When Good News Becomes Bad News

Just like in January, global markets gave up most of their gains in the last few days of February this time because of rising bond yields, which made the market nervous.

What is important to note that it was not only U.S. Treasury yields that rose but also the European and Chinese bond yields, so it was a global sell off in government bonds.

Why Did the Equity Market Get Rattled by Rising Bond Yields?

Normally rising bond yields are an indication of strong economic growth, which should be positive for equity markets. However, historically, rising yields have been negative for stock valuations when yields increased in response to hawkish central bank rhetoric. This is clearly not the case today. The Fed’s accommodative stance should limit any near-term upward pressure on U.S. bond yields. Therefore, we continue to favor equities over a 12-month horizon.

This equity and bond market sell off was triggered by fears that all the fiscal and monetary stimulus will lead to much higher inflation, which would force the Fed to raise interest rates and tighten monetary policy, which in turn would put pressure on stock market valuations, especially on stocks with high valuation multiples. That is the reason why for example the NASDAQ dropped more than the Dow Jones Index.

Rising Yields and Inflation

We expect U.S. inflation to move higher over the coming months. Oil prices have risen 70% since the end of October and rising energy prices will likely push up headline inflation. In addition, the effect from a weaker dollar should translate into higher goods prices in the U.S.

A stronger labor market and a slower pace of rent forgiveness should also boost housing inflation. If we add everything together, we think there is a risk that headline inflation in the US could temporarily rise to 3 to 4% in the coming months, which would increase the long-term inflation expectations and could again lead to a short-term increase in bond yields, which could cause another scare in the equity market.

Fiscal stimulus could further supercharge demand, adding to inflationary pressures. The impending passage of the $1.9 trillion American Rescue Act, combined with the economic stimulus packages from 2020 brings the total fiscal support to almost 25% of U.S. Gross Domestic Product (GDP), which is arguably larger than the economic damage caused by the pandemic.

However, we think this increase in inflation numbers will be temporary as the economy is still in recovery mode. So, we do believe Fed chairman Powell when he says the Fed is planning not to take any action for the next two years. If the Fed sticks to that plan, then the economic stimulus will support corporate earnings.

We have to remember that inflation is not necessarily bad for equity markets. Deflation is bad for stocks, just as is high inflation. Somewhere between deflation and inflation, however, lies reflation. Reflation is good for stocks. We are currently in a reflationary zone, where inflation expectations have risen but not by enough to force the Fed to tighten monetary policy.

A period of ultra-easy monetary policy can sow the seeds for economic overheating, rising inflation, and ultimately, much higher interest rates. Since this is precisely what happened in the 1970s, it is prudent to ask whether something like that could happen again. Investors today certainly do not believe a replay of the 1970s is in the cards. Yet, we would argue that a 1970s-style inflationary episode is at least a risk we need to keep in mind.

While no two periods are exactly the same, there are a number of striking similarities between the late 1960s and today. As is the case today, fiscal policy was highly expansionary back then. The same goes for monetary policy: just like today, the Fed kept interest rates well below the growth rate of the economy. In the 1960s, the Federal Reserve was still focused on avoiding a repeat of the Great Depression and the deflationary wave that accompanied it. Today, the Fed is equally focused on reflating the economy.

As long as the economy is growing solidly and the Fed remains on the sidelines, it is too early for investors to sell out of equities. Instead, equity investors should favor sectors that could benefit from higher inflation. Looking further out, the secular bull market in stocks will end when inflation rises to a level that the Fed cannot ignore. That day will arrive, but probably not for another two years.

Pandemic Subsiding

We cannot yet declare victory over COVID-19 but it is clearly going in the right direction as new case counts have plummeted from their January peak. Restrictions helped turn the tide in Europe, albeit at the cost of cutting off oxygen to the economy, but even in Sweden and the U.S., which avoided EU-style restrictions, the virus has lost momentum. The roll-out of the vaccines will help to suppress another flare up of the virus and supports our view that economies will be able to open up sustainably within the next three months. The potential for vaccine-resistant variants is a concern, but the pandemic news is clearly trending in the right direction.

Why This Time It is Different

The global economy has seen two significant crises in the space of a dozen years. The monetary policy response to both events has been substantially identical; the Fed swiftly cut the fed funds rate back to zero and started buying large amounts of Treasury and agency securities to support market liquidity.

The fiscal response has been dramatically different, however, with governments this time seemingly not concerned at all by borrowing large amounts of money to finance the economic stimulus plans.

Therefore, the outlook is quite different today compared to 2010 as central banks have gained a powerful and willing partner in their efforts to combat the damage wrought by a sudden shock. Pandemic fiscal stimulus initiatives have dwarfed the fiscal efforts after the Global Financial Crisis across the major economies. Once Congress passes the $1.9 trillion American Rescue Act, the U.S. will have doubled down on its 2020 initiatives, committing to aid equivalent to an extraordinary 25% of its annual output. The ultimate effect on inflation, interest rates and exchange rates remain to be seen, but it is clear that the post-pandemic economic recovery will not unfold in the same way as in the past decade.

The Difference

From 1966 until 1997, U.S. equity prices were negatively correlated with U.S. Treasury yields. Since 1997, U.S. share prices have been positively correlated with US government bond yields. We believe we are now in the process of a major paradigm shift in the stock-bond correlation, reverting to the pre-1997 relationship.

The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative, which effectively means that stock prices will fall when U.S. bond yields rise and will rally when Treasury yields drop. The reason is that the market will shift its focus from seeing deflation as the major risk to seeing higher inflation as the main macro risk. Investment strategies and frameworks that have worked over the past 24 years might require modifications as balanced portfolios that only hold equities and fixed income might not provide sufficient diversification in this macro climate.

What Happened in 1997?

In case you are wondering what happened in 1997: The basis for the 1997 reversal in the stock-bond correlation was a regime shift in the global macro backdrop. Before 1997, the main risk to business cycles and share prices was inflation. From 1997 until very recently, the main risk to equity markets was deflation or very low inflation. The watershed event that triggered this global macro shift from inflation to deflation was the Asian Crisis in 1997. The Asian currency devaluations allowed local producers – operating in these large manufacturing hubs – to cut their export prices in US dollar terms. The price reductions unleashed deflationary forces that spread all over the world.

The Impact on the USD

The Fed’s accommodative stance should limit any near-term upward pressure on the U.S. dollar. Whereas stocks are most sensitive to absolute changes in long-term real bond yields, the dollar is more sensitive to changes in short-term real rate differentials with U.S. trading partners. Since the Fed is unlikely to tighten monetary policy anytime soon, U.S. short-term real rates could fall further as inflation rises.

The Fed falling behind the inflation curve is fundamentally bearish for the U.S. dollar. That is why the primary trend for the dollar remains down. However, the dollar is oversold, and a short-term rebound is possible, especially if U.S. bond yields continue to rise, triggering a period of risk-off in global financial markets.

Investment Strategy

Given these conclusions, we recommend the following investment stance over the next 12 months: Stay positive on equities, which will generate excess returns over government bonds and cash in the absence of a negative COVID surprise.

Despite the high valuations of growth stocks, we favor a balanced approach as we expect corporate earnings to remain strong this year, also for growth stocks. We could see periods of rising bond yields which will create short-term fears and corrections in the markets. But we think bond yields will not rise sustainably this year and the monetary backdrop will remain supportive for equity valuations.

Longer-Term Investment Strategy

Relatively higher equity valuations means that a lot of good news is already discounted in prices and that means the equity rally is entering a riskier period where short-term corrections become more likely. Share prices will advance when U.S. bond yields drop, and they will dip when Treasury yields rise. As and when share prices drop due to concerns about higher inflation, the Fed will attempt to calm investors arguing that inflation is transitory, and it knows how to deal with it. Stocks and bonds will likely rally on reassurances of this kind.

Commodities

We are following commodities and may favor holding a position in precious metals and base commodities as a long-term diversification in a multi-asset portfolio.

Base metals prices have rallied by over 50% in dollar terms since last year’s COVID-induced meltdown. Nevertheless, we see further upside in metals prices, with the potential to develop into a multi-year structural bull market. The key driver is the world’s decisive push to a greener future, which in turn will significantly boost demand for several key base metals used in new energy infrastructure.

Although the world’s awareness of climate change has been increasing over the past several decades, 2020 became a pivotal year as major countries affirmed their commitment with concrete and measurable targets. The EU and Japan announced last year that they are striving for net zero greenhouse gas emission by 2050, while China is aiming for the decade after.

In the U.S., President Joe Biden also intends to set the U.S. on a path to net zero emissions by 2050 and has issued an executive order to rejoin the Paris Climate Accord, alongside other actions in favor of environmental policies. To meet the ambitious goals outlined in the Paris Agreement, governments need to implement aggressive efforts focused on improving energy efficiency, decarbonizing the power sector, switching to low or zero-carbon fuels, and utilizing carbon-capture technologies. These efforts could profoundly change energy infrastructure and consumption patterns in the coming decades.

In short, the combination of regulatory, financial, and social incentives points to an acceleration in the development of green infrastructure, including the construction of solar and wind energy power plants and electrification of vehicles, many of which are heavy consumers of copper and some other base metals. This holds the promise of significantly boosting demand for these resources.

China’s demand for copper has been strong in the past several decades, and still holds the key in the near future. While the country’s transportation infrastructure has vastly improved, its campaign to build “new infrastructure” on the digitalization of its economy has just begun. The country has laid out ambitious plans to expand its 5G network and data centers, all of which are heavy consumers of copper.

^Portfolios

Global Equity markets performed strongly up till the last week of February when the rising bond yields created a sell-off which wiped out most of last month’s gains. Our balanced approach in portfolios of combining value with momentum worked well.

As bond yields have been rising globally, bonds didn’t have a great start of the year. Global fixed income markets are down 2.5% since the start of the year while equity markets are up 1.5%. Which means that fixed income heavy portfolios are lagging. Non-qualified models have benefitted from municipal bond holdings as they have fared better than their treasury counterparts. Qualified models will see the return of senior floating rate bank notes to the lineup after a short absence. The potential for rising rates and the low duration associated with senior notes make them a favorable addition.

Listen to the brief audio version or read the full overview below.

Twelve months after the first reports of a new virus started to show up and ten months after the start of a global pandemic, there is a light at the end of the tunnel. Vaccines developed by Pfizer-BioNTech and Moderna seem to have efficacy rates of around 95%. AstraZeneca’s vaccine, developed together with Oxford University, has shown an efficacy rate of 90%. Russia and China have also launched vaccines. The Russian vaccine, Gamaleya, displayed an efficacy rate of 91% based on 22,000 test participants. Such high efficacy rates are on par with the measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu vaccine.

If we combine the global roll-out of the vaccines with the typical cycle of previous viral pandemics, we could very well see a sharp drop in new Covid cases in the coming months. When effective vaccines allow everyone to live a normal life again, there will be a burst of economic activity of every kind. When this happens, it will unlock tremendous pent-up demand around the world. There will be party booms, travel booms, shopping malls will be filled with people and airports will be busy again.

The Covid-19 crisis is a natural disaster and historically, the impact of this kind of crisis on the economy and society is always “temporary”. This time is no different. The speed of the economic rebound since April has been fast and surprised many investors. Retail sales in the U.S. and Europe have not only clawed back all their lost ground but have made new highs.

Another reason for a recovery boom is that, although the Covid-19 crisis is a
temporary shock, it has caused structural shifts in policy. This will make the
recovery story very different from the post-2009 recovery. Back then, the world economy was plagued by a badly damaged banking system in the West, prolonged deleveraging, and a crash in Chinese investment spending. This led to a long period of low growth, sustained deflationary threat and a secular bear market in commodities.

A Roaring 2020s?

The 1918 Spanish Flu pandemic gave way to the roaring 1920s, business boomed, stocks roared ahead, and the world economy experienced unprecedented prosperity. Is there a chance that we will see a repeat with a roaring 2020s?

This is certainly possible as all the economic and monetary stimulus most likely has extended the economic cycle and the secular bull market by another few years.

The path is already well greased with liquidity, and the current economic backdrop bears some similarities to the 1920s. Back then, there were many game-changing new technologies and innovations such as electricity, the automobile, the telephone, radio, consumer appliances, assembly-line production and so on. These new developments played major roles in driving down inflation and stimulating growth, which led to rising profits and stock prices until it abruptly ended in 1929.

Today, corporate profits are recovering strongly from the recession last year and stocks are trading at a forward Price/Earnings Ratio (P/E) of 22, which is not low but also not overly expensive by historical standards, especially taking into account the much lower interest rates. This is not to mention the many important technological advances in recent decades.

Obviously, there are key differences between the 1920s and now. More than a century ago, Americans were younger, and the economy was more vibrant and growing faster. Today, the population is getting older, the economy invests a lot less and growth is much slower. However, these differences are not the reasons preventing a financial mania. There are already areas of speculation, but we must differentiate between pockets of speculation like stocks of electric car makers or bitcoin, and the general market. We are nowhere near a general financial mania yet.

If we get a roaring 2020s, when and how could it end?

We could see an extended bull market in risk assets until we see the next financial recession, which could be triggered by monetary tightening. Almost all previous asset bubbles were pricked by monetary tightening. If the Fed is serious about its forward guidance, rates are likely to stay low for a few years, which is the key reason why the market could run up a lot further and could lead to asset bubbles and financial manias this decade.

But be careful: policymakers can change their minds quickly and the risk to equity prices will escalate when the Fed is preparing to “normalize” policy again. However, this likely still several years down the road.

The world economy is recovering fast but governments and central banks are still worried about a “double dip” for the economy given the continued lockdowns and they will continue approving large economic stimulus packages. The U.S. has just agreed another fiscal package of around $900 billion, while the EU will push through its own €750 billion recovery fund.

Politically, the right thing to do is to give more money to the most affected people, but for the U.S. economy as whole, additional income subsidy might not be necessary to sustain the recovery. A large part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) expired at the end of July but the unemployment rate has continued to fall and the economy has continued to improve. Additional fiscal support in the U.S. or Europe will simply add more fuel to the potential spending recovery.

The Democratic wins in the Georgia senate races will also give the Biden-Harris administration more leeway to get larger economic stimulus packages through congress and investors do not need to fear a premature tightening of fiscal policy in the U.S.

Several European countries will hold elections this year or early 2022, which means politicians have very little incentive to stop the economic stimulus any time soon.

Fiscal policy around the world has been so far focused on giving out income support for people, but the emphasis could shift to rebuilding the economy. As such, infrastructure spending could be increased significantly from the U.S. to Europe to Asia, fueling a surge in construction activity. This could be good news for commodity prices. And indirectly emerging markets.

Our overall view is therefore that the global economy will strengthen in 2021 as the pandemic winds down. Inflation will remain low for the next 2-to-3 years before possibly moving higher by the middle of the decade.

Interest rates should stay low as long as there is no real inflation threat, and this is positive for equity markets. Right now, stocks are technically overbought and vulnerable to a short-term correction. Nevertheless, investors should continue to favour equities over bonds in 2021 given the likelihood that earnings will accelerate while monetary policy stays accommodative. If social instability in the U.S. would affect the markets in the short-term, we would be more inclined to buy the dip rather than sell.

Given the strong divergence in markets last year with large cap tech stocks accounting for most of the gains, it is not unlikely that we will see some mean-reversion this year and last year’s losers could be this year’s winners.

In 2021, international stocks could outperform US stocks, small caps can outperform large caps and banks and industrial companies can catch up to large cap tech. A weaker dollar will also help to make international markets more attractive.

Bond yields could rise modestly this year on the back of an improving economy, but the move is unlikely to be very large as central banks will want to avoid the situation that fast rising bond yields would hurt the recovering economy.

Investment grade bonds remain preferential to treasuries as we continue to view credit risk as a better alternative to rate risk. Given the rise in inflation expectations (which is not the same as inflation), inflation-protected securities may be attractive as well.

The US dollar will likely continue to weaken in 2021. The collapse in US interest rate differentials versus its trading partners, stronger global growth, and a widening US trade deficit are all bearish for the dollar.

Positive Risk In 2021

There is a ‘risk’ that stocks rise much more than investor can imagine and mega-cap growth stocks continue to lead the way. A liquidity tsunami is still in the making and major central banks except China are working in overdrive to print money and monetize debt. Next year, Quantitative Easing (Q.E.) will likely be significantly enlarged.

The U.S. Treasury will likely issue $2.4 trillion in new debt, and a large part of the new issuance will be absorbed by the Federal Reserve. This means that the Fed’s balance sheet will continue to grow, particularly if they try to keep bond yields down.

All this newly created money will not create inflation in the short-term, but it will flow into stocks, real estate and anything that has some yield, or into momentum plays like bitcoin.

In the meantime, there are captivating growth stories in the technology, biotech and clean energy space, which could easily capture investors’ imagination and generate more inflows into these sectors.

The price pattern of Facebook, Apple, Amazon, Netflix and Google (FAANGs) is very similar to the financial mania in technology, media and telecom in the 1990s. These mega-cap names are natural hot spots for investors to deploy large amounts of liquid capital. At the height of the last technology bubble, the average annual return for the S&P500 was 30% from 1996 to 1999.

Geopolitical Risks

Beijing has been the key source of negative shocks to risk assets in recent years. Policymakers in China are fixated on their Debt-Gross Domestic Product (GDP) ratio and have taken every opportunity of the economic recovery to hammer. Next to that China has taken a firmer stand regarding Taiwan and the South China sea and this has the potential to lead to conflicts.

The announcement from Iran that they will start to enrich more uranium will increase tension not only with the U.S. but also Europe.  The recent seizure of a South Korean tanker could be the start of more tensions in the Middle East.

Geopolitical risks could lead to sharp corrections in equity markets but are unlikely to unsettle the underlying economic trends.

Emerging Markets Transition to a Structural Bull Market

The current macro environment surrounding emerging market assets shares some similarities to what happened after the U.S. tech bubble bust two decades ago. Emerging market assets were battered by multiple crises in the 1990s and became deeply undervalued and under-owned. The Fed eased aggressively to fight the deflationary shock, which pushed down the dollar and released massive liquidity into the global financial system. This, together with strong Chinese growth, created a spectacular bull market in emerging market that lasted until after the Global Financial Crisis in 2008.

While history never repeats itself and it is overly simplistic to draw historical parallels, financial markets are subject to long-term mean reversion. The fact that emerging market equities have underperformed developed markets by so much in the past decade and are trading at much more lower multiples holds the promise of higher returns over the long run.

In addition, a few important factors suggest that the cyclical emerging market bull market has the potential to develop into a multi-year structural one.

First, the ongoing rally in commodity prices likely reflects more than just the Fed easing and a weaker dollar. Rather, it could be a sign of a demand-supply mismatch. On the demand side, China is full-throttle supporting the development of the country’s booming new energy vehicles (NEVs) industry, aiming to double its market share in auto sales in five years, which requires aggressive investment in related infrastructure. The country is also pushing development of “new infrastructure” such as 5G stations, high-voltage power grids, intra-city rail transitand data centers, all of which are commodity intensive undertakings.

In addition, China’s “belt and road initiative” has suffered a setback due to U.S.- China tensions and the pandemic but will inevitably continue to gain momentum in the coming years. The belt and road initiative is essentially a series of basic transportation infrastructure projects in developing countries financed by Chinese institutions.

Meanwhile, the U.S. under a Biden presidency will also likely push on infrastructure development, setting the stage for stronger demand for commodities.

On the supply side, a decade-long bear market in commodity prices has significantly reduced capital spending in mining.

Investment in infrastructure and clean energy technology is a trend that will continue in the coming years.

Portfolios

In previous years, we’ve been more inclined to tactically reallocate portfolios to meet changes in the economic cycle and market attitude. This year was a return to traditional rebalancing of portfolios and a harvesting of profits and purchase of lesser performing assets. The result, our portfolios have remained globally diversified and maintained have their weightings. As such, we have participated in the “stay at home” tech momentum and have benefitted from strengthening foreign companies as well. While value hasn’t kept pace with growth for some number of quarters it has been profitable and the past few trading sessions it has been the benefactor of a slight sell off in growth and big tech stocks. Should that continue we are positioned to benefit as well. Our attitude on bonds is reflected in our positioning; we are satisfied to collect the yield, albeit lowered, and not stretch for more than is realistic. Our risk exposure is derived from our equity positioning and shouldn’t be enhanced with a reach for yield.

---

Disclaimers: This newsletter contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no
guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

*Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred.  Returns do not include reinvested dividends.