View From the Top: Hotel California

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: watch the real yield if you want to know what’s happening. Inflation-adjusted 10-year Treasury debt in the US now yields -3% versus 0% at the end of March. Such a remarkable change in such a short period implies that both lower growth and more persistent inflation are now being discounted increasingly when looking ahead. However, the continued highs being achieved in equity markets suggest that many investors seem unperturbed. The presence of still highly accommodative Central Banks combined with government-sponsored fiscal profligacy perhaps offers the best explanation, in our view. Investors remain programmed to receive. Authorities will likely continue to provide a reassuring backstop in the event of adversity even if talk of potential stagflation may just be hyperbole. We counsel ongoing portfolio diversification in the interests of pragmatism.

Asset Allocation:

Many readers of this piece will now have returned from their summer holidays and be back at their desks (whether office- or home-based is a moot point). With equity markets continuing to make new all-time highs and bond yields in retreat, it’s almost as if nothing has changed in the past month. In some ways, it’s easy forget both the resilience of the COVID-19 virus and the growing instability in Afghanistan for just a moment. When seeking to provide an explanation for the above, the lyrics of Hotel California by the Eagles sprung to your author’s mind. Investors remain “programmed to receive.” The Federal Reserve and its counterparts around the world face the potentially inescapable dilemma of being able to “check out when they [you] like” although they “never can leave.”

The commentary from Jerome Powell at the recent Jackson Hole Symposium perhaps speaks best to this point. While the Federal Reserve “could” begin to reduce bond purchases this year, it is in “no hurry” to raise interest rates. Needless to say, investors interpreted this commentary as being generally dovish; there is less need to worry about tighter monetary policy in the near future than previously thought. It’s almost as if the inflation-scare that characterised sentiment at the start of this year is now a long-distant memory.

Dig into the semantics of the Fed’s commentary and you find yourself in Hotel California. The language used is deliberately vague (and implicitly intended to reassure investors). There is no guarantee whatsoever that tapering will begin before the end of 2021 and interest rates look currently unlikely to rise any time soon. Credit at least to the Fed for avoiding the mistake of the Bernanke era – the likelihood of a ‘tantrum’ (or an abrupt upward move in bond yields accompanied by an adverse equity market reaction) looks low. The Fed ‘put’ remains alive and kicking, albeit this time around supported by government-inspired stimulus too.

Why the ongoing dovishness? Well, as Bill Clinton famously put it, “it’s the economy, stupid!” Look at the data and the pace of the economy is slowing. Consumer sentiment is also deteriorating. Perhaps it’s not uncoincidental that incidents of COVID-19 are continuing to spike across the world. Hospitalisations in the US are at their highest since March 2020. There is much accompanying talk/ expectation globally about both a ‘fourth wave’ as well as the need for booster vaccines. Of course, do not forget that many around the world – in both developed and developing countries – have yet even to receive initial vaccines (just 14% of the globe’s population have had two jabs, per the World Health Organisation).

It hardly takes a genius to realise that a resurgent virus will likely be negative for economic growth. Industrial output and purchasing manager survey data around the world likely peaked in May/ June and recent numbers have fallen below consensus expectations. At the same time, consumer sentiment figures are showing clear deterioration too. Data from the University of Michigan show that Americans are more negative now about the future than they were at the time the pandemic first struck in April 2020. Indeed, they have not been this negative since 2011, per the survey. Only 36% of those interviewed expect a decline in the unemployment rate over the next year, despite close-to-record job openings. Investors also seem to agree, with just 25% of the Fund Managers interviewed monthly by Bank of America Merrill Lynch expecting “a stronger economic recovery” over the next 12 months, down from over 75% at the start of the year.

Sure, benign monetary policy might be a salve for investors, reinforcing the positioning to which they have become accustomed, but it certainly cannot solve all problems. It certainly can’t cure the virus nor do much, say, about helping to reopen port terminals that have been shut owing to renewed coronavirus outbreaks. The OECD estimates that the balance sheets of the major Central Banks globally could total $28tn by the end of this year, some 40% above the level which they ended 2019. The precedent of Japan remains an ominous one. Sustained growth has remained elusive despite continued stimulus.

The real yield is perhaps the most important indicator for investors to be monitoring. Just six months ago, the yield on US government 10-year debt adjusted for inflation was just above 0%. Now it is -3% – a quite remarkable change. One clear interpretation is that the possibility of lower growth is being increasingly discounted at the same time as potentially higher and more persistent inflation over time. As the port terminal observation above suggests, the COVID-19 pandemic can both depress growth and raise prices.

It’s hard to know at this stage whether talk of stagflation is hyperbolic or merely prescient. What we do know is that even if history does not quite repeat itself, it can still rhyme. The similarities between now and the 1970s are evident (for the record, Hotel California was released in 1977). Consider that transitory inflation is proving hotter and more persistent than expected and real economic growth is cooling, while millions of workers remain side-lined. The data also support the idea that consumers are paying more for goods, without wages keeping up. In the US, personal consumer expenditure (the Fed’s preferred measure for inflation) is rising at 5.4%, ahead of the last-reported rate of 4.0% growth in average hourly earnings.

Should investors be concerned? The messaging from the Federal Reserve (et al) is intended to reassure. First, inflation is believed to be transitory. Certainly, it’s comforting to see that inflation expectations for 12 months out are below last-reported levels, while 5-10 years expectations are markedly lower (at 4.6% and 2.9% respectively). Next, the Central Bank mantra has shifted to permit for somewhat higher inflation. Average inflation targeting is now both the new normal at the Federal Reserve and the European Central Bank. Jerome Powell stated explicitly at Jackson Hole that “maximum employment” would be the main criteria considered when assessing the timing of interest rate hikes. This still looks a long way off. Finally, we “remain programmed to receive.” When push comes to shove, either monetary or fiscal authorities (or both) will do what it takes to keep not only the economy but also probably the stock market from cratering.

The consequences of such a course of action will be both intended and unintended. Begin with the former. With an ongoing backdrop, it’s hard to escape from the ‘TINA’ (there is no alternative) mentality. This partly explains why equity markets continue to make new highs, when there are no more compelling mainstream asset classes available. In terms of the latter, remember that debt levels, whether for governments or corporates, have never been higher. Accommodative policy has created moral hazard. At some stage there will have to be a reckoning. However, once the Rubicon has been crossed, it’s almost impossible to go back. Monetary accommodation is nothing new, but it is now being accompanied by fiscal profligacy too.

For many, it would be easy just to do nothing and adopt the Chuck Prince approach of “dancing” while the music “keeps playing.” Ongoing excess liquidity should be highly supportive to global equities. At the same time, bonds remain both  unattractive and overvalued relative to their equity counterparts. It’s hard to know when the music will stop playing, especially should investors keep dancing to the tune of Hotel California. Nonetheless, we consider it both prudent and pragmatic to continue our long-advocated strategy of portfolio diversification and investment into a broad range of uncorrelated asset classes. Stay balanced and nimble.       

Alex Gunz, Fund Manager, Heptagon Capital