The fundamentals remain intact; the Covid-Policy Induced Economic shutdown is clearly behind us, with Asia (ex Hong Kong) and the US leading the return to normality while Europe and the UK still lag. Temporary demand supply/imbalances are spiking commodity prices but this still looks more like reflation than inflation. The second quarter saw an increase in financial market intervention however; with a seemingly coordinated effort to curb the strength of crypto currencies being followed by pressure from the Chinese to curb speculative activity in industrial commodities such as copper, steel and coal. June saw ‘intervention’ from the Fed, which stabilised bond markets while doing little to stop the equity ‘melt up’. It did however cause some renewed rotation within equities and, importantly, within the dollar cross rates, with strength against financial pairs such as the Euro and Yen, but weakness against the industrial pairs such as the Taiwanese $, Korean Won and of course the Chinese Yuan. This split between Financial and Industrial Capitalism is the underlying mega-trend emerging post pandemic.
Short Term Uncertainties
The US started to reduce uncertainties around Covid restrictions during the second quarter. This, we believe, largely reflected the US political landscape, where a heightened sense of crisis was undoubtedly part of the campaign to dislodge Donald Trump – as demonstrated by the most draconian measures (including mask mandates) taking place in Democrat states. However, as the political mantra runs that ‘after 100 days in office, any problems become yours’ the end of Joe Biden’s first 100 days in office coincided with a notable reduction in Covid rhetoric as the most pro lockdown Governors and politicians shifted their tone. Asia too, with the notable exception of Hong Kong, began to shift to a more pragmatic line, with June seeing Singapore actually state a policy of ‘living with Covid’. Europe, along with Australia and New Zealand remained the last hold out for Zero Covid fundamentalists, but even here cracks began to appear, most notably in the UK, where the defenestration of Health Minister Matt Hancock was taken as an opportunity to flip the narrative from seemingly never ending lockdown to a regime of personal responsibility.
This narrative switching is very familiar in markets, where the consensus on commodities and currencies more often than not reaches a rhetorical high just before inverting and all the accepted facts are replaced with alternative facts that were always there, but never presented. Thus the ‘facts’ on low hospitalisation and death rates, the circularity of mass testing producing mass positive results without addressing the inherent problems of false positives and the stress on the Health Service from forcing thousands of healthy workers to ‘self isolate’ even though they were vaccinated are now being presented to justify opening up the UK on July 19th. The fact that all these things were also true on June 21st (when the economy was supposed to open up) or indeed at Christmas, seems not to matter. For markets however, it means the direction of uncertainty is now reversed.
Normally June is a less important quarter end than March, with the quadruple witching in the derivatives markets generally far less disruptive than the March equivalent – a tendency exaggerated last year by the Fed intervention in bond markets around the time of the March expiry that basically put the floor under markets. This year, however, June saw a similar distortion from the Fed, albeit of less magnitude and of course in the opposite direction. Statements from the Fed about inflation came against a background of some other government intervention (principally Chinese) in overheated Commodity markets that conspired to produce a sharp rotation within markets, However, we believe that the medium term trends remain intact and that the reflation trade will continue to deliver a period of super-normal profits to companies associated with cyclical recovery and supply demand imbalances.
Governments have also become more effective at market intervention to exaggerate market movements already underway – don’t fight the tape as they used to say. Back in the 1980s/90s the Japanese government was very adept at intervening in the Yen when the market was already anticipating a change of direction and the moves by the Fed in June to try and talk down inflation expectations were very much from this rule book. Bonds rallied and cyclical stocks and commodities sold off as speculators jumped ship on perceived Fed intervention. The latter were already bruised by Chinese action to dampen speculative activity in commodities generally, with the Chinese authorities sending a clear signal that they were not going to let speculators set the cost of their raw materials. As such, it looks like ‘excessive’ speculative activity across any and all markets is now going to meet some government resistance going forward.
Medium Term Risks
Part of our Market Thinking framework includes trying to understand the market mechanics that can lead to apparently ‘irrational’ behaviour. Thus, while it might seem to some that it is irrational for equities to continue to rise when they are ‘already expensive’, the reality is that this is an ongoing asset allocation driven ‘melt up’ consistent with the world of zero (unleveraged) returns available elsewhere. Cash is chasing cash flow. Mechanically, much of this is coming through two channels – retail buying of ETFs and Quant driven buying of market indices. The latter tends to track low volatility and produces a skew to megacap performance – witness the extra-ordinary 10% plus jump in Apple and Microsoft, the two biggest stocks in the market during June – while the former tends to skew towards growth themes and narratives. Both effectively act to ‘buy on dips’ which means that while there is a lot of churning beneath the surface there are frequent entry points for investors (rather than just for traders) and that the biggest risk is actually to be sat in cash.
There is also the reality of operational-gearing driven earnings upgrades delivering strong cash flows to owners of equities. Despite the sell off mid-month in most commodities, we note that Oil continued to be strong as the underlying demand/supply conditions remained favourable to higher prices. Because it is a much deeper market, Oil tends to give a better ‘read’ on underlying cyclical recovery pressures than some of the other Producer Price indices that are subject to speculative activity (and have been ‘hit’ by the Chinese recently). Operational gearing is a powerful driver of profitability at this point in a cyclical recovery and while stocks related to providing the ‘picks and shovels’ for a commodity boom, such as mining stocks, timber stocks and OIl service companies have already done extremely well year to date, they remain very attractive on valuation grounds. Looking at our Internal Rate of Return (IRR) calculations, the sectors exposed to these areas continued to see upgrades in medium term earnings outpacing price rises, making them look (increasingly) good value. While there was once again some attempt at rotation in Q2, ( in April and then June) there was also a lot of buying on the dips and we would expect this to continue.
Long Term Trends
We tend to look at the currency markets more for shorter term risks than longer term trends, but an interesting phenomenon is emerging with the US dollar that merits further consideration. Many macro commentators (ourselves included) tend to watch the Dollar trade weighted index – the DXY as it is known – and have noted that for much of this year it was remained in a relatively tight trading range between 89 and 93. However, the reality is that nobody actually trades the DXY, they trade (or hedge) the underlying ‘pairs’ and, if we look at these separately, we notice something interesting. The pairs with ‘financial’ partners, such as the Yen, the Euro and to some extent Sterling, where the dominant flows reflect capital flows based around interest rate differentials, are all strengthening from a US$ viewpoint, particularly in the wake of the shift in expectations about Fed interest rate policy in mid June. In effect, the financialised economies of ‘the west’ are seeing the US leading an interest rate and investment return cycle. By contrast, the pairs trades with the industrialised countries in Asia such as Taiwan, South Korea and of course China – as well as the real economy commodity currencies such as Australia – are all ‘weakening’ from a US$ viewpoint. This contrast between what (one of our favourite Economists) Michael Hudson calls Financial Capitalism and Industrial Capitalism is a major long term trend for where returns on capital are going.
Meanwhile, another long term trend emerging in the wake of the pandemic is that one of the effects of Covid policies has been to exaggerate the divide between those with access to capital (and existing wealth) and those without. As journalist Rachel Johnson (sister to UK PM Boris) famously put it, between “the haves and the have yachts”. Trillions of dollars of Magic Money Tree funds have found their way into the real economy and those closest to the fire hose have not had to do much to get soaked in liquidity. With some irony this means that many ‘first world’ countries have taken on the appearance of ‘third world’ countries, where patronage and proximity to government ministers is the key to success. In the UK for example, where corporate lobbying is limited and where most decisions had previously been taken at EU level, ministers suddenly find themselves responsible for enormous spending Budgets meaning a nation of middle men has suddenly sprung up; humble office supplies merchants suddenly millionaire PPE providers, headhunters with government contacts suddenly becoming highly successful providers of (overpriced) testing kits to name but two real world personal anecdotal encounters in the last few weeks that compound the myriad stories emerging in the press as the previously uncritical media start to scent a new story.
It’s not just the Private jet and yacht owning classes that are prospering (although they very much are), but also providers of Veblen Goods everywhere. (Thorsten Veblen, famously noted that certain goods found that their demand increased more the higher they put up the prices). An obvious beneficiary of this new influx of nouveau riche is luxury goods stocks and the queues outside Chanel and LVMH, while not perhaps ‘typical’ are very real and are clearly spending a lot of money. The flip side of this is that the millions currently on furlough are due a rude awakening in the next half year as government support ends and the realty of a lot of low end consumption and production hits home. As with so much else going on in western society, the economy looks like it is going to become even more binary.
