As the third quarter ended, markets celebrated the sixth consecutive quarter with positive return for US equities. September also marked the first full month of the year with a significant decline in the S&P 500. This is the kind of volatility which are normal when a recovery moves from its initial spike to a more sustainable growth path. As has been the case all this year, we remain fully invested with a very large US bias across both mandates and funds (please see the update below). About a year ago, we had the first significant dip in the current bull market and “prudent voices” grew louder. Still the total return of the S&P 500 was close to 30% year on year to end September. To some, this shows how overvalued the market is. To others it is a reminder that the key lesson of the last 120 years of market history is, that one should remain invested most of the time and only step out when there are specific good reasons for doing so. As a portfolio manager, it almost always feels great to view oneself as prudent and to reduce risk time and time again. Unless there is a good and fast way of reinvesting again, however, feeling prudent can have a substantial cost to investors. This is illustrated in Figure 1, which shows the total returns of a set of equity markets since the “local peak” in 2008.
None of the above will prevent us from reducing risk when market conditions deteriorate sufficiently. According to our analysis and algorithms, however, this is not yet the case. That said, the key events of September and early October are a good example of a development which could potentially justify such a reduction. Policy tightening from the Fed at the ongoing redirection of the Chinese economy and financial markets could potentially spiral out of hand and should both processes go wrong, it would be close to a perfect storm. But we do not expect this to happen. For the time being, what we have seen are two rounds of limited market sell offs. The first leg,
Figure 1: Positive equity market returns before and after the previous US rate hiking cycle.
emanating out of China mainly hit Asia and emerging markets. It was driven by the fear of a collapse in Evergrande and an associated spike in the risk of a collapse of the whole Chinese equity story, taking down larger and smaller Chinese companies and prompting talk of a “Chinese Lehman”. The second leg of volatility emanated from the Fed preparing the market for its coming taper. Having scaled back and closed the credit market emergency programs earlier this year, a “taper” in the form of a reduction in the USD 120 billion monthly bond purchases is the next natural step in the gradual normalisation of monetary policy. And it could go wrong. However, with still very cheap credit funding, a strong demand, top-line growth and solid earnings growth, all reflected in the positive reading of our algorithms, we find it more likely that it will lead to a development as seen after the first Fed hike in December 2015. After an initial correction China, EMU, Emerging Markets and especially the US Market all delivered positive returns. When compared to the current situation, reference can obviously be made to the changes across the world economy and markets since 2015, but we don’t think that the spread of home office, cloud computing and streaming TV, has changed the functioning of the global economy and markets. We therefore expect a gradual transition to growth led by consumption and investments. When companies generate profits, they invest. When consumers see their wealth and income increase, they spend. This cycle is likely to unfold even if the unusually strong demand has now led to an unusually large spike in energy prices. We outline the main risks on the following page, but for now we remain invested. Specifically:
We maintain our 100% equity allocation (40% overweight) in our Systematic Equity Allocation trategy and the associated ACCI SA fund with a US large cap technology and digital exposure. Despite a setback towards the end of September, the strategy ended the quarter with a yearto-date return of 14% and a year-on-year return of 27%.
Across our global fixed income opportunities portfolios, we maintain our short duration high credit risk positioning. Despite a small set back, these strategies are up 2% year-to-date and 7% year-on-year, meaning that the strategy and the associated fund ended the quarter s ahead of the US Agg bond index with more than 4% year-to-date and 7% year-on-year.
In our multi-asset mandates and funds, we retain the full allocation to equities and the enhanced 30% allocation to high yield bonds with duration of around 3 years. These portfolios finished the quarter up 8%-13% year to date and 14%-19% year on year, dependent on risk and base currency.
The nucleus of risk lies in the Fed and the Chinese government
Even if the announcement from the Fed was largely along lines of what was expected, it still helped to push the yield on the US 10-year government bond to above 1.50%. Before we return to the positive long-term outlook, therefore, let us recap on the most immediate dangers to the transition to the sustained and sustainable recovery. Relative to our mid-month update, the risk of a US debt ceiling debacle is reduced and the likelihood of a blow-up of Evergrande taking down Chinese financials has come down. On the other hand, as commodity and energy prices have continued to increase and there is now widespread fear of persistent inflation. Other things can also go wrong which are not listed here but would be captured in our algorithms. For our positions to perform as we expect them to do in this market situation, the main challenges to be addressed —and solved, resolved or forgotten—, are as follows:
A solution to the Evergrande and wider home builder crises together with the provision of sufficient capital and liquidity to prevent a collapse in China’s housing activity before and after any rescue, or managed default plan. China still needs more modern housing even after years of building boom.
Clarity on the policy goals and means of the Chinese government. China needs its own form of capitalism, but a continued and expanding clampdown on corporate activities risk changing the signal from a strategic move to realign the corporate sector and the government, to outright hostility towards capitalism.
Clarity on the gradual nature of the Fed's policy and a very clear plan for a very gradual taper and a cautious move towards any future rate hike. Moving the US 10-year yield up one basis point per week for a couple of years should not kill the recovery, but a move of 100bps in a few weeks would. And as seen many times even moving 25-50bps quickly can be a problem for markets.
The current global recovery is stronger than anyone expected or has seen for decades. Despite the internal logic of higher growth leading to higher inflation, there is a risk of market participants losing their faith in the Fed’s ability to control future inflation. As seen in Figures 2 and 3, this is not yet the case. Looking and the policy initiatives in Europe to keep energy prices down, there is also a risk of populism, fiscal spending and social unrest.
As equity markets across the world are losing some of their positive momentum, there is now a risk that a further decline could unleash self-reinforcing risk reductions and market declines. Since this would mean a tightening of financial conditions, it would represent a risk to the cyclical outlook for the economy. If it were to spill over into wider credit spreads, there is a genuine risk of a reflexive self-reinforcing correction in equity and credit markets.
Growth transition, policy tightening and market reactions
Our modern societies undergo constant changes and much has evolved since the latest hiking cycle, but probably not so much has changed with the way the global economy and financial markets interact. The basic machine remains the same even if, for example, debt levels are higher, the mechanics making consumers and companies face higher costs when interest rates go up are the same. We therefore think that some references to history are warranted. As mentioned, one such historical observation is that markets have tended to go up as long as there is nominal global growth.The traditional counter arguments against the continuous advance in global and US equities are that they have already moved up a lot, that they are very expensive, that earnings growth will soon peak, and that bond yields must normalize. These arguments are all interlinked to some extent, and they are all in line with what we heard in 2003-07 and 2011-16. As we know, at some time they will also look right as markets eventually crash. This is the second of the big lessons, namely that even if markets tend to go up, they do sometimes crash, and such crashes can last years and even decades. But there is a lot to be lost from not taking part in the upside of equity markets every time it might look dangerous, so we continue to revive the arguments. There is no doubt that earnings growth will peak, but this has always been the case in a recovery. Earnings growth typically spikes as the recovery gains traction and subsequently moderation. Normally, earnings growth slows down, and equity markets thereafter move up driven by
Figure 2 Global bond yields. The US 10-year is back above it bottom in 2016.
a combination of abating fear and slower but still positive earnings growth. This then leads to a mid and late cycle increase in multiples, not necessarily to a crash or major correction.
Another risk to equity markets is the level of interest rates. A quick spike to a new level of 2.5% or 3.0% for the US 10-year yield in a few weeks or months would most likely bring both an end to the recovery and the bull market in equities. This is, of course, the very reason that it will not be allowed to happen, if the Fed and other central banks are able to control it —that is to say, unless they lose control of monetary policy by undermining their own credibility. And there is a big difference between a gradual increase and a violent move. In our view, equity markets can easily progress during the former: for example, a weekly increase of 1 bp would still bring a significant increase within two to three years. As shown in Figure 2, the period after the first US rate hike in 2005 shows a cyclical pattern, with the markets following the economy and equity markets. US yields declined into 2016 and were then moving up through 2016 and into 2017. This pattern is very much in line with the real economic development, with the slowdown in growth and the increase in market volatility in the second half of 2015 and early 2016, followed by a cyclical rebound and a boom after the US presidential election. Remembering how strong equity markets were in the periods 2013, 2016, 2017 and early 2018, this graph shows that Equity markets can move up in line with yields, especially if yields are driven up by growth. Given the strong link between wealth creation, equity markets and US consumption, it is possible, and in our opinion very likely, that a stable equity market is a necessary condition if not for the tapering to start, then at least for yields to move up. In a quick turn of events and a further sign of the politization of the Fed as an institution, the left leaning side of the Democrat Party has again taken up its criticism of Powell for not being dovish enough after he dared to argue for the likely start of the taper. We still
Figure 3 US Implied “Break Even” inflation expectations for 5 and 10-years.
expect this to be mainly political positioning and posturing and for Powell to be re-confirmed, particularly in view of the support he enjoys from Yellen, who still holds a lot of sway over the left and also formal power through her position as Treasury Secretary. More dangerous for the recovery could be that inflation does not moderate and that inflation expectations drift out of control. As seen in Figure 3 below, this is not yet the case. Both 5 year and 10-year break evens are back at levels close to 2.5%. Maybe that is where they belong given historic levels and how much central banks have fought for ending deflationary risks. Bearing in mind that this is below current levels and in line with the Fed’s target, it is not yet a reason for concern and a gradual a further move up of say 25-50bps is probably not a threat to long term stability, even though it would generate headlines. But a renewed spike beyond such levels would add to market fear, to the ensuing risk, and to the probability of a market sell off in both bonds and equities.
If a submarine cannot be ESG at least a steel manufacturer can
Recent months have brought new evidence of the direction the world is taking, the conflicts in power politics and how these will develop, and on how far the association with ESG and sustainability will be pushed. Both the EU commission and the British government have declared with great fanfare their intentions to issue significant amounts of ESG bonds for the green transition. Given how government finances work, this can be seen as both a “great idea” and as a “great greenwashing exercise”. The nearer you may be to the line of thought that publicity is needed to save our planet and that the end justifies the means, the more likely you will be to accept the marketing stunt. It should be clear to anyone, however, that all government spending has a substitution effect and given the likely political consequences of building coal fired powerplants, suddenly claiming that investing in wind and sun instead is “ESG investing” resembles a teenager asking for money for not making trouble. In the same way claiming that infrastructure is more ESG than paying pensions or school buildings is a bit twisted as well. Even so, the “green” agenda is likely to be pushed through especially now that investment is needed to secure energy infrastructure in order to prevent the spikes, we are currently seeing in energy prices from getting worse in the future. Some of this is likely to be wind, some will be solar, and some will be other sources, but independently of the use or misuse of the ESG and sustainability labels associated with the bond issues for one project or another, they will be pushing up investments and aggregate demand. We also assume that there is close to global consensus that the current British Prime Minister will “spin” it to the utmost, thereby securing cheap funding (ultimately from the Bank of England). This again will be supportive of growth, through jobs, investment and ultimately consumption. We think that the link to the submarines is reasonably direct. While many people are still somewhat uncomfortable with nuclear energy, they use it in one form or another. We, at least, are increasingly of the opinion that it is better to use modern, safer and smaller reactors than it is to increase reliance on gas from politically questionable regimes and coal powered power plants, thus contaminating the air. The fact that Putin now seems to be less of a friend of Europe than when Merkel started her tenure and decided to continue to rely on Russian gas will only make it more urgent for Germany to gain at least some independence from the current version of Putin. In this context, it is reassuring to see that both the newly formed AUKUS alliance and the Polish steel industry are considering and planning to use modern nuclear technology. This should secure both cheaper, less contaminating and more reliable power supplies, all of which have varying importance in projects as diverse as submarines and power plants. And importantly for the social and governance part of ESG, it has the potential to push decisionmaking power towards the users of energy and thereby increases accountability and supervision while reducing pollution.
Mads N. S. Pedersen, Managing Partner and CIO