View From The Top

Just the beginning? Nobody knows…. Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic…

View From The Top

Just the beginning? Nobody knows....

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: Whatever your view on inflation, on a core consumer CPI measure, there is no escaping the fact that the most recent reading in America constitutes the highest seen in 25 years. Causation and correlation are always hard to disentangle, but the world is undergoing its biggest ever experiment in joint fiscal and monetary stimulus. To suggest that there won’t be consequences – both intended and unintended – is to miss the point. Even if it’s still unclear to what extent the inflationary pressures we’re witnessing are cyclical in nature versus more structural, we think it is crucial to recognise that there has been a clear regime change. We have argued for some time that investors need to position appropriately: portfolios should embrace a variety of investment styles. Diversify beyond long duration and seek a balance between growth and value, cyclical and quality.

Asset Allocation:

  • Equities: Global markets have continued to make new nominal highs, helped by very strong corporate reports. The 49% year-on-year earnings growth recorded for the S&P 500 Index in the first quarter of 2021 compares to an estimate of 24% at the start of April, with Bloomberg noting that this has been the best quarter for positive earnings surprises since it began tracking the data in 1993. Year-on-year comparisons get even easier in the upcoming quarter. Our caution relates only to how much of the good news may already be priced in. Our counsel – per above – is to keep diversifying.
  • Fixed Income/ Credit: Even if government bond yields have retreated somewhat from their recent highs (the US 10-year yields 1.62% currently versus 1.74% at the end of March), yields are markedly more elevated than a year prior (0.68%). The future direction of travel for yields will be largely contingent on inflationary trends and expectations although a more moderate pace of acceleration seems likely. At the same time, investors appear to be increasing their attention on riskier segments of the market (with higher yielding prospects), leading to a narrowing in spreads.
  • FX: After a marked rise at the start of the year, the US Dollar Index has weakened since the start of April and is now close to levels where it began 2021. The Euro (and Sterling) have correspondingly appreciated. While we have no active currency views currently, we can see good reasons why the Dollar should fall further.
  • Gold: The 11% quarter-to-date gain in the gold price may be sustained, in our view. Not only is a weaker Dollar positive for the gold price, but lower real (inflation-adjusted) yields should also be supportive. We have long advocated that gold can serve both as a very good portfolio diversifier and also a low-cost portfolio hedge. Supply is also constrained.
  • 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.

Few things are likely to inflame debate among both economists and commentators on financial markets more than the topic of inflation. The subject is, naturally, of immense importance not only for policymakers but also asset allocators. Currently it is top of mind, with concerns over inflation having replaced those of the impact of the pandemic (at least in the opinion of investors, who rank it as the market’s number-one risk, per the latest Bank of America Merrill Lynch Fund Manager survey). What is unambiguously clear is that after little more than 100 days since Joseph Biden became the US President, headline core CPI US inflation is currently 3.0%, the highest it has been in 25 years. Where inflation goes from here is, of course, a much more controversial topic.

Our take on the inflation debate is perhaps most accurately summed up as “nobody knows.” Do not think of this as a cop-out, or a convenient sitting-on-the-fence approach to avoid looking foolish. It is simply a pragmatic reflection of the large number of (complicated) moving parts. Even with this stance, it is certainly possible to reach some firm conclusions regarding asset allocation. The approach we have consistently advocated since the start of 2021 has been to embrace a variety of styles. Put another way, diversify and make sure that your portfolio contains growth and value, quality and cyclical exposure.

The nobody-knows stance is a defensible one, we believe. There is also a strong precedent for it. Think back to the very early 1980s when Paul Volcker had recently assumed the role of Chair at the Federal Reserve. Inflation was rampant and so he took the radical step of switching the Fed’s policy from targeting interest rates to targeting money supply. At the time, nobody knew whether the approach would work, let alone what its consequences (both intended and unintended) might be.

Might 2021 therefore be a 1981 redux? Today, of course, the problem is not inflation; rather it has been deflation and persistently low growth that have plagued most western economies since the end of the credit crisis. The low/negative inflation thesis and accompanying low rates of interest/ negative bond yields has become the accepted narrative. Many have almost taken it for granted, perhaps not uncoincidentally since few current investors can even remember a time when inflation was present (full disclosure: your author was aged 5 in 1981, and had not heard of Paul Volcker then).

To say that the pandemic changed everything could be considered an under-statement. What we do know is that an unprecedented amount of stimulus has been and is continuing to be thrown at economies globally. What’s different this time – especially when compared to the Great Financial Crisis – is that not only have monetary bazookas been unleashed but fiscal ones too. Total global policy stimulus of all forms is likely to sum $30tr over 2020 and 2021, per Bank of America Merrill Lynch. Roughly one-third of this is estimated to be fiscal.

We have wondered in the past whether policymakers (and we mean here Governments much more so than Central Banks) have committed a major strategic error, arguably without even having realised they were doing so. Put another way, there is a possibility that economies have been over-stimulated and that policy will need to catch up to rectify it. Perhaps it’s deliberate. Governments rarely play by the rules. Favouring short-term gratification over the consideration of long-term consequences is nothing new.

For now, policymakers probably feel they deserve a metaphorical pat on the back. Latest GDP and PMI data from across the world shows that economies everywhere are booming, with purchasing manager surveys in both manufacturing and services reaching record highs. With economies reopening, pent-up demand is being unleashed. The problem, however, is that at the same time supply is constrained, leading to cost pressures. Input prices in the US are currently at their highest in 13 years, per the Institute of Supply Management. This is the consequence of multiple factors. Semiconductor chip shortages have had major ramifications for many industries. Adverse weather and still-compromised supply chains have complicated matters. Further, many service industries are struggling to fill vacancies, leading to wage pressure (McDonalds, for example, raised salaries globally by an average of 10% in May).

Multiple moving parts muddy the waters. Have no doubt, we are clearly seeing some clear evidence of cyclical inflationary pressures, as reflected in reported data. However, the debate between when something ceases to be transitory and then becomes permanent is far more than just an exercise in semantics. Supply chains may remain disrupted for months. We also know that many consumers are sitting on high levels of savings, potentially waiting to be spent. A sui generis event (the pandemic) required an unprecedented response. With the consequences of both still unfolding, there is no evident playbook to which policymakers can resort.

It might then be fair to ask why do the Federal Reserve (and other Central Banks) appear so sanguine. Our view: partly because they have to be. The last thing policymakers want is a repeat of the 2013 ‘taper tantrum’ let alone a return to the inflationary havoc of the 1970s. More practically, the Fed draws comfort from the fact that long-term (5-10 year) inflation expectations are below 1-year levels, at 3.4% and 4.6% respectively. This may be supportive of the ‘transitory’ argument but it is to miss the point that just a month ago, these figures were 2.7% and 3.1%. Expectations matter. Prophecies can become self-fulfilling. We note that inflation mentions on corporate earnings calls are at a 10-year high (per Bloomberg).

In the long run “we’re all dead”, Keynes famously remarked. Most investors understand the longer-term arguments for secular deflation: demographics (the old spend less than the young), technology (more bang for your buck) and globalisation (more efficient supply chains) – if you believe the latter will return at some stage. The shorter-term, of course, is very different. At the very least, we feel it is necessary to accept and embrace the notion of regime change: things are different now.

Not only have Governments opened the fiscal spigots, but Central Banks (or the Fed specifically) have said that they are willing to tolerate ‘some’ inflation, preferring to let the economy run somewhat hotter than usual, rather than risk withdrawing stimulus too early. There is also the consideration that with no appetite currently either for tax rises or spending cuts, inflation may have to ‘pay’ for higher debt burdens. In marked contrast to after the Financial Crisis, austerity is out; higher debt/fiscal burdens have become the norm. New debt is currently both politically popular and socially necessary.  

If we accept that regime change is underway, then it is important to position correctly for it. A deflationary regime (i.e. the recent past) has been highly supportive to longer duration assets. Their correspondingly more elevated current valuations logically suggest poorer long-term returns. This is not to say that certain asset classes will see their valuations stretch still further in the very near-term, driven by a perceived fear of missing out as much as anything. Our counsel is more to reduce exposure to longer duration as a style and to balance it with other, complementary asset classes. We have also noted in the past that a degree of speculative frenzy has reached certain corners of the market, as evidenced by elevated levels of retail interest, particularly in areas such as bitcoin and SPACs (special purpose acquisition companies). Not participating in these areas can help both to reduce risks and enhance returns. Balance matters; a discipline that will hopefully not go unheeded by policymakers either. 

Alex Gunz, Fund Manager, Heptagon Capital

Disclaimers 

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 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, 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 is under no obligation to update or revise information contained in the document. Furthermore, Heptagon Capital 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. 

The document is protected by copyright. The use of any trademarks and logos displayed in the document without Heptagon Capital's prior written consent is strictly prohibited. Information in the document must not be published or redistributed without Heptagon Capital's prior written consent. 

Heptagon Capital LLP, 63 Brook Street, Mayfair, London W1K 4HS
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fax +44 20 7070 1881
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