February 22, 2021
In the latest Friday Market Thinking, we concluded that the biggest medium term risk to markets was likely to be bonds, given their historic tendency to damage other asset classes as they deleverage. The risk models behind our Model Portfolios, which had been fully weighted this time a year ago, started selling long bonds after the peak in August last year and have been fully disinvested for several months now. We suspect that the talk of inflation is now part of a new narrative justifying a ‘fundamental’ shift out of US long bonds (and with it the dollar). In effect this looks and feels like a regime change for bonds, from buying dips to selling rallies.
Chart 1 shows the long bond ETF since it is sometimes easier to think of bonds as ‘stocks’ rather than in terms of yields – thus a yield rising means the capital value falling. We can see that as yields have broken higher, the price of the ETF has just broken down through the level that had previously proven resistance back in 2016, effectively unwinding the huge Q1 rally that we saw (and exploited) this time last year.
Chart 1. Long Bonds falling rapidly out of favour
In fact this looks (and feels) like the regime change following the final bursting of the DotCom bubble in equities back in 2000, where a long period of buying the dips switched to one of selling the rallies and the long term uptrend rolled over and became a multi year down trend. Notice also how the rallies began at the start of each quarter as asset allocators rebalanced/tried a value trade only to be met with long term investors selling, with the ultimate 25% adjustment downwards having a blow off liquidation period from 1200 on the S&P down to 800 and back up again – ie a 2/3rds drop before a 50% rally. It was then another two years before any real progress was made from there.
Chart 2: The regime change out of equities in 2000
When we look at inflation, we always need to consider whether it is a supply shock – something cutting supplies of essential goods, principally energy, or demand driven (too much money chasing too few goods). It is of course usually the latter, which is why economists previously developed a concern about growth in the money supply, but we also need to look at who is expanding their balance sheets, for it is balance sheet expansion that leads to the biggest imbalances between demand and supply.
And here of course we can see that culprit is government itself – not the central banks, except in that they have been the buyers of government bonds – but governments who have chosen the politically expedient route of ‘stimulus’ to counteract their own demand destruction due to their covid policies. This will be inflationary in two ways; first where the fall in demand has been temporary and when Covid restrictions ease there will be huge pent up demand – especially where the policies have also killed off some element of supply. Second, it will be inflationary in that government spending rarely focuses on value for money and to the extent that it crowds out the private sector, prices rise. However, not all inflation ends up with the consumer, it often gets absorbed in corporate margins, particularly where there is competition to supply the end product. As such we would start to expect that a classic cyclical versus defensive narrative will appear in terms of earnings and margins. As copper hits an all time high for example, copper producers do well, but many copper consumers do not. The same obviously occurs with energy.
Tricky questions are coming for ESG
One of the issues with the recent rally in commodity prices and their associated stocks of course will be the tricky questions it will pose for ESG analysts and fund managers. Is BHP, to pick one example, bad/off the list because they use up lots of energy and damage the environment? Or are they good/on the list because they produce the copper that everyone will be forced to buy due to pressure for electrification of transportation? What about BP, or Shell? Are they bad oil producers or good green energy champions with LNG as a medium term solution to cleaner energy? We have heard it argued both ways, but what will the pressure be on the ESG fund that has been out trying to raise money on the basis of, lets face it, a performance track record that was basically being underweight cyclicals, when, as the graphic shows, the last three months has seen a big swing in the other direction? What if it continues? Even worse, what if their big rival has decided that BHP, or Shell or BP has actually gone from the bad to the good category and has thus stolen a big relative performance?
On the other side of the long tech/short cyclicals trade, tricky questions are also starting to appear for Big Tech, with the fuss over FaceBook in Australia starting to reveal strains in the relationship between big tech and big(ger) government. As we suggested in our recent piece on reforming the BBC, there is arguably a role for governments worldwide in restoring the concept of public goods, rather than continuing to allow global oligarchs to privatise them, not least because if they are really serious about controlling inflationary pressures, then a public good such as messaging, email accounts or a basic level of content streaming is a powerful counter to oligopolistic pricing. It will not have escaped notice that internet providers and streaming services have all recently pushed up their subscription prices, blaming (but in reality exploiting) Covid. The tactic of low and predatory pricing to eliminate rivals before exploiting the resultant monopoly is as old as the practice of political donations. Equally, the provision of competing public goods is as powerful as any anti-trust regulation.
Likely the thing to watch will be new revenues. Facebook has got itself slightly caught up with reports that it has been exaggerating its reach in terms of claiming the value of its advertising, (weirdly the spell check just came out as fake books. Hmm.) and certainly aside from government it’s difficult to see ad spend having gone up in the last 12 months. But perhaps more important will be the base effect from the fact that while Facebook’s total revenues grew $15bn last year, this was a year when an estimated $14bn was spent on political advertising alone, double that seen in the 2016 election. A large chunk of this will be with Facebook if the individual trends of Mike Bloomberg etc are anything to go on. This was almost certainly a feature in the 15% jump in Facebook earnings estimates that analysts made this time a year ago and it will be interesting to see how they react to the next set of earnings given the estimates are currently for 20% growth for this coming year as well. If you are trading on 8x revenues then you need to believe those revenues will keep growing.
To conclude, just as the 60s as we remember them really started in 1961/2 with the Beatles and the 70s in 1973 with the Oil crisis, the 1980s in 1981 with Ronald Reagan (and Margaret Thatcher) and the 1990s in 1991 with the fall of the Soviet Union, we should get used to the character of the decade not really beginning on the first month. True, in markets, the Japan era ended in early 1990, while the dot com equity era ended in early 2000 (as mentioned above) but the world of Hedge Fund excess that many think of as defining the noughties started in 2003 and lasted barely five years before QE and financial crisis started. Meanwhile, although the European financial crisis really took place in 2011, the emerging economic dominance of China – a key part of the 2010s for investors at least – only really only began with Xi in 2012.
So will the 2020s be the decade of Covid for investors, with the hoped for and feared, in equal parts, Great Reset? Or perhaps they will mark a different sort of regime change, a shift from Bonds to nominal assets along with a shift from the West to the East? HSBC’s announcement today is very interesting in this regard, forced to choose, they have fully pivoted to Asia. Will the ‘if you aren’t paying for the product then you are the product’ business models of Big Tech survive? And if not how will the momentum effect from their massive weighting in benchmarks unwind? We remain of the view that multi-polarity is coming – hence our stance on suggested investment exposure – and in the meantime observe that when regime change does occur, historic models of how assets perform can break down with them. Nobody ever said it was easy.