We last wrote about markets in mid-December. We suggested that the global economy was on course for a V-shaped recovery, even if it didn’t feel like that, but that markets were approaching a cyclical peak. Our main argument was that, as economies recover, investors will sell financial assets to invest in the real economy. We were particularly wary about fixed income at this stage of the cycle.
We would like to say ‘and so it came to pass.’ Equity markets have sputtered upwards and there are clear signs that at least in Asia normality is returning. Bond yields have risen, so that the US 10 year Treasury is now yielding 1.2% compared to 0.9% in December and a low of 0.5% in August. Previously shunned areas such as industrial commodities, emerging markets, value stocks and even the ultimate pariah, United Kingdom equities, have done better.
But it still feels like uphill work. Central banks are pumping money into the system and investors’ risk appetite is still close to the five year average. Overall funding liquidity, as measured by our friends at CrossBorder Capital, at 84, remains close to peak levels and would be even higher if it were not for China at 28 (index score of 0 to 100). Throughout the COVID crisis the PBOC has provided markedly less stimulus, though its stance is now distinctly easier than it was last year. The desire for a stable yuan is the most likely driver behind this rather than concerns over the economy.
Last year at a global level private cash generation was strong, in our view the direct result of the measures taken against the pandemic. Companies as well as individuals were less able to spend and in many cases took advantages of loans or furlough schemes from governments, so it is unsurprising that cash balances rose.
Private sector cash and credit balances are now reducing again as the economy normalises and money moves to the real economy. China is the clearest example, where private sector liquidity (i.e. cash and credit) dropped sharply in January. We see this as more evidence that the economic recovery is indeed unfolding in a V shape.
If we are right, the gloomy 2020 headlines (last week’s ‘worst UK recession in 300 years’), however disconcerting, are history because the rest of the world will follow a similar path to China. Money will start to move from financial assets into the real economy. It is likely to mean an uptick in supply side inflation, as we are already seeing in commodity prices. We currently see this as a temporary phenomenon, because there are still plenty of deflationary pressures around, most obviously technology and the oversupply of labour. But it is another reason to expect higher bond yields going forward.
For investors we would suggest the following implications:
Bond yields will continue to rise and yield curves steepen. Our initial target would be a US long bond yield of 3% (today standing at 1.9%). That would be normal at this stage in the cycle as investors move money out of safe financial assets into the real economy. A minority scenario, but one which cannot be discounted, is that the steepening happens by means of short rates turning even more negative.
If bond yields at the long end rise substantially, that will be the catalyst for a turning point in equities, as we have argued previously. We do not expect equity indices to make much further ground from here but, if bond yields do rise, the mathematics of cashflow discounting suggests a shift away from long duration assets, ie. tech and ‘quality’ stocks. This may impact equity indices, because these stocks are so heavily weighted, but is unlikely of itself to precipitate selling. We note that at a global level investor appetite for equities is neutral on CrossBorder Capital’s measures.
There are scenarios involving a sharper fall in equities, even without the possibility of a political shock. Investors may choose to sell equities to invest in the economy or perhaps to put money back into bonds if yields rise to a level where they once again deliver a positive real yield. At some point there has to be an unwinding of the retail-driven short squeeze against a range of old economy stocks. We do not see these as central but, if they do precipitate a bear market in equities rather than a ‘buy the dip’ or a ‘revolve away from growth’ phase, there is a long way to fall.
If bond yields do rise in a sustained way, we would put a marker against both private equity and infrastructure. The latter tends to be priced off bond yields and is of course by nature very long duration; the former uses a highly leveraged model which will become more expensive. In both cases, returns could be below current expectations.
We put a much larger marker against the US$. There are a host of reasons, technical and political, why we think it is likely to have a period of weakness. The political ones are fairly obvious: the gradual ceding to China of the dollar’s status as the world’s reserve currency; its declining status as a safe haven; and concerns over the new Administration’s policy. Add to that the Federal Reserve’s explicit targeting of a higher inflation in the short term and CrossBorder Capital’s data showing capital flows into Europe, and we see a high possibility of US$ weakness.
From an economic perspective we are still trudging uphill, at least in Europe, but at some point in 2021 we expect to breast the top and find a very different investing environment. We suggest that investors should begin thinking how they will react to that.