Our last article on markets and economies, V for Victory, was in mid-May. At that time, with most companies still in the middle of lockdown, although markets had already risen a long way, almost all commentators were sceptical that the economies could recover. We begged to differ: we saw central banks and governments in many parts of the world determined to do what they could. The combination of the biggest year-on-year fiscal boost since Tudor times, the biggest liquidity boost ever and investors’ excessive aversion to risk was in our view bullish for markets.
Two months later, lockdown has ended, the liquidity boost has continued into June and July, we are no longer the only commentators prepared to put money on a V-shaped recovery, and main markets have edged higher. On the less bullish side, gold is above $1800 near to its all-time high and bond yields have continued to fall to all-time lows despite the prospect of vast bond issuance. Admittedly the yield curve is not inverted but it is very flat.
Not for the first time, investors face a conundrum where equity and bond markets are facing in different directions. Normally in such circumstances we go with bonds as having the better predictive ability. However, these are not normal times: the Fed has implicitly guaranteed many investment grade corporates, so they become a safe if low-yielding asset for risk-averse investors; pension funds are continuing down the path of de-risking through liability matching; and the need for ‘safe’ assets to keep repo markets liquid has not gone away. It is therefore hardly a surprise that both index linked gilt real yields and conventional gilt term premia (we think of these as a measure of investors’ willingness or not to take reinvestment risk) are at all-time lows.
Gold is probably easier to read. The consequence of the largest monetary boost for 500 years has eventually to be some form of debasement of fiat money. Even if this is still several years ahead, we can see evidence of a near-term rise in inflation in producer prices today. Gold is an obvious hedge against these risks.
On the other side, listed equities have become the default asset of choice for investors unwilling to risk less transparent private markets. The market has successfully absorbed significant capital raising as companies adjust to a post-COVID-19 world. We view the rise in prices as less related to optimism than to the fact that the famous Fed ‘put’ remains in place to provide a floor for the equity market. Investors feel safer investing there.
So what might happen to markets going forward? We are optimistic about the economy but we accept that there may be further near-term pain, perhaps for longer than expected, before activity returns to previous levels, let alone rises again. We note above the likelihood of a bump in inflation. We also note the tensions surrounding China, both in respect of Hong Kong and trade, and other frictions with the United States.
On the other hand, the monetary environment is as supportive as it was in the aftermath of the Global Financial Crisis and investors remain somewhat underweight equities compared to their five year norm. Data from our friends at CrossBorder Capital at end June gives a reading of -16 (scale -100 to +100) compared to a low in February of -66. We also suspect we will see the return of some blockbuster takeover or merger activity, perhaps even among the largest tech companies. They have reached such a size that it is now the only way for them to sustain their growth trajectory and, by implication, their rating. All in all, therefore, for the time being we remain quite positive about the outlook for equities. While dividend and earnings support has clearly fallen away, ultra-low bond yields provide strong valuation support. If the economic recovery does turn out to be V-shaped, then there may be further fuel to add to the fire. We favour sectors which are exposed to government spending, have cash to spend and, of course, those well-placed after COVID-19.
There are plenty of reasons for bond yields to rise from here: normalisation of term premia, the prospect of inflation and the vast issuance of bonds to come. However, we suspect that low yields may largely remain in place for the time being. Our thinking is that the Federal Reserve’s pledge to buy most investment grade bonds in order to prevent dislocations in the credit and repo markets will keep government yields not far away from zero.
But bond yields, as so often, remain the key indicator to watch. If we are wrong and bond yields do rise significantly, it will remove the valuation support behind equities. The mathematics of discounting means it would have a particular impact on long duration asset classes, such as Growth equities and infrastructure. Could value equities, after so long in the wilderness, once more find themselves in favour?
And gold? Our friends at CrossBorder believe it could rise by a further 50% to well above $2,500. To find out their reasoning, please contact us.