Market Thinking

making sense of the narrative

Market Thinking December

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As usual, markets are now largely flat going into year end and the investor time horizon is starting to stretch out a little as we consider the prospects for 2021. By all accounts, the government restrictions, particularly in the west – and by extension the Covid driven nature of economies and markets – may spill over for one more quarter, but looking through this, we would suggest a need to diversify eastward has become even more important.

November turned into a very strong month for equity markets globally, albeit much of it coming from a rebound from the mid-October, pre US Election, weakness. Importantly, this was not a vote of confidence in the Election per se, but rather a lifting of some of the risk premium markets had been factoring in to reflect uncertainty. Indeed, even though the Presidential Election itself remains ‘unresolved’, it was the lack of a ‘blue wave’ across Congress and the Senate – something that many in the, far from objective, mainstream media had been confidently predicting – that reassured markets. Markets don’t like governments being too powerful, especially if they can hit corporate profitability.

Short Term Uncertainties

The short term uncertainties for markets remain focused, as indeed they have done for most of the year, on Covid and the US Election. To put that more precisely on the economic damage from the political response to Covid and on the failure, as yet, to resolve the uncertainties around the US Election. Having said that, most positions are now square going into year end, with investors starting to think about the year ahead. Ironically, this year has been terrible economically but generally excellent for markets (if you could stand the volatility) such that while next year we can look forward to reducing the largely self inflicted damage from Covid restrictions, not everyone is going to survive the upturn.

Medium Term Risks

The global economy should rebound as Covid finally disappears from our screens, but so much depends on the official response. Objectively, Covid has already long gone in terms of actual (not asymptomatic) infections, deaths from rather than with Covid etc , but so long as the PCR test with its high false positive rate continues to be widely rolled out, the apparent pandemic (or case-demic) will effectively continue as long as governments want it to. This means that some economies will continue to try and move forward with the handbrake on in 2021, while others will be more or less free – most obviously North Asia.

In many senses, elements of the Covid response feel like a degree of retribution being played out; areas that have seen an upsurge in populism in the last few years seem to have felt some of the hardest restrictions from their governments under the guise of ‘public health’ for example. Moreover, many of the restrictions seem to have little to do with the purported health crisis and much more to do with other, previous agendas. In that sense it feels like- to quote M. Barnier at the start of the Brexit negotiations – that “When a fight breaks out in a bar, you don’t punch the guy trying to hit you, you punch the guy you have always wanted to punch.” Add that to the other quote from Mike Tyson that “Everybody has a plan until they get punched in the face” and you have a pretty clear summary of 2020.

Everybody has a plan until they get punched in the face

Mike Tyson – predicting 2020

The seemingly (somehow?) co-ordinated response from ‘the west’ and most obviously the so called 5 Eyes countries of the US, UK, Australia, Canada and New Zealand to Covid seems to suggest ongoing restrictions until perhaps Easter 2021, leaving Q1 as being more like 2020 than the hoped for start of the rebound. On the positive side, savings have built up and there is a lot of pent up demand, especially in low to mid ticket items and services. On the negative side, a lot of weak balance sheets are going to collapse and a lot of wealth will be transferred from the (previously) mildly wealthy to the already extremely wealthy.

However the apparent repression of populism across the world as part of the Covid response does not look sustainable and, at least where there is the semblance of democracy, we suspect some serious political backlash against the repression and the propaganda. For example, looking into next year there is a strong possibility that the proposed Reform Party in the UK could dominate the local elections in the manner of En Marche and Macron before he came to power in France, while Macron himself faces a return of the Gillet Jaunes as he starts to consider his own re-election campaign for 2022. All of this will drive market uncertainty and also lead to greater government spending on ‘inequality’ issues.

The other uncertainty remains Brexit – which was always going to go to the very last – but in reality is now as much about the French Election in 2022 as anything else. Currently it is being used by the FX market as part of their narrative on sterling, but it doesn’t feel that convincing, especially against a backdrop of a potential wider dollar depreciation policy.

Long Term Trends – the Magic Money Tree and the 5 Cs

As discussed in recent months, the Dollar continued to weaken, with the DXY sitting just below 91, down from 97.5 back in June. In part this reflects an unwind of the mid year ‘flight to quality, but it also reflects market concerns that the US is going to print its way out of trouble and indeed that there may well be a deliberate policy to talk the $ down in 2021.

A weaker dollar generally helps emerging markets and thus one obvious play is the Emerging Market Consumer, given the correlations we observe. But this is more about the fact that the emerging consumer tends to have $ denominated debt and thus a weaker dollar acts like a tax cut, a boost to cash flows. It also makes what we consider to be a more important point that, if there is a weaker $, then investors should seek to at least start to diversify away from $s in general. This leads us to the notion that we discussed in the blog of A great Portfolio Reset using the notion of the ‘5 Cs’ as a way for investors to think about diversifying their portfolios for the longer term.

The first of the 5 C’s we highlighted is cash flow. Healthy balance sheets and strong cash flows are the essence of sound equity investing and the global factors that we follow such as Quality and Value tend to capture this reasonably well. The second C to consider therefore are Convertible Bonds. With Bonds themselves yielding less than 1%, a convertible bond portfolio – or even single ETF – can yield 2-3% and yet continue to offer equity like exposure to the upside.

Third we have to consider China as part of a long term diversification. Currently, the index level alone is probably enough, given the lack of exposure generally, but here again there are multiple indices available, of A Shares, B Shares and H Shares Hong Kong. There are also benchmarks such as Greater China (including Hong Kong and Taiwan) or more specific ones such as the Shanghai Composite or the HSI in Hong Kong. All can be played via ETFs. In this sense, China is a proxy now for Asia exposure generally, where the increased integration of China into other regional economies is very real.

In particular, we would also point out that while the UK and EU continue to fight over Brexit until the very last moment, the huge RCEP trade agreement that basically links the economic and industrial giants of China, Japan and South Korea with the ASEAN block of south East Asia as well as Australia and New Zealand was signed last month. This has important implications for the necessary reset of the global supply chain in the wake of the US/China trade war and raises the question of how underweight international investors are in the fastest growing part of the world, not least since it seems to have dealt with the Covid outbreak far better and done less underlying damage to its economy.

The fourth C that we are looking at is Commodities. This is not buying commodities or Commodity trading per se, rather taking the approach that in a gold rush, we are probably best served by investing in the people providing the picks and shovels, such as some of the industrial mining stocks. The likely excess demand is going to come not only from Asian countries continuing to invest in physical infrastructure, but also from the west starting to follow suit. We noted in the blog that a response to the expansion of government balance sheets thanks to Modern Monetary Thinking or MMT (otherwise known as Magic Money Tree) is likely to be inflation in those areas where governments are either increasing demand with their new ‘free’ money or collapsing supply with their restrictions and regulations. Demand is likely to be in areas such as infrastructure and building, hence our view on commodities, but also in other areas like healthcare, defense, internet infrastructure and cyber security.

Finally, and given we are highlighting both a weaker dollar and a general debasement of fiat currencies via rapid expansion of money supplies – it is worth considering some diversification into crypto currencies. This however should perhaps be seen as a portfolio hedge, rather than a catastrophe theory, in the same way that one might use gold. Indeed, just as we would use Gold ETFs as part of a diversified portfolio, we could consider using a bitcoin trust ETF.

Note. Each of the Five C’s can be accessed via some of the myriad of ETFs available but importantly this does not represent investment advice.

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