for example – than raising rates and endangering a nascent recovery.
It is useful to remember that market expectations of future inflation have a profoundly chequered history.
We remain positively postured and are risk-on. As always, we are guided by the four pillars of our investment process:
- Economic regime: Our Leading Economic Macro Indicator (LEMI) suggests the global economy is in a state of expansion, which is clearly favourable for risk-taking.
- Valuations: Valuations for equities – the largest source of risk and return in most strategies – remain challenging in absolute terms, particularly in the US, which remains the most expensive global region. Heightened valuations have been further challenged by increased inflation expectations, which raises the spectre of rates rising. However, we believe central banks have little appetite to raise rates at present and inflation is likely to remain subdued over time, albeit it a transitory rise may well occur. Moreover, while government bonds yields have moved higher, they still are far less attractive to equities. For these reasons, we remain tolerant of higher global equity valuations at the headline level, but are tilting out exposure towards cheaper, more cyclical regions.
- Momentum: Global equities are in positive momentum on the ten-month moving average metric that we favour. This is supportive of increasing exposure to the asset class.
- Sentiment: Of the indicators we follow, some, such as the trade-weighted US dollar and S&P 500 net speculative positions, imply increased bearishness. Others such as global equity fund flows imply increased bullishness. On balance, we are in neutral territory.
We believe the case for increased risk-taking is well supported given a strengthening economic backdrop, tolerable valuations, strong momentum and sentiment that is not overbought. Nonetheless, we continue to hold a stable of safe-haven assets to offset risks, particularly those from equities. These include gold, low-volatility, defensive alternatives (e.g. hedge funds) and government bonds.
As ever, we are constantly monitoring markets. Should conditions change, particularly with the economic regime, or signals from our valuation, momentum or sentiment framework, we will adjust our asset allocation accordingly.
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