A recovery into 2021?
To most people Biden is the winner of the US election. The current president, Trump seems less convinced and the multiple reasons he has for choosing this point of view means we should expect the noise to continue. However, for the purpose of this note, the confirmation by both Fox News and by former president George W Bush is sufficient to assume Biden is the new president. For markets, the most important changes could be that things will not change as fast and as extremely as they did during the last 4 years as Biden seeks compromises acceptable to at least the most moderate Republicans.
With the US and Chines recovery moving ahead the major unknown for the world economy and markets has been the intertwined development in the Covid case count and the political reactions to this. Europe is a good example of this. Increased restrictions work well for politicians in terms of voter backing. They work less well for the European economy, where the recovery therefore stalled in September and October. A vaccine seems the easiest way back to a form of normality and the news on the Pfizer vaccine is a significant positive step.
As expected, the Fed and the ECB have confirmed their ongoing support for the global recovery via a continuation of their very substantial quantitative easing and targeted lending policy (QE+). The Fed implements this in a tactical way letting the daily purchases vary with market conditions. This policy is providing a strong boost to the US consumer, not least via declining mortgage rates (see figure 1 on below), which will continue to support consumption into 2021. This provides the Fed yet another clear reason for their implicit and potential explicit interest rate and spread control.
Figure 1: The Fed rate cuts, and Balance Sheet expansion has brought down mortgage rates
The positive effects of QE+ is seen and felt across the financial world not least in the credit market, where we therefore maintain significant positions as we hold on to the shift from high grade bonds to high yield we implemented in our Diversified portfolios in Q2. In the same way as March provided an example of the future risk facing buy and hold investors in high yield and EMD, the recent back up in yields offers a good example of why one cannot rely on treasuries or investment grade bonds to consistently and continuously deliver future return. Figure 4 below offers a historic context to this and our Global Fixed Income Opportunities mandates and fund provides a proposed solution for fixed income investors. We return to the outlook for a continued global recovery into 2021 below. For now, we note that the outlook has improved, our algorithms have turned around and we have again been adding equities and high yield exposure. Specifically:
US and Chinese data show that the cyclical recoveries in these economies are gaining traction. Along with stabilising equity markets and tightening credit spreads, this has led to a turnaround in our algorithms which signal a more positive outlook. We have therefore re-established the more constructive positions we held until a few weeks ago.
In the European mandates and funds, we have moved back to a Positive allocation, holding 50% equities in our European mandates and up to a balanced position of 30% equities in the Welzia Global Flexible fund.
In the ACCI SA fund, we have moved back up from 70% equities to 100%. In the ACCI Global Fixed Income Opportunities fund, from 70% high yield bonds to 100% and, in the ACCI Diversified USD fund, we have increased equities in two steps from 30% to 60%., which we hold along with a 30% allocation to High Yield bonds.
The rationale for our relatively quick allocation moves recently is that if big drawdowns are to be avoided, it is necessary to run the risk of acting a bit early and maybe a bit too often. Algorithms, furthermore, do not act on human pride and biases. When the data change, their signals change independent of previously expressed views.
The US election result is clear to most people, including the US television networks, who consider Biden as the winner. With the confirmation by both Fox News and former president George W Bush that Biden is the new president, this should for all practical purposes be decided. Rather than guessing on what exactly is going on in the Trump camp, we just note that there are a large number of potential career paths, ranging from politics to showbiz, to celebrity show host and property tycoon, for which a lot of noise and denial of a defeat in the election makes sense. So, while it might not be the best for the credibility of the United States of America, it is not unlikely that Trump envisages that a lot of noise is the best for him and his brand, so that is what we should expect to get.
In terms of the future of US politics, the result itself and the lack of any blue or red wave means that when the noise cools down, one of the more practical implications will be a slower pace of change than in the recent 4 years. The reason for this is that the Republicans now look to get at least 50 Senators and Biden therefore will need to seek changes acceptable across the aisle to at least the most moderate Republicans. For markets, this would be a positive development, in particular if it is still possible, as expected, to push through a trillion or more in fiscal stimulus. In a world where politicians behave as though money were free, and markets price money for governments in the same way at least for now, this should not be too complicated a task. Having said that, it is perhaps worth remembering the transition in 2008-09. Back then, markets expected a new plan from the new administration. No such plan was ready when they took over in early 2009 and US equities hit new lows.
Returning to the topic of global growth, the continued recoveries in the US and Chinese were confirmed by strong housing market and investment data, supportive US manufacturing ISM surveys and Chinese PMI readings and months of strong US labour market and employment data, rounded off by a very strong October labour market report supporting the US consumer, whom for decades now has also been the main driver of cyclical swings in final demand globally. In this context it is worth noting that a 4% growth rate in today’s China helps the world economy more than an 8% growth did 20 years ago, simply 3 because the Chinese economy's share of global GDP is more than double what it was 20 years ago. The fact that so many countries and sectors are dependent on demand from the US consumer also offers a key insight into why the Chinese are so focused on strengthening domestic demand. This is reflected both in the current cyclical recovery, in the five-year plans, which were recently renewed, and in the more strategic long-term planning. As the Chinese economy has grown, both the nation and its companies can progressively afford to invest in future green technology. Given the state of the world and the environmental situation in China, prioritising both green technology and green investments makes a lot of sense. So, assuming Biden delivers on his election promises, renewed investments in this area are likely to be on the agenda across the world and in any case both China and the US are now pulling the global recovery forward.
The major unknown factor for the world economy and markets remains the interrelated development in the number of Covid cases and the resulting political reactions. Here Europe is an excellent example. What works for European politicians in terms of voter backing, namely increased restrictions, does not work well for the European economy. A vaccine seems the easiest way back to some form of normality and the positive news on the Pfizer vaccine trials is a very welcome relief. It also explains the relatively better performance of European equities on the day. It does not mean, however, that the European economy is more dynamic or that politics are more inclined to push for unpopular reforms, so while the outperformance of European equities can run for some time, we remain unconvinced that capitalism will have easier conditions in Europe in the near future and we therefore maintain an underweight in the region across funds and mandates.
QE+ and its market implications
For the ECB, caught in the success of its own quantitative easing policy, the path of least resistance continues to be to add QE as stimulus and it therefore seems likely the bank will buy practically the same quantity of government bonds that the EMU governments issue next year. This also means that the ECB is again reduced to adjusting its policy to the changing environment
Figure 2: German and Italian 10-year government bond yields tending down.
and doing the best it can to help the EMU to avoid a split up or the stages leading up to it, namely, declining inflation, widening spreads, persistent recessions and populist political movements. These are all commendable goals, and the ECB is doing as good a job as anyone could have hoped just a few years ago in financing governments and thereby avoiding the ultimate Figure 2: German and Italian 10-year government bond yields tending down. 4 enemy which is deflation and depressions, and which is likely to hit at least part of the EMU in case of a break up or even a free market pricing of government bonds. This result is illustrated in the chart below that shows German and Italian bond spreads. As the spreads widened during the "Euro crises", the first task for keeping the union together was to get the yield on the Italian bonds down to a level where a debt crisis was not a self-fulfilling prophecy, such as when spreads spiral out of control in emerging markets. Then came the consolidation phase and, lately, the low real and nominal growth. This situation made it necessary to implement reforms to the economies across the euro zone while the ECB kept yields low. Or so was the plan, but the reform did not gain much traction and the result has been that the ECB, the supposedly independent central bank, has lost the freedom to set its monetary policy. The fact that Draghi saved the day, and possibly the Union itself, by promising to do whatever it takes leaved the ECB caught in the role as a facilitator of financing for governments, and the banks monetary policy is therefore broadly reduced to a role of quantitative management of the QE. In this role, it can carve out high moral ground by assisting, accelerating, and streamlining the Union's use and issuance of Green Bonds, thus assisting the transition of the regional economy to a more sustainable footing that is highly needed. Apart from such positive side effects, the whole situation is rather tragic in a classical sense: an independent Central Bank ends up holding up the roof of the European world like another Atlas, buying government bonds with its left hand while lending money to banks to buy government bonds with its right hand.
Figure 3: The ACCI Global Fixed Income Opportunities Portfolio
As no one has a better solution to finance debt and budget deficits, it looks as though QE and low yields are also here to stay in the EMU and associated EU countries. Reforms of the EMU to make Europe more business friendly will likely be as slow-moving as at any other time during the last decades and the best way forward seems to be to pair them with the green transformation agenda. The latter is only getting stronger as it is practically the only story Figure 3: The ACCI Global Fixed Income Opportunities Portfolio 5 in town which has both real meaningful content and popular support, possibly along with the vision of educating the labour force to the higher demands of post-industrial society. The market implication of all this QE is the continuation and lock-in of lower government bond yields. Obviously, government bonds will be less useful for investors than they used to be both as generators of yield and total return and also in terms of their use as a "balancing factor" in "balanced portfolios" of multiple asset classes or cross-asset class investing. This is illustrated in figure 3 above, where the dark "Benchmark" line in this case is set as the Bloomberg Barclays US treasury Total Return index.
Figure 4: US Highs Yield and Investment Grade spreads (OAS)
This index had delivered a total return of slightly above 20% since early 2015. However, it can also be seen that US treasuries delivered no return from Q1 2015 to Q4 2018, when Powell made a pivot and restarted the current easing cycle. In the same way, US treasuries have delivered no return since Q2 of this year and the outlook Is not much better for the coming years. Since there are no readily available substitutes and since in multi asset portfolios our proposed solution it to hold more equities and high yield bonds to generate return most of the Specifically we continue to recommend holding more high yield bonds, which the worlds dominating Central Banks can hardly afford to allow to default and which in any case are benefiting from the ongoing QE and the cyclical recovery. To avoid the drawdown during recessions we therefore also need to be more decisive in taking advantage of allocation changes when risk increases. An example is the ACCI GFO fund shown in figure 3, where we currently hold 100% US high yield (the fund was launched in March 2019 and is a continuation of a set of strategies launched in 2015; the figure shows simulated performance before March 2019.) In the same spirit active risk management means that while some drawdowns are avoided, there are also times where, at least after the fact, stepping out of risk may seem unnecessary. We have just been through such a situation: we reduced risk in late October and Early November, when our algorithms signalled increasing uncertainty and the possibility of a larger correction. In most portfolios and mandates, we moved to a balanced allocation (or neutral, as it is called in multi-asset jargon). In one fund which is particularly cautious, we went all the way to Defensive. Since then the strength of the US and Chinese recovery has been confirmed, the corporate earnings rebound has continued, equity market have calmed down and credit spreads have again tightened. These are all mutually reinforcing factors feeding into our algorithms which have again turned around signalling a more stable market outlook and a better risk return outlook. We have therefore moved back to the "Positive" portfolio allocation with maximum allocation to risk across most mandates and funds.
Scenarios for 2021 and beyond
It is easy to construct a negative market scenario from here. It could consist of any given combination of a world where the economic recovery gets stuck while the massive QE leads to inflation. If this happens equities could fall as much as in any other recession and possibly more. As a counterbalance to this, we believe that a positive scenario, which we find more likely, could be constructed around the following assumptions: if despite the headlines, national or international politics don’t get in the way, central banks deliver the necessary liquidity, and the pandemic is brought under control, —as seems to be the case judging by recent test results—, then there should be another global recovery on its way. This would possibly be the last one to be driven by the combination of final demand from the US economy and the mega cycle of declining interest rates. In such a scenario, corporate earnings could reach new highs as companies benefit from increasing nominal demand and from interest rates that will be lower during this recovery than they were during the previous one. At the same time both high yield bonds and equities could reach new highs as markets prices in higher corporate revenues and earnings, possibly based on new (green and ecological) technology. The problem with this scenario is not so much that it sounds too good to be true; so, did ours and any other optimist’s multi-year forecasts when presented at the end of 2002 and 2008. The real challenge is that some of the conditions will always be lacking or about to fail. When this happens it risk starting a reflexive movement so that other conditions deteriorate, and a significant market correction sets in. Additionally, even if things go according to the optimistic picture painted above, imbalances and debt will continue to grow, so when the next recession hits, the correction is likely to be of the same magnitude and duration as in 2001-03 and 2008-09. To protect again the drawdowns associated with such recession while still having a chance of capturing the upside from positive markets we are using our very dynamic allocation methodology. The more QE the more this will be needed in the future.
In the same way as portfolio managers and traders prefer to use optimization systems and programs when they calculate optimal portfolio, hedge ratios, and options pricing, we use a systematic set-up, with a large data set and statistical programming technology to understand how the aggregate financial condition in the world are changing from day to day. Adding these calculations up over time leads to the algorithms you see on the following page. In this context the size of the allocation moves we make in the portfolios, originate from the idea that when we change the allocation in a portfolio it should have an impact the client can benefit from. Reducing an equity position of 50% or 60% down to 55% and 45% and holding this through a recession won`t make enough of a difference to make the journey any more comfortable than holding the original 50% or 60%. But reducing to 30% can make a difference even if it is not done on the exact optimal day. We see it as an attempt at reducing risk when market is so nervous that larger self-reinforcing corrections become likely. This increases the risk of missing out in the short run, but it hopefully also increases the comfort our clients' experience and therefore allows them to be invested over the long run with higher confidence and higher risk allocations when the outlook is attractive. This is not what Milton Freedman taught in Chicago, but it is in line with what we can learn from Kahneman, Schiller and Thaler and we have more confidence in behavioural economics and finance then in the existence of efficient markets. What matters for us is to generate solid return on invested capital by being invested through the while avoiding large drawdowns.
Best regards,
Mads N. S. Pedersen, Managing Partner and CIO
+ 41 765 878 979
Algorithms
Figure A: The Income-DMP 2.0 algorithm
Figure B: The V1 Algorithm
Figure C: The Income TR algorithm
