View from the top

The waiting game

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

View from the very top: Something will have to give; we’re waiting to see what. We doubt it is possible to have a trifecta of a booming economy, a roaring stock market and restrained bond yields. Just because inflation has been absent for so long does not mean it cannot reappear. Much will depend, therefore, on how Central Banks manage the prospect of greater inflation. At the least, investors should prepare themselves for the potentially greater inflation volatility, an outcome which could be negative for both bonds and equities. The case for conventional 60:40 fixed income/ equity allocations clearly needs to be rethought, particularly in a world of higher yields. Investors should position appropriately: seek exposure to a broad variety of styles (growth and value, quality and cyclical) and continue to diversify into uncorrelated and especially real assets.

Asset Allocation:

  • Equities: Many global markets remain close to all-time nominal highs, helped by improving fundamentals, with earnings revisions generally trending higher on the back of an improved outlook. Further potential earnings upgrades could help sustain the momentum even if certain pockets of the market are exhibiting stretched valuations, at least relative to history. We have been encouraged by the way in which the rally has broadened and it is notable that the S&P’s Value Index has outperformed its Growth counterpart by around ten percentage points year-to-date. We continue to favour allocations to managers with truly active and differentiated strategies that ideally offer exposure to a variety of factors.
  • Fixed Income/ Credit: Higher growth and inflation expectations have inevitably been negative for bonds, as evidenced by the year-to-date move in yields. Dovish Central Bank commentary has done little to help. Even if there is a pause for breath in the very near-term – the rapidity of the recent move in yields has surprised many – we can see a scenario where government bond yields might move still higher. Risks are, therefore, weighted to the downside for now. It will also be important to continue monitoring the deterioration of credit quality in certain market segments such as high yield.
  • FX: Even if the US Dollar may be buoyed near-term by the relative progress made by America in terms of its vaccination efforts and its corresponding impact on the economy, over the longer-term there are good reasons why the US Dollar should weaken, particularly in the context of high debt levels and growing deficits (both government and fiscal).
  • Gold: We see a continued place for gold in investors’ portfolios and believe that the recent price weakness helps create a potentially attractive entry point. Gold can serve both as a very good portfolio diversifier and also a low-cost portfolio hedge. A weaker Dollar would could also be supportive for the gold price, in our view.
  • Alternative Assets: We see a clear role for such assets in portfolios and are attracted to them owing to their diversification benefits, income generating potential and the protection they would offer in the event of higher inflation. We expect infrastructure assets to benefit from a likely increase in fiscal stimulus spend. Elsewhere, we see selected opportunities for business models with strong balance sheets such as seniors’ housing or logistics REITS.

Everyone is waiting for something. For many of us, it’s some combination of getting vaccinated, life returning towards normal as economies re-open, warmer weather and even perhaps the prospect of a summer holiday abroad. Investors are no different in hoping for the above, but for this group, the waiting game also assumes a different format. We’ve been waiting for signs of sustained inflation for almost 40 years. Most are therefore unfamiliar with how to behave if and when it does arrive. Policymakers face a more profound challenge: not only do they have to manage inflation, but highly elevated expectations. We’re waiting not just for inflation, but also a coherent response. Our counsel: tread carefully, maintain balance and exposure to a wide range of asset classes.

Have no doubt, the world is a very different place to a year ago. Consensus assumes that US GDP will expand by 5.7% over the next 12 months. A year ago, the comparable figure was just 1.3% (per Bloomberg). The reasons for such a profound shift are well-understood. Swift and concerted policy action combined with the arrival of vaccines are stimulating economies globally, releasing pent-up demand that was halted by a sui generis event. Better growth prospects are far from a US-only phenomenon, with the OECD raising its forecast for global growth in 2021 from 4.2% three months ago to 5.6% during March. China’s economy may grow by as much as 7.8% per the organisation’s latest forecast. Monthly manufacturing surveys from across the world are also highly supportive of the idea of improving growth. If anything, current forecasts may be too conservative.

Investors, unsurpsingly, have responded positively to these improving dynamics. The risk extreme aversion of a year ago has shifted to an opposite polarity of, arguably, excessive risk tolerance. Anyone who had invested in the S&P 500 Index at its nadir on 23 March 2020 would have made 80% over the following 12 months. However, over the same period, bitcoin – to call out just one possible candidate exhibiting irrational exuberance – has returned over 750%. Consider also that since the start of 2021, more than 275 special purpose acquisition vehicles (or SPACs) have listed, raising more money in the past three months than over all of 2020. High yield has been another guest at the party, with the $130bn raised in the US in Q1 of this year marking the second highest quarter ever for new issuance (all data per Bloomberg and Grant’s Interest Rate Observer). Further, it would be highly surprising if some portion of the stimulus cheques soon arriving in America’s households does not also find its way into these assets.

It all almost sounds to good to be true – particularly if you did invest in the ‘right’ assets at the right time. First, a reality check. The ‘cost’ of such a shift in fortunes can be seen firstly in terms of the swelling of the Federal Reserve’s balance sheet, which has grown by $3.0tr to $7.7tr in the past year. Similarly, the US budget deficit has expanded by a massive 240% to $296bn over the same period. At the same time, while the S&P 500 Index traded on a median 12-month forward P/E of just 12.5x back in March 2020, the comparable figure today is 27.1x. Using Robert Shiller’s cyclically-adjusted P/E (or CAPE) ratio, the S&P’s multiple of 35.5x has only ever been exceeded during the TMT boom. Lest we forget, the yield on the 10-year US Treasury has expanded from 0.58% to 1.72% in the past year (all data per Bloomberg).

We now arrive at the crucial conundrum, We doubt it is possible to have a trifecta of a booming economy, a roaring stock market and restrained Treasury (or bond) yields.Something will likely have to give; we’re just waiting to see what. Optimists, of course, might argue that there is little fear. We could potentially be entering a new era – perhaps the roaring 20s – where sustained growth can be enjoyed as societies are rebuilt and technology continues to transform industries for the better. Personal savings are robust and leverage levels among both consumers and corporates are low by historic standards. Sure, there may be pockets of excess (see our earlier observations about bitcoin or SPACs), but many industry leaders/ tech pioneers are strongly cash-generative – a marked contrast to a generation ago.

Hold on, what about inflation? Its death has been greatly exaggerated. Just because we haven’t seen it for so long doesn’t mean that it can’t return. At the least, investors should think about preparing themselves for a world of greater inflation volatility. Such an outcome could be negative for both bonds and equities. It’s important to try and disentangle the structural from the cyclical. On both counts, it would be fair to say that the jury remains out. It’s also not yet clear which will gain the upper hand in terms of perceptions and policymaking. Although somewhat unhelpful as a conclusion, this contention is at least supportive of the idea that we should expect more volatility.

Begin with the structural. The presence of inflation currently feels such an unrealistic prospect since deflationary forces have been at work for the last 30-40 years. A combination of the Cold War ending, China joining the World Trade Organisation and a corresponding rapid increase in globalisation all helped to exert a strong downward influence on prices. At the same time, a global shift of women entering the workforce served to reduce wage pressures. This is the past; it won’t be repeated. Indeed, with growing US-China tensions, the world is arguably becoming more siloed and less global, perhaps implying a reversal in trends. Whether deteriorating developed world demographics (elderly people spend less) and the ongoing digitalisation of life (better processing power implies more for less) are enough to offset the absence of the above is unclear.

What we do know is that input prices are rising currently. It might be easy to blame a series of seemingly exogenous factors – from cold weather in Texas disrupting oil supplies to a stranded container ship in the Suez Canal – but like it or not, latest data from the US Institute of Supply Managers show producer prices at their highest since 2008 and delivery times at their second longest since 1979. Unsurprisingly, supply chain shortages in everything from semiconductors to food are translating into higher inflation expectations. In the US, five year expectations are their most elevated since 2014; on a ten-year basis, you have to go back to 2008 to last see levels this pronounced (per Bloomberg).

Whether such expectations (and a similar picture is also playing out elsewhere around the world) become self-fulfilling depends on the credibility of policymakers. The mentality which still seems ingrained in Central Bankers is one of fearing deflation more than inflation. Further, their historic success in fighting inflation perhaps gives them undue confidence in their ability to manage the threat of higher prices. At present there is arguably both a logical and an implicit political imperative to favour reflation (after a pandemic) over prudence, hence the case for introducing a policy such as average inflation targeting and permitting the economy to ‘run hot’ for some time. No one wants to be accused of withdrawing stimulus prematurely, hence halting a burgeoning recovery.

Three questions arise: will such a stance work, at what level of higher inflation (and bond yields) will Central Banks decide to act and what will be the consequences? It’s a waiting game. We concur that some inflation is desirable and that bond yields will probably trend higher from current levels. However, at some point, higher yields (perhaps above 2% on the US 10-year) will be negative both for equity and fixed income investors. We’ve said it before, but the case for conventional 60:40 fixed income/ equity allocations clearly needs to be rethought, particularly in a world of higher yields. The logic of exposure not only into a variety of styles (growth and value, quality and cyclical) but across assets classes (diversification, particularly into real assets) continues only to grow in our view.

Alex Gunz, Fund Manager, Heptagon Capital


The document is provided for information purposes only and does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. The document is not intended to be construed as investment research. The contents of this document are based upon sources of information which Heptagon Capital LLP believes to be reliable. However, except to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to the accuracy or completeness of this document or its contents and, Heptagon Capital LLP, its affiliate companies and its members, officers, employees, agents and advisors do not accept any liability or responsibility in respect of the information or any views expressed herein. Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation. Where this document provides forward-looking statements which are based on relevant reports, current opinions, expectations and projections, actual results could differ materially from those anticipated in such statements. All opinions and estimates included in the document are subject to change without notice and Heptagon Capital LLP is under no obligation to update or revise information contained in the document. Furthermore, Heptagon Capital LLP disclaims any liability for any loss, damage, costs or expenses (including direct, indirect, special and consequential) howsoever arising which any person may suffer or incur as a result of viewing or utilising any information included in this document. 

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