Market Thinking April
April 6, 2021
As March ended and closed out the first quarter, it also marked the anniversary of the equity and Credit market lows triggered by the Great Covid Panic of 2020. Intervention by the Fed to prevent market dislocation and an unprecedented swing to Fiscal Stimulus – $3.2trn in 2020 plus a further $1.9trn in 2021 with an additional $2trn asked for ‘infrastructure’ – has simultaneously pushed equities forward and bonds back. While the Covid policies continue to create great uncertainty (and indeed economic harm), large, well capitalised companies seem to be benefiting. Meanwhile, looking at the relative performance of the two asset classes on any of a 1, 3, 5 or 10 year view and considering the impact of massive fiscal stimulus, its increasingly difficult to make the case for buying bonds.
Global Equities versus Global Bonds
Short Term Uncertainties
The triple witching for March is often the time at which Asset Allocators shift their hedging strategies, either rolling existing positions or letting them slide. Sometimes they will put on new hedges. Any of these options can have outsized impacts around quarter end and thus much of the short term uncertainty around this is resolved one way or the other as we hit Q2. More generally, the trend for the speculators to leave the equity and longer term bond markets and retreat to their more familiar haunts in FX and commodities continued to play out during March, helping reduce volatility and uncertainty for the medium and long term investors. Covid, or rather Covid policies, remain a source of uncertainty of course, but perhaps the main concern as we look into April will be around any further issues of forced de-leveraging, the spectacular blow up of the highly leveraged ‘Family Office’ run by hedge funder Bill Hwang right at the end of the quarter having triggered memories of the seemingly innocuous collapse of a couple of Soc Gen hedge funds back in 2008, latterly seen as the early warning on the Lehman collapse.
Medium Term Risks
We do not see that sort of risk at the moment, although the current, all too familiar, egregious behaviour of the financial sector generally may be a source of increased medium term risk. From the behaviour of some of the US Investment Banks, who effectively acted as ‘insiders’ (though not technically and thus not attracting the regulators) in dumping the collateral of Bill Hwang’s funds and leaving the non US banks nursing huge losses to the, often dubious, practices occurring in Special Purpose Acquisition Companies (SPACs) and the allocations of IPOs and Pre-IPOs, Politicians and even regulators are starting to make noises. Meanwhile, as we approach Joe Biden’s 100th day in office at the end of this month, we see, Covid aside, something of an Obama redux, particularly on foreign policy, where if anything the Biden/Harris administration (as we are officially supposed to style it) is more aggressive than Trump, or even Obama. In our view this will tend to increase medium term uncertainties, exacerbate the trends already underway to drive China, Russia and Iran closer together (and away from the US$) and also exaggerate US tensions with the EU, which is increasingly reluctant to damage its own economy by sanctioning countries that displease the USA.
Meanwhile, with governments everywhere, but particularly in the US, expanding their balance sheets and boosting fiscal spending dramatically, inflation concerns are rising and we see this trend continuing (see below). As such one of the biggest medium term concerns for Asset Allocators remains how much they are overweight fixed income and underweight cyclicals and commodities. The Bond markets had a first quarter as bad as the first quarter of 2020 was good and commodities and cyclical stocks continue to play well in portfolios – ETFs like WOOD (timber stocks) and PICK (industrial metal mining companies) had double digit q1 returns on the back of very strong returns in q4 2020. Meanwhile, Oil has remained steady around $60, an extra-ordinary return for those quick enough and smart enough to buy it during the futures related debacle of last April. This is also being compounded by the relentless push into ESG funds which has essentially created a ‘short-energy’ position against a benchmark for those funds aiming to claim the virtue of ESG while simultaneously trumpeting out-performance against a benchmark forced to own what until recently were declining stocks. During 2020 this seemed like a win:win strategy and, as recently noted, a number of the bigger marketers made a lot of this, raising billions for environmental and thematic funds based around ESG. As the chart shows, a ‘Clean Energy’ ETF (here we use the I-Shares clean energy tracker that we have in our Thematic Dynamic Asset Allocation Model Portfolio) more than doubled relative to the more traditional Energy index from June to December last year. However, as we explained in an earlier post, this was because of a very different risk return profile and if we look at relative returns even since October, ‘Clean Energy’ is down almost 30% relative to Old Energy.
‘Clean Energy’ versus ‘Old Energy’
Proper due diligence should be highlighting that these types of funds are not for Core holdings, but rather for satellite purposes, and, even then, should only be one part of a non core portfolio. Our own Global Thematic Model Portfolio has Clean Energy as one of 7 options for thematic growth and has been steadily reducing exposure here ytd after a tremendously strong 2020.
For the more ‘hedge’ related part of portfolios, we continue to observe that BitCoin appears to have taken on the role previously ascribed to Gold as a non correlated stabiliser and that the yellow metal, which is followers claimed was good in times of either inflation or deflation, is certainly not responding to the renewed concerns about inflation apparently coming from the Bond markets.
Long Term Themes
The bellicose US rhetoric around Russia and China has undoubtedly driven them closer together and emphasised the need for de-linking to the US$. The prospect of a larger scale $ devaluation remains a key risk for portfolios and after something of a rally in late March – possibly associated with the forced deleveraging – the trade weighted index is, once again, starting to weaken. Partly this is associated with the prospect of de-dollarisation, but we suspect primarily it is about concerns over inflation reappearing in the US due to massive fiscal spending. This makes total sense since the point (ultimately) of the exchange rate is to maintain the internal and external purchasing power of a currency, which is why long term models of the exchange rate (such as there are) are structured around the concept of Purchasing Power Parity (PPP).
The easiest way to think of PPP is in terms of the McDonald’s big Mac index published regularly by the Economist magazine. Leaving aside some issues such as taxes, the idea is that the price of a Big Mac should be broadly similar around the world when converted back into $s. PPP simply takes a bigger basket of goods and services. Now obviously there are opportunities for arbitrage as some countries will be more efficient at making goods or services than others and that of course is exactly what drives international trade, which is the mechanism for maintaining internal and external purchasing power. To exaggerate to explain; if the price of goods in the US suddenly rises 30% due to domestic inflation pressures, then US consumers will seek to import the equivalents from abroad, selling $s and buying, say, Euros, to do so. This will cause the $ to fall against the Euro and thus adjust up the domestic price of imports. So, fear of inflation is translating into concerns over the $, which has obvious implications for asset allocation.
In terms of whether or not there is actually any inflation, we would refer back to our Four Balance Sheets model, where we divide the economy into four sectors; Consumer, Corporate, Government and Financial. The latter is there to facilitate the cash flows and balances sheets of the other three and when it allows one or more sector to expand its balance sheet through the wonders of fractional reserve banking then it essentially creates money without creating goods or services. Whoever has access to that money (i.e whoever has just expanded their balance sheet) is thus the potential engine of inflation, depending on how they spend that new cash. If it is the domestic consumer (as it largely has been since the development of consumer credit in the 1920s and mortgage finance since the 1960s) then it tends to drive up the price of the household goods and services they consume more of – and in the case of a lack of domestic production will lead to an import surge and a weaker exchange rate. Mostly though it tended to produce house price inflation. If it is the corporate sector then it tends to inflate the price of the assets they are buying – usually other corporates, but also real assets and increasingly their own stock – and thus creates a form of asset price inflation as well as wage inflation for all those ‘associated’ with this borrowing. This of course is primarily the Financial. Insurance and Real Estate sector (sometimes known as FIRE). More recently, thanks to QE, we have seen the Financial Sector expanding the balance sheet of the Financial Sector itself, which has accelerated the asset price inflation, particularly in areas associated with leverage. These include areas such as Private Equity, leveraged loans or any of the other so called ‘alternatives’ that the Investment Consultants are so dangerously telling long term investment institutions are ‘low risk’ based on a reckless obsession with volatility and correlation as the ‘only’ measures of risk that matter.
A trend shift to sustained Fiscal Stimulus
Despite this, we have seen massive increases in Bank Reserves, most of which are held with the Fed itself as Banks essentially hoard money and the liquidity remains stuck in the banking sector. Now, however, we see the Government sector (outside of the Central Banks) expanding its balance sheet dramatically under the banner of Covid relief. Regardless of one’s views on the wisdom (or lack thereof) associated with the response to Covid, the undoubted result is that there has been a trend shift towards fiscal and monetary expansion, i.e., rather than lending to consumers or corporates, the Financial Sector is now giving ‘free money’ to politicians, none more so than in the US. How and where the politicians spend this money will be our guide as to any future inflation. The most obvious example of this will be in basic materials as a result of the planned billions on infrastructure spending. This is akin to the Chinese Government spending in 2009; whereas the west channeled billions in cheap money into the financial markets, the Chinese put it into physical assets, specifically the One belt One road strategy, which was a tremendous boost to commodities and commodity producers like Australia. Currently the Australian Dollar is struggling to break out of its post 2015 range against the US$, but this looks to us more like a consolidation after a 40% rally over the last 12 months. Otherwise the beneficiaries of this political patronage (apart from the political class themselves of course) are likely to be large and politically connected corporates (plus their lawyers and other support services), particularly in Health and Defense spending – the Military Industrial Complex and the Medical Industrial Complex. At the other end of the scale, the de facto Universal basic Income system means lots of cash flow into “Bread and Circuses”.
The long trend of making money from leverage between financial assets is switching to making money from inserting oneself into streams of cash flow generated by governments. Perhaps the motto should be to think like a Hong Kong tycoon?