The Monthly View – April 2021

A Volatile But Positive Quarter for Equity Markets

March turned out to be another volatile month for equity markets. The continued rise in U.S. bond yields continued to put pressure on equity markets, especially on higher valued growth stocks.

The sharp sell-off in U.S. Treasuries since the start of the year raised hopes that the Federal Reserve (Fed) would take a more active role in calming markets. They did not do that, disappointing financial markets. Instead, Jay Powell (Chairman of the Board of the Federal Reserve Bank) stressed that the Fed takes a broad view of financial conditions and that they remain highly accommodative, justifying the Fed’s current stance.

Moreover, he stressed that the economy is still far from meeting conditions that would warrant tighter monetary policy. He highlighted the fact that the unemployment rate is still high and that it will take time for the U.S. economy to recover properly.

The good news is that the economy is recovering as evidenced by economic data. Helped by the economic stimulus combined with the vaccination drive, the global economy should continue rebound over the course of the year, with momentum rotating from the US to the rest of the world.

The approval of the American Rescue Plan by congress also stoked fears that the additional $1.9 trillion of stimulus will lead to much higher inflation. U.S. households were sitting on around $1.7 trillion in excess savings as of the end of January. Households generated about two-thirds of those excess savings by cutting back on spending during the pandemic, with the remaining one-third stemming from stimulus payments.

It is estimated that the latest stimulus bill will boost household savings by an additional $300 billion, bringing the stock of excess savings to $2 trillion by April. As the lockdown measures ease, it is reasonable to assume that households will spend a portion of this cash cushion.

Unlike President Trump’s Tax Cuts and Jobs Act, Biden’s American Rescue Plan Act will raise the incomes of the poor much more than the rich. Since the poor tend to spend a greater share of each dollar of disposable income than the rich, aggregate demand could rise meaningfully.

Well, who’s afraid of a little inflation? Certainly not the Fed.

Consumer prices will rise “well in excess” of 2.5% before settling back, Robert Kaplan (President of Dallas branch of Federal Reserve Bank) said, adding that the Dallas branch forecasts GDP growth of around 6.5% this year. Charles Evans (President of Chicago branch of Federal Reserve Bank) also downplayed inflation of 2.5%, saying even 3% “would be welcome, actually” for some period. He reiterated that rising bond yields is a sign of economic optimism.

Chairman Powell also reiterated that the Fed views the upcoming inflationary spike as transitory and will not justify a change in Fed policy. Powell’s recent speeches highlighted that while Fed policy will remain accommodative for an extended period, the central bank will not attempt to micromanage fluctuations in long-dated bond yields.

Is the Federal Reserve’s Relaxed View Towards Inflation Risk Justified?

The Fed knows full well that headline inflation could temporarily reach 4% over the next two months due to base effects from last year’s economic shock, supply chain disruptions, the rebound in oil prices, and the lagged effect from dollar weakness. However, as it did in late 2011, when headline inflation nearly hit 4% and producer price inflation briefly topped 10%, the Fed is inclined to regard these price shocks as transitory. The Fed believes that headline inflation will tick up to 2.4% this year but then settle back down to 2% by the end of next year as most fiscal stimulus measures end.
Our view is that the Fed will be right about inflation in the near term, but that it could be wrong in the long term. That is to say, we think that core inflation will probably remain subdued for the next two years, as the Fed expects. However, inflation could rise significantly towards the middle of the decade, an outcome that is likely to surprise both the Fed and financial markets.
Stocks usually outperform bonds when economic growth is strong, and money is cheap. The end of the pandemic and ongoing fiscal stimulus should support growth this and next year, allowing the bull market to continue. With inflation slow to rise, monetary policy will remain accommodative over this period.
The recent back-up in long-term bond yields could destabilize stocks for a month or two. However, as long as yields do not rise enough to trigger a recession, stocks will shrug off their effect. Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stock markets.

End of the Pandemic

Over the past 6 weeks, the U.S. has continued to make incredible progress in vaccinating its population against COVID-19.

The pace of vaccination is now well within the range required for herd immunity to be in place by the end of the third quarter. If this pace continues at an average of 2.5 million doses per day, the U.S. will have vaccinated 90% of its population by the end of September. And these calculations assume the continuation of a two-dose regime, meaning that the rollout of Johnson & Johnson’s Janssen vaccine – which requires only one dose and has shown to be extremely effective at preventing severe illness and death – could shorten the time to herd immunity rates of vaccination among adults even further.

The situation is clearly different in Europe. The vaccination progress in several European countries is well behind that of the U.S. and the UK, and per capita new cases in the euro area have again risen significantly above that of the U.S.

Clean Energy, Infrastructure and Commodities

Last week’s unveiling of President Biden’s $2.4 trillion “American Jobs Plan” to modernize U.S. infrastructure is the biggest construction and highway upgrade since the 1950s. Spending will take place over 8 years, financed in part by an increase in corporate taxes. This will provide a short-term boost to growth and is positive for equity markets as investors expected the tax component and the spending is front-loaded while the tax increases are spread out over 15 years.

The proposal is not pure old economy – it includes $650B for green infrastructure, clean water and high-speed broadband, along with $180B for the biggest non-defense Research and Development program on record. The proposal has a high likelihood of passage before the end of the year given that infrastructure is popular and Democrats can pass the bill via reconciliation with zero Republican votes.

The plan will create jobs but will likely also need a lot of base commodities from iron ore for railroads to copper and lithium for upgrading the broadband grid.

The past 10 years have been rough for commodity investors. After a decade-long bull market in the early 2000s, major commodity indices have continuously underperformed equities. The question now is what to expect going forward?

The conditions that propelled natural resource prices in the early half of the 2000s are very different from today. Back then, China’s economic expansion was a major tailwind. Fast forward to today, China is prioritizing stability over growth.

However, another tailwind for commodities is emerging. Alongside preventing financial risks, Chinese policymakers are also prioritized the environment. This is consistent with global efforts to adopt greener technologies. Somewhat ironically, it implies greater demand for commodities – industrial metals in particular – to buildout power grids.

The global movement toward a low-carbon renewable-energy future is a key factor underpinning metals demand over the next decade. The U.S., E.U. and China have committed to net-zero carbon targets by 2050 / 2060. This will unleash immense investment into and restructuring of everything from energy grids to city design to even bitcoin mining. Advances in renewable costs likely mean oil and coal are on their way out.

This comes after years of low capital investment in metals and mining. The confluence of supply constraints and rising demand will ultimately drive-up commodity prices.

Bond Portfolios are Suffering

Global bond markets are experiencing one of their worst starts of the year and are down circa 4%. Given the low interest rates, it is hard to see how global fixed income can generate a positive return this year.

Interest rates continue to tick higher on the back of solid economic data. There is a self-limiting aspect though to how high bond yields can rise when inflation is subdued. Higher bond yields lead to tighter financial conditions. Tighter financial conditions, in turn, lead to weaker growth, which justifies an even longer period of low rates. It is only when inflation rises to a level that central banks find uncomfortable that tighter financial conditions become desirable. We are far from that level today.

However, sharply falling bond yields are also not in the cards, so being short duration and owning corporate bonds and emerging market debt in our fixed income portfolios is helping us to create outperformance.

Investment Implications

Equities might face some more near-term volatility stemming from the recent rise in bond yields. But our core view is that the “Goldilocks” environment for risk assets, where growth is strong, inflation is contained, and monetary policy is accommodative, should last another two years. We expect corporate earnings to grow healthily this year and next, and strong earnings will continue to underpin the global equity markets.

Value stocks could lead the equity market higher over the next 12 months. The pandemic benefited growth names, especially in the tech space. The end of lockdown measures will favor value names. Not only is value still cheap in comparison to growth, but traditional value sectors such as banks and energy companies have seen stronger upward earnings revisions than tech stocks since the start of the year.

Looking further ahead, the cyclical bull market in stocks could end when inflation rises so high that central banks are forced to tighten monetary policy. While this is not a near-term risk, it is a major risk for the middle of the decade and beyond. Inflation is often slow to rise in response to an overheated economy, but when it does rise, it can rise fast.

Investors looking to hedge long-term inflation risk should favor inflation-protected securities over nominal bonds, precious metals and commodities, and they should own direct or indirect property investments.

Portfolio Actions

After adding a global value Exchange Traded Fund (ETF) and a global REIT (Real Estate Investment Trusts) ETF to our core portfolios in quarter four of last year. We have now added more value exposure by adding a thematic position in the global financial sector. Global banks have been underperforming for years due the falling interest rates, while last year banks took large bad loan provisions in the expectation that the recession would last longer. Now that the economy is recovering banks can write back the provisions in their earnings, which will accelerate their profit growth this year.

We have also added exposure to a broad commodity index ETF, as we believe base commodities will be big winners of the push to more sustainable energy grids and the large investments in infrastructure. As we already own exposure to clean energy stocks, we decided that direct commodity exposure was the best complement to the global portfolio.