11 Jul 2021
The difficulties of predicting short-term market moves were highlighted in Q2 with the sharp reversal in style leadership in the market. After many growth orientated strategies had a torrid first quarter in what seems a remarkable turn of events as global growth prospects improve, it was funds utilising this style which topped the leader board in the second quarter. Funds such as FSSA Japan Focus and Baillie Gifford American were top performers in their respective sectors, having been amongst the poorest performers in the first quarter of the year.
Markets entered 2021 looking like they would be torn between the structural disinflationary trends prevalent in the post GFC period and cyclical inflationary forces. Investor belief in secular stagnation was challenged as shorter-term cyclical pressures rose with inflation rates in many developed economies expected to peak during the summer period at 3-4%. The pickup in inflation reflected both base effects as prices of some goods and services had fallen at the nadir of economic activity during Covid-19 and there has also been evidence of supply side pressures. Commodity prices such as copper, lumber, and iron ore have shown significant strength as economies re-opened. In the labour market, despite unemployment figures remaining significantly above pre-Covid-19 levels in most developed economies, certain sectors have seen labour shortages emerge, primarily in construction and re-hire attempts in the hospitality sector.
As economic prospects improved and inflationary pressures rose during the first quarter, market participants became concerned that inflation would not be as transitory as those believing in the ‘goldilocks economy’ scenario had argued. There was also concern that central bank largesse would keep rates low, even if inflationary pressures rose. The concern is that ‘over easy’ monetary policy at a time of rising inflationary pressures can lead to significant problems down the line, as was seen when Paul Volcker was forced to tighten US monetary policy abruptly in the eighties and recessionary conditions followed. If central banks had acted too late, there was a fear that rates would have to rise at a more rapid pace and to higher levels, with negative economic implications, compared to central banks taking the normal course of action to pre-emptively slow runaway economic activity. During the first quarter of the year, the post-vaccine rally in value names continued with bond yields moving up to the 1.77% level at which they peaked back in March.
This reflation trade abruptly turned around during the May and June periods after the Federal Reserve unexpectedly signalled a shift in its stance on inflation. Since then, many commodity prices have tumbled, whilst US government bond yields have declined from over 1.7% to the 1.4-1.45% range after Fed officials reacted to rising inflation data by moving forward their forecasts for when interest rate increases would occur to 2023. Investor positioning had moved to favour assets and individual companies that were expected to benefit from faster inflation. As well as loose monetary policy, the global economy is now seeing policies in the form of combined monetary and fiscal stimulus that have not occurred in tandem in the post-crisis period. The world has moved away from total reliance on monetary policy to revive economic growth and today, whilst it would be too big a step to argue MMT (Modern Monetary Theory) has been truly adopted, certainly at the policy level, we are ‘all Keynesians now’.
The US Federal Reserve had for months been wary of signalling any end to its pandemic response of ultra-loose monetary policy. There hadn’t even been an acknowledgement that discussions would need to start about the ending of bond buying (QE). The Federal Reserve meeting in mid-June indicated that the date when asset purchases would begin to be wound down was sooner than market participants expected. Federal Reserve officials under Chair Jay Powell indicated that there was now an expectation of two rate rises in 2023, with revised economic projections forecasting faster growth and higher inflation this year. Back in March, most Fed officials had predicted current rates would be maintained until at least 2024, but now the Fed consensus, as illustrated in the ‘dot plot’ chart, suggests that initial rate rises will occur in 2023. The Federal Reserve has also become more optimistic on the pace of job creation, arguing that recent near-term weakness was a result of lockdown measures, including extensive and high pandemic support for unemployed workers. Many workers in low paid jobs with few benefits were actually better off staying at home, and whilst pandemic support measures in the US were scheduled to end in September, at least half of the individual States have brought forward the end to pandemic support with, as a result, the latest non-farm payroll figures released on the first Friday of July showing a significant and unexpectedly strong pickup in job creation. Federal Reserve policy, together with that of US Treasury Secretary Janet Yellen and the Biden administration is to increase the US participation rate which is remaining stuck at around the 61% level.
The extent of the economic rebound in 2021 is illustrated with Fed official estimates for (real) GDP now at around the 7% level this year which, combined with forecasts for a core inflation rate of 3%, suggests that US nominal GDP could come in at double digit levels in 2021. At a recent meeting, the Fed also underlined that its asset purchase programme would remain steady at $120bn per month and that any proposed adjustments would be communicated ‘well in advance’. The Fed committed to only raise rates if the economy was at full employment with inflation at 2% and on track to exceed that level for some time. Fed Chair Powell stated that participants were now more comfortable that the economic conditions for future tightening of policy will be met somewhat sooner than previously anticipated. The Fed statement was described as a ‘pivot’ in interest rate policy and reassured investors that the Fed would not risk being ‘behind the curve’ in setting monetary policy and reinforced the rally in bond markets that has occurred since the start of April.
After the concerns of 2020, this year has seen the global economy enjoy a strong but divergent recovery. The chief driver of this has been the varied success of vaccine programmes across different countries. As a result, some parts of the global economy are seeing cyclical inflationary pressures, whilst others are still lagging trend growth rates. In the 21st Century, recessions have rarely been caused by the need for central banks to curb excessive inflationary pressures (in fact the last traditional economic downturn occurred in the year 2000), but by exogenous events such as a Financial Crisis and now a virus. The success of the vaccine programme, combined with the post-crisis unprecedented stimulus measures of both ultra-loose monetary policy and fiscal spending, has seen the world enjoy its strongest recovery from recession since 1945. This is in marked contrast to the decade post the Financial Crisis when the upswing, whilst long lasting, was extremely muted compared to previous cycles.
Another differentiating feature about this recovery is how the emerging world, apart from North Asia, has lagged developed economies due to poor vaccine roll out caused by unaffordability or incompetence, and in some cases a mixture of both. A survey produced by Global Economic Prospects suggests that 94% of high-income countries will regain pre-recession GDP per capita within two years, whilst in the developing world this will only be 40%. It has often been argued that emerging countries have stronger fiscal positions than many in the developed world, but the low levels of government revenue from taxation has meant that their ability to respond with fiscal stimulus has been limited. In many developing countries, government revenues are dependent on oil prices. There has been some recovery this year, but they did suffer a large hit in 2020. The developed world has also been able to implement quantitative easing; fiscal support averaged 17% in high-income countries against 5% in emerging and developing countries. Some smaller countries in the emerging world have even seen an increase in their borrowing costs in contrast to Western nations.
Advanced economies global growth rates are now generally above those in the emerging world. Outside of China, India and some parts of developing Asia, large parts of the emerging world have stagnated economically as the commodity supercycle ended and corruption and poor economic management took its toll. Within the developed world the chief driver of recovery has been the US.
To date, 2021 has not been a year when market volatility has been driven by concerns about a coronavirus second wave, or economic slowdown. The primary driver of volatility this year has been fears of a reduction in global liquidity led by the US Federal Reserve in response to a pickup in inflation. Producer price inflation in China has exceeded 9%, whilst the most recent US inflation prints have shown a rise of 5% for the headline measure, and 3.8% for core inflation. The upward inflationary trend in 2021 has been faster than many expected, but markets have on the whole been relaxed in recent months about this data with a view that this upward inflation pressure is mainly driven by supply side bottlenecks and will prove to be transitory. Therefore, government bond yields peaked in March at around 1.77%, before falling back to the low 140s.
The Fed has continued to reiterate that, until the economy is at full employment and there is actual evidence that both this and inflation are at target levels, monetary policy will remain easy, a reflection of its ‘outcomes based’ policy framework. There is also a view that part of the resurgence in demand is a spill over from the enforced reduction in consumer spending by lockdown measures and therefore economic growth in years to come will revert to lower levels. Labour shortages have been ascribed to the fact that many workers, due to pandemic payments, have remained relatively well-off during periods out of the labour market, certainly compared to previous recessions and this is especially true of the US. The most recent employment numbers in the US with non-farm pay rolls have increased by 850,000 in June and do provide some evidence that, with the end of pandemic payments, job creation will increase. The participation rate remains relatively modest at a little over 61%. Equity market fears of a sharp reversal in monetary policy, with the Fed not reacting until inflation had taken off, was ironically eased by the recent Fed dot plot charts, indicating a majority expect a necessity for two rate rises in 2023.
The second quarter of 2021 saw a resurgence by market participants in the belief of a ‘goldilocks’-like scenario in economic conditions which would be neither too hot to force a rapid ending to benign monetary conditions, nor too cold to cause the economic recovery to falter. Therefore, markets have, as a consensus position, adopted three core hypotheses: durable high (by post GFC standards) global growth, transitory inflation, and ever friendly central banks. Ironically, this has pushed both equity and bond prices higher during Q2, and with the change in global economic policy from the austerity years following the crisis, growth led by the United States, China, and even the European Union, looks likely to remain robust. European growth rates should be close to the 5% level and unemployment is now falling significantly. The overall Eurozone service sector PMI rose to 58.3% in June, its highest level since July 2007. The number of unemployed people in the EU dropped by 382,000 in May, with manufacturer`s hiring at the fastest rate for two decades. The jobless rate has now fallen in Europe from a peak of 7.7% in September of last year to 7.3% but remains above its pre-pandemic level of 6.6%. This again suggests that ECB rates will remain anchored in negative territory for several years to come.
Those arguing the case for transitory inflation have several arguments in their favour. The secular disinflationary forces of the 3D’s remain in place: Debt, Demographics, and Devices (technological change). One of the key drivers of inflationary pressures this year has been supply chain disruption and this should ease as vaccination levels increase. Furthermore, some markets will respond to higher prices by seeing a fall-off in demand; the lumber price has already retreated around 40% from its peak. Copper prices have also come off their highs. Due to the pandemic, businesses have increased their use of technology, which arguably will reinforce disinflationary pressures further ahead with a trend towards automation accelerated.
The world entered the pandemic with a severe debt overhang, and clearly with government support measures for workers, this has worsened significantly. 2020 saw a 37% surge in debt relative to GDP, a record level of increase which was clearly socially necessary, but if the traditional view is upheld that borrowing today reduces growth rates in the future, it suggests that the global economy will be vulnerable to any attempts by governments to de-leverage. In China, credit growth has already slowed and with the country emerging stronger on a relative basis from the pandemic, the authorities there have re-focused on de-leveraging, which explains the dull performance of the Chinese equity market this year despite the pickup in economic growth.
Since 1980, global population growth has dropped dramatically resulting in the average age of the world increasing sharply, especially in the major developed economies of Japan, the US, Europe, and now China. Economic growth is driven by two factors; firstly, growth in the labour force, and secondly, growth in productivity, and both have disappointed over the past decade. Birth rates are positively correlated with investment by both households and businesses and birth rates in the US and China are at record lows, with the latter a result of the long period of the one child policy, which has now permanently altered attitudes to large families in that country. Japan has both a declining and ageing population with a falling birth rate added into the bargain. This has not lifted wage rates in the post-crisis period due to negative real investment effects. Technological developments have reduced the need for labour which has also weighed on the ability of workforces to benefit from tighter domestic labour market conditions (with the exception of China) due to the ability of companies to re-locate (offshoring) on a global basis to take advantage of cheaper wage rates. Despite trade tensions between China and the US, the trend to offshoring jobs is likely to continue and in the service sector, may actually be accelerated by the pandemic as it is now apparent that on the ground presence in an office is not necessary for all types of jobs.
Monetarist economists such as Tim Congdon and Russell Napier have argued that acceleration in M2 will result in higher levels of inflation, but the post-crisis period has seen a continued drop in the velocity of money despite more and more QE in developed economies. There is now evidence that when the money supply increases, but the velocity of money falls, this money is trapped in the financial markets and whilst potentially providing distortions in price levels of financial assets, this has only had a minimal impact on the real economy over longer time periods.
2020 was a year when it became apparent how difficult short-term forecasting is and despite the consensus view being fulfilled of a strengthening economic recovery and continued stimulative monetary policy, markets in 2021 have seen some of the strongest levels of style rotation in the post-crisis period, demonstrating how easy it is for investors to be whipsawed and therefore suffer relative underperformance. This market volatility is not readily apparent at the index level and perhaps a lesson to take from this is the necessity of taking a longer-term view in today’s world as few investors would be able to successfully anticipate these moves and rotate portfolios in a pre-emptive rather than reactive manner. One of the important lessons for experienced investors is that they are undertaking a risk management exercise and therefore at times of uncertainty, making strong market bets can be foolish rather than a demonstration of conviction. Successful active investment management is not always about having a strong view, but rather knowing when to and when not to exercise this. As a result, a policy of stepping back and thinking about longer-term thematic change, combined with economic fundamentals, the valuation opportunities or lack of the same and market sentiment remain as pertinent today as before.
Markets have continued to front run the global economic recovery and have been prepared to look through second or third waves of Covid-19 lockdowns due to the belief that vaccine efficacy will result in eventual economic recovery. As discussed, this is especially true of the developed versus the emerging world where growth rates are now below those of advanced economies, apart from North Asia. Markets continue to focus on the prospects for recovery in the second half of this year and out into 2022 and beyond, encouraged by the step change in economic policy making, combining fiscal support with monetary stimulus.
The world is undoubtedly seeing the most dramatic policy shift that has occurred in the last 30-40 years. In the US, Joe Biden has increased the government’s share of GDP to 25% versus the 20% pre-pandemic level. With the adoption of Keynesian policies, there is a belief in a trickle up rather than trickle down (stimulus via tax cuts) response. Markets have even been unperturbed by potential shifts in taxation and by US standards, the Biden administration is advocating a significant re-distribution of wealth from companies and high earners, favouring those with the greatest propensity to spend. Developed country governments and central banks now all favour higher wages for the lower paid and there has been a sea change in attitudes to fiscal policy away from the belief that government debt levels matter, which ushered in a period of austerity post the Financial Crisis. Whilst modern monetary theory (MMT) has not, as yet, been fully adopted, central banks have altered their thinking towards outcome-based policies rather than being outlook focused, which is very different to what has occurred in the past 30 years.
Markets have remained relatively relaxed after a period of turbulence in February and March, due to the belief that inflationary pressures will be transitory and there are clearly strong arguments both for and against this view. For inflationary pressures to persist, it will be necessary for wages to increase in line with price rises, as this would result in seemingly one-off increases in prices to cascade through the system and permanently raise inflationary expectations; this remains the chief threat to financial market stability today. Unfortunately, as much of current economic policy can be best described as experimental, the precise outcomes must have a significantly lower level of certainty than the continuation of more tried and tested macroeconomic policies. As discussed, forecasting has always been uncertain and the distinct events of the past two quarters, when the driver of equity market outperformance has arguably been solely down to movements in government bond yields, suggests that the most prudent course for investors is to adopt a balanced approach to portfolio construction. Historically, investors would expect value-orientated strategies to perform well when economic growth is accelerating, and whilst this proved true in the latter two months of 2020, post positive vaccine announcements and the first quarter of 2021, cannot explain the underperformance of value in the second quarter of this year. Value has underperformed even as economic growth rates and forecasts of economic profitability have improved.
The importance of stimulatory monetary policy on equity markets is demonstrated by the two largest markets in the Asia Pacific region. China experienced a strong bounce back in growth and avoided a further coronavirus induced lockdown but its equity market underperformed India where, despite a humanitarian tragedy, investors this year have been rewarded with strong gains.
My January outlook piece was called ‘A Year of Living Dangerously’ and for investors depending on relative performance, this has been demonstrated by the strong style rotations this year. After value was in the ascendancy in the first quarter, there was an abrupt reversal in the outperformance of value during the second quarter leading to the title of this outlook ‘The Last Will be First and The First Will be Last’. This intermarket volatility suggests that, for most investors, extreme style views could be costly and the chances of successfully exploiting style rotation in a portfolio is unlikely. Overall, to date in 2021, economic fundamentals have improved, and even in areas such as South Asia where coronavirus numbers have remained persistently high, valuation opportunities and the more favourable demographics suggest that exposure to the consumer story for long-term investors will be profitable.
Market valuations remain above long-term averages, but a combination of a lasting economic recovery and historically low interest rates gives support to equities, especially when no other asset classes offer strong long-term value. June has seen a significant pick up in investor confidence, and when market sentiment is elevated, there is always the potential for sharp setbacks on any adverse news. The influence of the retail investor cannot be discounted and having been on a declining trend in the post WWII period, investment in the post-pandemic era has shown that rising levels of private client market participation can alter the drivers of market performance. This has been much commented on in the US with younger investors favouring stocks showing price momentum and secular growth characteristics. This has also been apparent in Asian markets including India and has helped the outperformance of small caps in that country. This may well be a factor limiting the ability of value stocks to deliver sustained outperformance, with these strategies seemingly dependent on a return to more traditional economic cycles which could yet emerge due to the dramatic policy shift now occurring. Whilst many professional investors like to argue that future returns will depend on stock picking, this has not been the case to date in 2021, where the chief driver of returns has been the ongoing battle between structural disinflationary pressures and a cyclical upturn in the inflation rate. The growth versus value debate will continue to depend on whether the era of secular stagnation highlighted by Laurence Summers has ended or not. Overall, equity markets seem likely to be supported by the continued economic recovery and pro-growth measures, but market leadership is likely to continue to rotate in a volatile manner.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
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