Goldilocks versus the bears
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: When markets are this benign, there are good reasons to be sceptical. Sure, it’s hard currently to ignore the positive narrative. Investors seem to be enjoying a ‘Goldilocks-like’ moment where the delicate balancing act of the authorities returning economies to growth is running just right. At what price the biggest stimulus experiment in history will come at remains to be seen. Investor complacency could be a danger, particularly since Central Banks/ Governments may not even be aware of the policy mistake they have already made (i.e. potentially having inadvertently over-stimulated the economy). Only time will tell, but with clear pockets of irrational exuberance evident, we continue to counsel both balance and diversification across asset classes. We favour uncorrelated assets and exposure to a range of styles; growth and value, secular and cyclical.
- Equities: Global equities have gained around 10% year-to-date with many markets achieving new nominal highs. The rally has been helped by upgrades to earnings (albeit from a low base). Valuation levels on most metrics are exceptionally high relative to history, but need to be seen in the context of other mainstream liquid asset classes. We continue to prefer equities over fixed income and are encouraged by the fact that the recent rally has seen a broadening, rather than being restricted to certain sectors. We favour a combination of styles and advocate truly active approaches.
- Fixed Income/ Credit: After the first quarter of 2021, which saw government bonds generate their worst returns in over 20 years (per Bloomberg), an inevitable mean reversion occurred during April. Although the likely direction of travel for bond yields is upwards, we expect the rate of change to decelerate. From a positioning perspective, the move in government bond yields is continuing to force investors into riskier segments of the market (with higher yielding prospects), leading to a narrowing in spreads. We recommend only limited allocations.
- FX: Just as bond yields have retreated from their highs, so did the US Dollar weaken over April. We have no active currency views currently. Over the longer-term, however, we can see good reasons why the Dollar should fall further, particularly given America’s higher relative debt levels and growing deficits (both government and fiscal).
- Gold: We see a continued place for gold in investors’ portfolios. A weaker Dollar has helped gold move off its recent lows. Our conviction is more fundamental: gold can serve both as a very good portfolio diversifier and also a low-cost portfolio hedge. Supply is also constrained. We also see listed gold miners (who are cash-generative) as an attractive play.
- Alternative Assets: Similar in some ways to gold, these assets bring clear diversification benefits to investors’ portfolios. We are also attracted to their 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.
There is an eerie calm across markets. The VIX Index of volatility is close to a one-year low, equities globally continue to make new highs (the S&P 500 Index has marked 27 new record daily closes year-to-date) and government bond yields have retreated, following their dizzying ascent at the start of the year. Although such an outcome should have sceptics – such as this author – worried, we do also wonder whether investors (like Goldilocks) are getting to have their metaphorical porridge and eat it. Similar to the third breakfast bowl enjoyed by the protagonist of this well-known fairy story, everything seems ‘just right’ at present. Put another way, it’s hard to ignore the positive narrative.
The story is a simple one: we have an improving economy, corporate earnings reports are very strong (albeit flattered by easy year-on-year comparisons) and the authorities are being given the benefit of the doubt. In their favour, they have history on their side – unconventional experimentation has delivered returns – and current policy dovishness is helping to keep investor optimism alive. However, the bears still lurk. We wonder when they may get their metaphoric revenge on Goldilocks – for this is what happens in the tale – and much of the investment community. Have no doubt, there are clear pockets of exuberance currently and it is also very sobering to be reminded that some 66% of investors currently see US equities in a late-stage bull market (per the latest Bank of America Merrill Lynch Fund Manager survey).
First the good news. The global economy appears to be firing on all cylinders. The IMF raised its estimate for world GDP growth in April to 6.0% versus the 5.5% it had forecast three months prior. Such growth would be the fastest achieved since the 1960s, even if there are clear divergences globally between those countries that have implemented rapid vaccination rollout programmes relative to those who have lagged. Widening inequalities will have to be dealt with at some stage. Nonetheless, the current confidence of the IMF (and indeed most other forecasters) is a function of improving industrial and service data across all major economies. Eurozone manufacturing is expanding at its fastest pace since the single currency union was formed, while the latest ISM survey of US services recorded its highest reading since inception in 1997.
Jerome Powell, Chair of the Federal Reserve, believes that the US economy is only currently at “an inflection point.” Stronger growth could be ahead, helped by increased hiring and further vaccine rollouts. Then, there is a potential infrastructure boom to come too, with President Biden targeting a $2.25tr programme to run over eight years. Such an approach constitutes a rapid departure from the use of tax cuts to stimulate the economy and could also be seen as inherently populist (since it will be primarily funded through higher corporate taxes). It will be interesting to see how many other countries follow suit.
Better economic prospects have also fed through to the corporate level. Factset data suggest that the constituents comprising the S&P 500 will record 27% year-on-year earnings growth in the first quarter of 2021. If so, this would be the fastest earnings growth reported in over a decade. As an indicator of improving optimism, at the start of this year, the same Factset figure was 16%. Elsewhere, high yield default rates have fallen in the US from 3.5% to 2.0% for 2021 and by 4.5% to 3.0% for 2022. Meanwhile, aggregate corporate free cashflow levels (ex-financials) stand at an all-time high (data from Fitch and Credit Suisse respectively).
What we can’t help but wonder, however, is how much is priced in? Bullishness seems almost consensual. Consider that money managers currently hold a median 3.5% cash position, down from 10% a year ago and relative to a long-term average of 5%. At the same time, household ownership of equities as a percentage of total assets stands at a 50-year high (per Citigroup). Short positions are also apparently at a 17-year low (per Goldman Sachs). Valuation levels cannot be dismissed either. It may be great that companies are beating expectations and estimates are increasing, but what if equities are now priced for disappointment? The fact that relative to history, almost every valuation metric for the US market is in at least the 90th percentile (and some, such as valuing businesses on EV/Sales or EV/EBITDA, in the 100th) ought to send a warning signal. Do not forget that the Shiller P/E, which looks at cyclically adjusted earnings over a ten-year period, stands at 37.5x for the S&P 500. The only time it topped this level was prior to the 1999/2000 TMT bust. The median level recorded over the last 150 years is just 15.8x (data per JP Morgan).
Beyond positioning and valuation, if we were looking for signs of potential excess or exuberance, then they would not be difficult to enumerate. Begin with bitcoin, the asset class to reach $1tr in value more quickly than any other. Might bitcoin be to the early 21st Century what Tulip Fever was to the 17th Century? Only time will tell. Our list would not be complete without referencing the 300+ SPACs (special purpose acquisition companies) that have listed year-to-date, raising over $100bn and contributing to the largest ever quarter for M&A activity (all data per Bloomberg). Finally, consider the Greenshill and Archegos incidents. Maybe they were isolated, but they are indicative to us of top-of-the-market recklessness.
Complacency is perhaps the biggest concern. Whether investors like it or not, the role played by the Central Bank ‘put’ remains crucial, particularly in terms of the risk-tolerant stance it effectively continues to encourage. Thought of another way, if anything goes wrong, Central Banks will be there to bail not only the economy but also investors out. Governments, with their stimulus policies, have provided additional support this time around. Against this background, it is worth pondering – and this may be the critical question of our time – whether the authorities have made a policy mistake, and do not know about it yet. Think of the current strategy as being the biggest stimulus experiment in history. We will need to wait to see to what extent such levels of monetary and fiscal largesse prove to be greater than the estimated output gap and hence could be potentially highly inflationary.
We were intrigued to read several announcements from the Bank of Canada (BOC) in late April that may have been overlooked by the broader investment community. No surprise that the BOC raised its forecast for 2021 GDP growth from 4.0% to 6.5%. Of more note, the Canadian Central Bank expects to hit its 2% inflation target in the second half of next year. These are words that investors are certainly not used to hearing. Correspondingly, it has now begun tapering, with weekly asset purchases shrinking by 25% (albeit still to a level of C$3bn). The reaction in markets was remarkably sanguine, with local equities and government bond yields barely moving. Why so calm? We can only venture to suggest that after the ‘taperless tantrum’ experienced by markets during the first quarter, much of the news was already discounted.
The Federal Reserve may draw comfort from this Canadian episode, but do not forget, the Fed’s weekly bond purchases are around ten times the BOC’s level. Investors still fret that a ‘genuine’ taper tantrum, or further abrupt move in yields is the biggest current risk facing markets (per Bank of America Merrill Lynch’s latest survey). Of course, tapering is one thing, but raising interest rates is quite another. Our bigger concern is that Central Banks (and potentially Governments) in general are too anchored to the past and not focused enough on the future. Previous playbooks for managing through economic cycles may simply not work this time around. We all know the world has changed, post the Cold War/credit crisis/ COVID-19 pandemic and so on. For now, let them eat porridge, but do not forget to keep a watchful eye for those nasty bears lurking around the corner. Practically, we continue to counsel that investors seek to gain exposure to a variety of asset classes and styles to manage across a range of potentially unknown outcomes.
Alex Gunz, Fund Manager, Heptagon Capital
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