Since March 2020 we have consistently held the line that the scale of monetary support from central banks in response to COVID-19 was bound to lead to rising asset prices. In 2021 the authorities have clearly chosen to err on the side of safety in order to assure economic recovery.
As a result, bond yields have been backing up for almost a year now, and over the last few months equities have lost some momentum and seen a shift from growth to value. In our view this is all normal cyclical behaviour at this stage of the cycle. Risk appetite grows and investors sell financial assets to invest in the real economy.
Of course this cycle is not normal: many Western countries have embraced the magic money tree, issuing huge amounts of debt; despite the Federal Reserve’s clearing its throat last week, interest rates are anchored close to zero; and as a result the bond yield curve is under some tension. But market behaviour so far is in line with historic cycles.
The end-May liquidity data from our friends at CrossBorder Capital shows a loss of momentum from its extended levels over the past twelve months. Central bank money issuance is still well above its average level of the past five years, but there is clearly some weakening, with the U.K. and China slowest. The real shift over the past twelve months has come from a massive drop in cross-border money flows. We can only assume the cause is a reduction of trade and investment from a combination of COVID-19, friction with China, and BREXIT.
We have followed CrossBorder’s data for 25 years, and a peak in liquidity growth is a clear signal that the end of this bull market in equities is in sight. That is not to say it is imminent, and it is quite possible that if the economic recovery stalls as new variants extend lockdowns, the authorities will once again turn to the magic money tree. However, unless something like that happens, we are pencilling in a peak in equities for the 4th quarter of 2021 or the beginning of 2022.
The big question for long-term investors will be whether there are more systemic consequences of a bear market in equities. On the positive side, we believe interest rates will remain low because parts of the economy cannot stand more than a token raise. We remember what happened in late 2018 when the Federal Reserve tried to raise interest rates and had to change course abruptly.
Inevitably some companies, particularly those in areas like leisure and travel worst affected by the lockdowns, will find themselves either with a cashflow crisis or unable to maintain debt covenants. If the economic recovery falters, perhaps because the Fed. does indeed raise rates sooner than it is currently threatening, this could happen sooner rather than later.
We suspect the impact of all this on the financial system will be less than (say) 2008/9 or 2018 for several reasons: these companies represent a much smaller part of the index because of the growth of tech, so the headlines will be less dramatic; secondly, there is a mountain of private equity ‘dry powder’ ready to pick up the assets; and thirdly, banks’ role in corporate lending has been partially taken over by private debt funds and they are better capitalised, so there is less systemic danger. Equity, and to a lesser extent debt holders, may well lose out, but financial markets will not be rocked in the way they were in 1990/1, 2002/3, or 2008/9.
What about bonds? Most commentators have been predicting a steep rise in yields because of expected inflation and have been somewhat confounded by the recent declines. We would argue that in an environment of monetary tightening yield curves should flatten. Yes, there probably will be little tightening at the short end, especially in countries such as the U.S. or Australia, but most of the move will come from lower yields at the longer end. And of course, that may in turn have a positive impact on the valuations of quality growth companies.
Finally, over the past five years, as regular readers will recall, we have monitored the availability of high-quality collateral for repo (or reverse repo, as it now seems to be called) lending. The explosion of public debt and consequently collateral assets in the past twelve months seems to have solved that problem, but it is worth noting that repo lending is a critical part of the financial system and any blockages here do have the potential to cause systemic problems.
In summary, we are ready to signal a top in equity markets. However, unless there is another turn or twist over the summer, we do not believe it will turn out to be a very dramatic one. We expect an environment of low or negative returns from equities and bonds. The big change may be that alpha will become much more valuable. Did we say active investment might actually find itself in vogue again?
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