24 march 2021
Welcome to CLEARCUT, a monthly discussion on macro and allocation
Tough rates_ The key developments over the past weeks have taken place in rates, which have risen markedly and are now back to pre-Covid levels in the US. In general, investors have taken the habit of debating whether they are moving for “good” or “bad” reasons: good being associated with better economic prospects, while bad are related to policy tightening. We would take both narratives with a pinch of salt and argue that large market moves are most often the result of a combination of factors that align at a certain point in time.
Bright sky_ Regarding economic prospects, it is difficult to argue that they have not improved. Even though the pandemic is upon us in most of Europe, the markets continue to look through the near term and anticipate the “great reopening” that will come later this year. As discussed at length last month, time is on our side and the likelihood of a significant delay is shrinking every day. If anything, the calendar of reopening was brought forward in several countries, such as the US, where the pace of vaccination has picked up materially.
Men in Black_ What is more, policymakers around the globe are doing everything to erase the pandemic from our memory by fighting hard against the sequels it may leave on companies and workers. The massive ‘American Rescue Plan’ worth $1.9tr was finally passed this month in Congress, with its most hotly debated measure, a check to all Americans earning less than 75,000$ per year. Supporting measures are also addressed to small companies and local governments. The programme’s size as well as its lack of targeting make it look as close as you get to helicopter money. Most recently, plans have emerged about an additional infrastructure programme destined to accelerate the green transition.
Boom for the buck_ Combining the natural catch-up that will ensue after the reopening and its amplification from policy, the Biden administration is not likely to have great bang for the buck but should certainly get the boom. The US economy will have recouped its Covid recession losses by the end of 2021, with growth around 7% this year.
Jet lag_ On the cyclical clock, the US is the most important needle. What is interesting though is that Europe is clearly 6 months behind, while China may be 6 months ahead. In Europe, the relative failure to quickly rolling out vaccines combines with sub-par policy support. This ends up with a deeper recession and a shallower recovery, with the economy probably back to its pre-pandemic size only by mid-2022. Additional fiscal programmes are currently being discussed in Germany, the country with most fiscal space and an upcoming election. Elsewhere, the lack of policy room is being badly felt, despite the ECB’s efforts to make debt as cheap as it gets.
China looks inward_ Meanwhile, China has turned to a tightening stance. With a conservative growth target for 2021 at just ‘over 6%’, the emphasis is put on the long run and the willingness to become the largest economy in the world by 2035. Financial stability, environmental preservation and technological innovation are the key priorities emerging from recent official communications. This inflexion not only means that tech competition is likely to amplify in coming years, but also that China may shrink its role as a key engine of growth for global manufacturing, except for commodities.
Test mode_ In the near term, and in this context of a widely expected economic upturn, markets have started to test the willingness of central banks to keep the tap open. Since we are now contemplating the first hiking cycle under average inflation targeting, markets are keen to start the ‘price discovery’ process of what exactly this concept means. In effect, the Fed is talking the talk, recently signalling no rate hike before 2024 and an outcome-based tapering of asset purchases. Nevertheless, markets doubt that the central bank will hold this line and are betting on a more aggressive path. History shows that relying on market expectations has not often proved a good idea. We rather dismiss them and, even though much can happen until 2024, the Fed is likely to err on the side of caution and stay away from ‘taper tantrum’ territory.
Inflation bump_ This conviction is reinforced by the fact that the inflation bump is likely transitory. Our structural view is that inflation will exit its anaemic state of the past 20 years, but this does not mean it will spiral out of control. In the next year or so, a temporary rise above 2% is well possible given the pandemic-related gluts to global supply chains and the need to invest in the fuel of tomorrow, semiconductors. But medium term, none of these drivers looks unsolvable. Corporate investment is starting to pick up in those areas, supported by public schemes and the massive volumes of capital raised in debt markets since 2020.
Regime shift_ From a cross-asset perspective, a key chart to watch is the bond-stock correlation, which abruptly turned positive in early 2021, signalling a change to the market regime of the past years. In the ‘QE dominance’ regime, yields were trending down and supporting risk assets because of lower discount rates and portfolio rebalancing towards higher-yielding securities. In the current ‘fiscal dominance’ regime, reflation expectations lift interest rates as well as risk assets because of stronger nominal growth prospects.
Under the microscope_ A close look at what has happened in the rates markets is therefore critical at this juncture. The yield rise has come in successive waves: it started from inflation components, drifted to a repricing of policy and term premia and again to inflation. The rapid rise in term premia has to do with positioning in our view, as being bearish on rates had become very fashionable in early 2021. As a result, our view is to tactically buy the dip in duration, mostly at the very long end of the US and Euro curves. Even though strategically, we expect bond yields to drift higher, the near term rather calls for a consolidation. Curve flattening trades in the 5-30Y sector also make sense.
Rates & spreads_ This recent dynamic also makes the preference of high yield over investment grade less clear-cut. The credit market has proved rather quiet and resilient to volatility both in rates and equities, confirming very solid technicals in a year when issuances should fall markedly. As a result, we have raised our overall fixed income allocation in cross-asset portfolios, reflecting higher expected returns. The one area of concern is emerging debt, where tensions on US rates have led to more discrimination.
An old friend_ One market that we have not discussed much in recent months is FX. A key driver in currencies is carry and relative changes in interest rates: the synchronised race to the bottom from central banks had taken a lot of the spice out of the market. We feel that now is the time it will get interesting again. While we have discussed the Fed, several central banks are now clearly on the move: in Russia, Brazil, and Norway, rate hikes were announced or are underway. Conversely, the ECB and the Bank of Japan look set to stay put for many years. As a result, we see opportunities in several currencies (CAD, NOK, AUD, MXN) that look either cheap or fair to outperform as their relative carry improves against funding currencies (EUR, CHF).
Pouring cold water_ In equities, the scenario we envisaged last month broadly unfolded. The regime change in rates led to some profit-taking and positioning rotation in some segments of the market, notably US momentum stocks which looked clearly hot. Nevertheless, the contagion was very limited in the broader market and the “cold” segments delivered continued positive performance. We see much more potential for “inflation assets” in coming months, especially when looking at their longer-term relative performance.
Many reflation trades_ Several sectors, factors and regions are exposed to the reflation theme. Key sectors we have investigated include commodity-related stocks, be it in the oil or metal segments, banks and specific industrials. From a style perspective, we continue to believe that small can outperform large, even though the trade has become very crowded in the US and may need some retracement. In terms of countries, we now see less potential in Japan after a very strong run. Emerging markets have also been penalised by heavy positioning and rising bond yields. In Europe, the near term may be blurred by lockdown extensions but medium term there is certainly value in quality names.
Rotation of the rotation_ After the correction in the hotter segments, we have seen signs of a ‘rotation of the rotation’ back to tech. There are also clearly opportunities to seize in long-term winners from the digital transition. A theme we are interested in is digital advertising, which benefits from both the cyclical boost of the advertising sector and the long-term shift to online. The sector offers opportunities over and above the tech mega-caps.
Gold not for now_ We turned negative on gold earlier this year and believe that the time has not come to get back. Now that rates have risen, there is more value in owning fixed-income safe assets than gold, which correlation to risk assets was volatile in recent months. Low expected returns in safe commodities are a key reason for our underweight in commodities overall. Elsewhere, the best Sharpe ratio continues to be in equities, reflecting our expectations of higher guidance from companies in months to come.
In a nutshell_ Overall, we continue to see upside in risk assets, especially as the macro scenario is only starting to materialise and has not fully translated into the micro. Even though positioning will play a key role this year and trigger volatility, the technicals are strong, with much cash on the sideline and limited risks from rising bond yields.