24 february 2021
Welcome to CLEARCUT, a monthly discussion on macro and allocation
Looking bubbly_ Markets have experienced a dramatic rise since November last year. A goldilocks environment of high expected growth, low inflation and aggressive policy have worked just as textbooks would have predicted. Today, valuations look rich for most assets and sentiment and positioning flash amber. How should we position?
Big picture_ We are often asked what the key risk to our positive macro scenario is. The answer is Covid. Markets are betting on a strong recovery starting in the second half of this year, and a lot of the recent price action depends on it. Thus far, there is no reason to doubt it, and for once, time is on our side.
A probabilistic view_ Variants have emerged in several parts of the world but have failed to derail the rosy scenario. Several of them proved more contagious, if not more deadly. Given that viruses mutate all the time, it was always a question of probability that one of them would outsmart vaccines and bring us back to square one. But two reasons make this scenario increasingly unlikely: first, the nature of mRNA vaccines makes them more flexible to adapt to variants than traditional vaccines. Second, vaccinations are a race against the clock: the quicker populations are vaccinated, the less the virus circulates and therefore mutates. Every passing day brings us closer to the end, indeed.
Start-up nation_ Furthermore, Israel is the place to watch in terms of what to expect from large scale vaccination. With now roughly half of the population having received its first jab, the data can give us substantial information about the true effectiveness of vaccines in a real-life setting. And the picture is comforting. Not only do vaccines prevent serious conditions and reduces fatalities but they also significantly reduce contagion.
Adapt or die_ The other good surprise from the past three months is how quickly the economy has adapted to pandemic-related restrictions. A plain look at the PMIs worldwide shows that the impact of lockdowns in late 2020 was probably about 20% of what it was in March. Evidence is particularly strong in the manufacturing sector where activity levels are solid, while construction is benefiting from ultra-low interest rates.
Chinese engine_ Another reason for the rebound in Western industries is the kickstart from China. Having stimulated its economy to engineer a strong rebound in the second half of last year, China supported industrial orders across the US and Europe in late 2020, helping dampen the soft patch at home. Given that Chinese authorities have again turned the screws on credit and infrastructure spending in early 2021, a slowdown in industrial momentum should be expected around mid-year in Europe though.
How big is too big?_ Despite such an encouraging backdrop, policymakers in the US and Europe have chosen to ‘go big’ nevertheless. In the EU, big will be slow though, as most of the NextGenerationEU funds will take several years to be disbursed. In the US, prominent economists have warned about the unexpected consequences of filling a 4% output gap with a fiscal package worth 8% of GDP. One of the main implications has been rising inflation expectations, despite low current numbers. Five-year inflation expectations have reached 2.35%, their highest level since 2013.
In a bind_ The situation may well imply that the goldilocks window will soon be closing for central banks. Even though they are pushing back for now on the seriousness of the inflation threat, markets are testing their nerves. The rise in commodity prices has been spectacular and will translate into higher – although transient – realised inflation. Massive fiscal plans may require higher interest rates. And central banks will face the dilemma of how much to accommodate this tightening in financing conditions.
Europe licking its wounds_ In Europe, we may not have vaccines, but we have ideas. A good one was to drag M. Draghi into politics as the new Italian Prime Minister. A broad Parliamentary majority gives him free hands to tackle structural reforms beyond the mere management of the sanitary crisis and its fiscal response. He will need to act fast though, so as not to let his political capital fade too quickly when Lega will start pushing for elections. For markets, beyond a decline in the political risk premium in Italy, a key question will be to what extent Draghi will confront Germany and France to engage into a deep reform of the fiscal oversight framework and strengthen the underpinnings of any future meaningful fiscal union.
The big repricing_ The angular stone of any change in market regime should be long-term interest rates. For that to happen, three things can occur: i) a significant reassessment of inflation in the medium and long run, ii) a loss of confidence in policy quality leading to a rise in the term premium; or iii) a significant alteration of bond markets’ supply/demand balances. All three are credible threats in years to come.
Inflation in the roaring twenties_ A key concern for markets these days is to what extent inflation is coming back. Several structural changes are in place for a return to more normal price dynamics after two decades of anaemia: a slowdown in globalisation, the tech dualism between the US and China, a reduction in market competitiveness, a policy drive to tackle inequalities. On the policy side, central banks have adjusted their mandate to AIT (average inflation targeting) as a way to preserve their credibility in front of prolonged failure. But from a political economy angle, it is increasingly clear that the central bank trade-off is tipping towards tolerating more inflation to accommodate sovereign debt levels on one side and support the reduction of private-sector inequalities from creditors to debtors on the other.
Duration diet_ Back to the market, this assessment leaves us with a strategic view that stars are aligning for a multi-year rise in interest rates, or at least excessively poor returns from duration. Market have just started to reprice the Fed while the fiscal push to come will pour loads of fresh duration into markets. Tactically, the recent move higher in rates was sharp and we have taken profits on steepeners. But the direction of travel has not changed.
Rethinking credit_ As a result, our view has been to position in spreads rather than rates for this year. Even though a “taper tantrum” à la 2013 is unlikely, most of the returns to expect in fixed income will come from carry and spread compression. True, all-in yields are already very low, but there is a fair chance that markets will test cyclical lows in coming months. Issuances are due to come down after massive primary activity in 2020 and default rates have peaked. We see the current environment as a bond picker’s market with alpha more important than beta to generate performance.
Some don’t like it hot_ The equity market is making new highs, defying sceptical investors calling a bubble and debating whether it’s 1995, 1997 or 1999. A number of indicators are undeniably flashing amber: equity positioning, options volumes, capital flows. Still, what is striking in our view is the market’s polarisation. Some segments look dangerously hot while others have stayed very cold. On the hotter side, one can think of ESG, penny stocks, IPOs, cryptocurrencies, SPACs. Still, large parts of the market have only started to get in the flow. One way to see this is to look at the median discount of the 20% cheapest stocks compared to market P/E ratio. Despite the dynamics since November, we are still very far from expensive territory.
In & out_ As a result, our positioning in equities has become more selective. What goes up can continue to go up for longer than we think: spotting a bubble is hard, timing one is impossible. The better way is just to stay away from those stocks that we think offer little value and focus on other segments that look attractive. Here are a few.
Financials_ European financial credit has been among the best performers in fixed income and remains one of our preferred segments for the year. Fundamentals are strong as the pandemic shock is fading away while issuances are coming down. An interesting question though is whether banks can also sustainably recover in equities. For that to happen, earnings need to take off after a lost decade. Stronger economic growth, solid balance sheets, significant adjustments to business models as well as sector consolidation may finally bear fruit.
Energy_ Oil has been among the best performing assets this year. A key driver has been the expected recovery in demand, as mobility normalises after the pandemic. The rise in demand was not met with higher production though. OPEC+ has remained disciplined so far even though tensions are emerging again from Russia. In any case, energy stocks have lagged significantly compared to the commodity and offer significant cash flows. As the anti-ESG asset, they have suffered unduly from massive reallocations towards cleaner securities, despite the significant efforts from some big oils to diversify into renewables.
Revisiting equities_ We make a few changes to our allocation grid this year. First, 2020 has shown that China is no longer an emerging market. First, the local market is not dependent on foreign investors, therefore immune to the swings in capital flows that characterise EM investing. Second, Chinese indices are now dominated by tech mega-caps that look more like the S&P 500 than to EM indices where financials and basic resources tend to be overrepresented.
Thematics_ We also add styles and thematics to the grid, reflecting more closely the way markets behave and investors think about allocating capital. Geographies have lost some of their explaining power as markets get more technical, while thematic investing has risen as a dominant growth approach. We are overweight in some key thematics, reflecting the ongoing digital transition that will endure in the post-pandemic world.