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Strategies for a Sustained Asset Bubble
In the past month we have seen strong first-quarter corporate earnings, a sharp decline in Covid infections in the U.S., the announcement of President Biden’s American Families Plan, and a dovish Fed statement, all of which are supportive of equity markets.
In February and March, we witnessed a sharp upward move in long-term U.S. bond yields, temporarily causing a sell-off in global equity markets and especially growth stocks.
In April we saw bond yields retracting, which triggered a healthy gain in equity markets, supported by very solid first-quarter corporate earnings. Of all the S&P 500 companies that have reported so far, earnings were on average 3% higher than the average analyst forecast.
Looking forward, we remain confident about equity markets. We still see ingredients for a strong recovery in the global economy, and although we believe there might be longer-term inflationary forces at work, fears for higher inflation in the short term are overblown.
Developed economies continue to transition towards a post-pandemic state. Europe has further to go, but it is lagging the US at a constant rate and is thus merely delayed – not on a different path. This ongoing transition is also reflected in the global macro data, which continues to surprise to the upside.
Despite elevated valuations, there is the potential for the Federal Reserve’s monetary policy to inflate a new speculative bubble. This bubble could run a lot longer than we think. Therefore, we continue to expect positive absolute returns from stocks over the coming 12 months and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio.
Whenever bond yields rise, you must remember that the bond market is trying to tell you something about the underlying economy. Rising bond yields are typically reflective of stronger economic growth. The ISM Manufacturing Index is at its highest level since 1983 – the world economy is in a strong recovery mode. Higher yields are consistent with the economy getting stronger. Under these circumstances, we would be more concerned if bond yields did not rise.
How Do Inflation Expectations Impact the Bond Yield?
Currently, there is no breakout in inflation expectations. We should not forget that in the decade after the global financial crisis, inflation expectations have fallen to very low levels. In the past decade we were collectively much more concerned about deflation. Inflation breakeven rates currently are between 2 and 2.2%, whereas the average range during the decade before 2009 was more like 2.5 to 3%. So, inflation expectations are returning to normal levels.
This means that 10-year Treasury yields are probably at fair value today given the state of the economy. Markets will always fluctuate, so it is possible that bond yields rise a bit further, but we don’t think that US Treasury yields will exceed the 2% level as long as the Fed continues its ultra-dovish stance.
Although global bond prices have come down circa 3% since the start of the year, we are a little bit more positive for the remainder of the year. As we do not expect bond yields to rise much further, the higher rates today will translate into higher income yield for the remainder of the year.
We are not concerned that inflation will be structurally higher in the short term. Having said that, we could see higher headline inflation numbers in May and June, but we think that this will be temporary inflation and mostly because of the base effect compared to 12 months ago when the whole world was in lockdown. That said, we could see more structural inflation pressure in a couple of years from now if aggregate demand keeps building on the back of structural government investment.
If we look at the fiscal position of the United States, the budget deficit is almost 20% of Gross Domestic Product (GDP). The Fed balance sheet has expanded by $7 trillion USD since the beginning of the pandemic, and the money supply measure M2 has exploded upward. This must be inflationary, right?
What happened is this: For all of 2020, the U.S. government unleashed $3.5 trillion in various rescue packages, because of which the federal government debt rose by $3.6 trillion. At the same time, the household sector’s disposable income increased by $3.5 trillion, and household savings shot up by $5.5 trillion. In other words, American households not only saved up all the transfer payments they received from the government, but they even saved $2 trillion more from their own income. These rescue programs did absolutely nothing to generate additional demand or GDP growth. What we have seen was not a fiscal stimulus to boost aggregate demand, but a transfer payment. This was no different than a one-time tax cut. We know that people’s spending behavior is determined by their outlook for sustainable income. If you give them a one-time tax cut, they will save it.
Now that the U.S. and Europe are reopening, we will likely see a demand surge. Consumption spending has been repressed for over a year as a result of Covid-19 related restrictions. When the world economy reopens, this spending will be released. But this is not inflationary, as the boom will be temporary. People will not party for the next twenty years. They will party for the next six months or so. For inflation to be a structural threat, you need aggregate demand exceeding aggregate supply on a sustainable basis.
We do not see that happening any time soon. The government subsidies simply amount to a huge balance sheet swap: government debt as a share of GDP has gone up, while consumers’ net worth has gone up even more. This balance sheet swap has nothing to do with additional aggregate demand.
What could be the driver for more structural inflation is real government spending, rather than stimulus checks. Extensive investment by governments in, for example, infrastructure could have this effect, as this could also lead to a boom in corporate capital expenditure, which has been relatively low since the global financial crisis.
President Biden’s American Jobs Act is a step towards that kind of transition. But it is not as big as the headline number suggests, because it envisions spending roughly $2.2 trillion over eight years, so each year it would add only about 0.8 or 0.9% of GDP. On top of that, Biden is proposing higher taxes to fund it. So, his infrastructure plan creates some growth on one hand, while taking it away with higher taxes on the other hand. Its net impact will only be around 0.4 or 0.5% of GDP per year. This will not be a game-changer in terms of inflation.
However, if this is done on a global scale in Europe and Asia as well, it could have a more structural impact on commodity prices or wages, which could translate into structurally higher inflation in a few years from now.
Dovish Central Banks
There is a tug of war going on between the Fed and financial markets: The Fed says they will stay dovish for a long time, while markets expect a lift-off in short-term rates next year. Who is right?
If you think about the last decade, Fed policy was always tight: The projected interest rate path by the Fed, as seen by the so-called Dot Plots, was always higher than market expectations. Because of that, we had several financial tremors: The taper tantrum in 2013, the collapse in oil and commodity prices in 2015, the collapse in stock markets in late 2018. We had almost ten years of low inflation and periodic stock market chaos because of monetary policy being too tight. In the end, the Fed always caved in and moved towards the market.
Now it is the other way round: The Fed is more dovish than market expectations. The market has priced in four or five rate hikes through 2023, while the Fed suggests they will not do anything before 2024.
The question is which side is right? If you only looked at the lessons of the last decade, you would say the market is right. But the difference today is that the Fed has abandoned its old reaction function and wants to stay ultra-stimulative until inflation is above 2% for a while. The Fed is now adamantly saying they are willing to be late this time, allowing the economy and inflation to run hotter than they would have in the old days. If that is the case, then markets may be wrong because they still assume the old reaction function of the Fed. So, we do not know yet, but it’s possible that the Fed will stay dovish much longer than markets think.
The consequence of this new Fed policy could be quite positive for risk assets. The stock market has already performed well and could go even further. If you look back in history you notice that asset bubbles grow back every ten years or so, and they are usually driven by easy monetary policy and lots of liquidity. So, this new reaction function by the Fed, plus the support from fiscal policy, means that markets could go through a bubbly period. This could apply to all risk assets including equity markets, but also real estate and digital assets can profit from this.
How Big Can An Asset Bubble Get?
If you look at history, all speculative bubbles burst eventually by tightening monetary policy. You never had a bubble burst while monetary policy was still easy. Asset bubbles pop when central banks tighten policy to a point of yield curve inversion. Today, we are far away from that. That is why this bubble could get a whole lot bigger.
Currently, we could be in the early stages of a stock market bubble, especially in the United States. There are many signs of speculative behavior, be it Bitcoin, Gamestop, and so on. But it is not as pervasive yet as it was in the late 1990s. When the technology bubble burst in 2000, everybody was bullish. Today, many people, even large investors, are still bearish. When they throw in the towel, then the final phase will begin. This bubble could be bigger than the 90s and it could run a lot longer than we think.
Could Rising Bond Yields Hurt the Equity Market?
Historically, rising yields hurt the economy and stock prices only when both long and short interest rates were moving up. It is unusual to see the long end of the curve move way up while short-term rates remain pressed down, as is actually the situation today.
There is a limit to the pain long-term rates can create for the economy because borrowers can always slide down the maturity curve to avoid having to pay higher interest rates. That is why we think 10-year Treasury yields are unlikely to move much higher than their fair value, while short-term rates remain at zero.
Based on this a possible scenario is that we will continue to see rising equity market for the next two years, with multiples going higher still. Then comes the point where the Fed just cannot remain dovish anymore and they will raise rates. At that point, the end would be nigh and that is the moment we could potentially see the next bear market but timing that is near impossible.
Late last year, everyone was bearish on the dollar. After staging a rebound in the first three months of the year, the U.S. dollar has resumed its weakening trend.
We expect the dollar to drift lower over the next 12 months, as global growth momentum rotates from the U.S. to the rest of the world, the Fed maintains its ultra-accommodative monetary stance, and the U.S. struggles to finance its burgeoning trade deficit.
China will provide adequate fiscal and monetary support for its economy, which can drive up commodity prices, the yuan, and other emerging markets currencies. The Euro/USD could rise to 1.25 by year-end. At the same time, the pound should strengthen against the Euro.
A global economic boom and a weaker dollar should be bullish for emerging markets. However, we must keep in mind that today’s emerging markets are very different from 20 years ago. Today, more than 40% of the MSCI Emerging Markets (EM) Index is made up by China. In China, the equity market is predominantly driven by big tech, with stocks like Alibaba and Tencent. So, China has a similar issue like the US tech sector: In an environment of rising bond yields, growth stocks tend to underperform.
The stock market is very sensitive to changes in liquidity conditions. We see a world of inverted roles: After the financial crisis, China embarked on a huge monetary and fiscal stimulus. Today it is the U.S., while China is tightening.
Last year Chinese growth stocks performed very well. This year their stock prices are struggling while earnings remained robust. So, we have seen valuations in some of Asian largest companies come down quite a bit. In the short term, the stock market is very sensitive to changes in liquidity conditions. If credit growth is slowing down, stocks perform poorly. From a longer-term perspective we think the Asian stock markets offer an attractive entry point now.
We offer an Asia Leaders Portfolio, which invests in leading companies across sectors that benefit from the growth of the domestic consumer in Asia. Recent underperformance offers an attractive entry point as we believe this strategy could outperform over the coming 12 months.
Other than equity risk exposure we have been observing commodity assets since the beginning of 2021. In our core portfolios we have included a commodity position that has exposure to diversified industrials and precious metals, energy, and agriculture positions. Thus far, commodities have risen nicely, and we expect this addition to help hedge against short-term inflationary pressures.
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