The most talked about topics in markets throughout May and into early June have been the cryptocurrency correction, inflationary pressures, and their effect on the US Fed's monetary policy. We are not cryptocurrency experts, but having our base in Zug, often referred to as "Crypto Valley", we have heard the argument that the Bitcoin and other cryptocurrencies are a safer store of value than traditional currencies like USD or CHF, because crypto is not subject to "money printing" and QE. These arguments were always doubtful and look even less well-founded just after a 50% price decline coinciding with an increasing fear of inflation that played itself out with low liquidity. We are not saying that the bitcoin or other crypto currencies will go away, but we are stating the obvious, that it is difficult to make a case for a store of value which collapses in value at the first hint of concern about inflation.
Possibly a more interesting conclusion from the latest crypto correction is the lack of spill over effects into equities. One reason for this lack of contagion is the still limited market capitalisation in cryptocurrencies; another is that this collapse is only the latest of an already long list of market segments experiencing troubles and negative returns. Apart from cryptocurrencies, this has hit a number of innovative and so-called disruptive companies and sectors with media headlines focussing on declines across smaller companies in tech, pharma and biotech along with, SPACs, Ark ETF and obviously Tesla and other companies with low or no-profit.
Figure 1: Return on US treasuries and the aggregate bonds vs. the ACCI Global Fixed Income Opportunities
The interesting observation linking all of this to US monetary policy is that the sell-off across asset classes already started at the middle of last year in the bond market when the Fed initiated the slow-down of monetary easing. An official tapering has obviously not yet been declared, with regards to the monthly purchases of US government and mortgage bonds. However, such a tapering in fact started when it first went from 750bln of purchases to "unlimited" and then later settled for "only" USD 120bln in monthly purchases. The effects are illustrated in Figure 1, below, with a strong rally in Government bonds continuing until mid-2020, after which both US treasuries and the aggregate US bond asset classes have sold off meaningfully. The situation has eased, and the stress has receded, since the "bond sell-off" rhetoric peaked at the end of first quarter. But renewed labour market strength and higher inflation numbers has brought the topic back into focus. It is therefore worth highlighting that we expect inflation, shown in Figure 3, to peak over the coming quarters and then decline towards the Fed's new symmetric target. With growth expected to decline from its unsustainably high level, but remain strong, we expect slack to be squeezed out of the economy, US government bond yields to resume the upward trend, and the 10-year benchmark yield to move towards 2.5%-3.0% over the next 12-24 months. In this context of continued pressure on government bonds, our Global Fixed Income Opportunity (GFO) strategies and the ACCI Global Fixed Income fund, shown as the blue line in Figure 1, remain invested predominantly in high yield bonds with limited duration, as has indeed been the case during most of the time since May last year.
As for the widely covered topic of a potential bubble in US equities, we note with 495 of the companies in S&P 500 having reported their Q1 2021 figures, earnings are up 50% year on year and as of the latest data released by Refinitiv in early June, revenue growth has been 12.6%. The implication is that market trades on a P/E ratio of above 30 when measured on 2020 earnings, but 22 times when measured on full year 2021 earnings, which are now expected to be up 36% in 2021. Importantly, these figures have not yet been adjusted after the blockbuster Q1 2021 earnings season, so earnings expectations look low for the current growth environment. Solid performance and recent inflows have lifted the aggregate AUM in the three ACCI funds that we manage to USD 181m, a significant step upwards from the USD 100m AUM these funds reached in Q1 of this year. Our total AUM is now above UDS 22m threshold and we would like to take this opportunity to thank our partners and our growing client base for the continued support. Before we return to the discussion of inflation, monetary policy, and the investment outlook, please find a short summery of our positioning below:
In our Systematic Equity Allocation strategy, we maintain a 100% equity allocation (a 40% overweight for those thinking in relative terms). As of early June, the strategy is up 12% year to date, with the ACCI SA fund in the top 90% of its peer group year on year.
In our multi-asset mandates and funds, we have a full allocation to equities (50%-70% depending on restrictions) and an enhanced 30% allocation to high yield bonds with duration of around 3 years. These portfolios are up 5%-8%+ year to date and 20% year on year.
In our Global Fixed Income Opportunities strategies and the associated ACCI funds, we maintain our high yield bond positions and a significant weighting in short duration assets, since we expect continued upwards pressure on bond yields weighing on returns of longer duration bonds. These portfolios are up more than 1% year to date and 8% year on year.
Inflation Fed policy and asset class sell-offs
In its re-interpretation of the inflation target, the Fed still aims for close to 2% inflation, but it now sees this target as symmetrical, meaning that if inflation undershot for a period, the Fed finds that it should also overshoot for a similar period. As seen in Figure 3, the most important inflation number, the so-called core Personal Consumption Expenditure index (Core PCE), has been below 2% most of the time over the last two decades, so for the average to be even close to 2%, the index will have to be above the 2% level for some a significant part of the coming years. Simultaneously to the change in its interpretation of price stability, the Fed has also adopted a broader, more inclusive definition of its goal of promoting growth and full employment, explicitly targeting higher growth for longer in order to help citizens from minority backgrounds and less privileged backgrounds to gain access to and take a foothold in the labour market. In order better to understand what is at stake, we summarise below a few of the key implications of Fed policy for the markets during this last decade:
The Fed does not need to hike rates to tighten. As the FOMC started tapering in 2013, the US bond market tanked and increasing government bond yields delivered a significant tightening of financial conditions supplemented by the sell-off in other asset classes, such as equities and credit.
As seen in Figure 2, it took more than 18 months for the ETF of 7–10-year US government bonds to recover fully after the tapering in 2013.
When actual tightening started the sell-off was even deeper and longer. In the end the Fed, assisted by verbal intervention from the Treasury had to rush through a 180 degrees turnaround in late 2018.
Active fixed income management is not dead, but as the challenges increase, we advise at least the use of both credit risk and duration management if there is a need to create returns above growth and inflation.
This time around, the initial upward movements in government bond yields were easily explained by the end of the acute part of the crisis and an increasingly strong recovery towards the end of 2020 and into 2021. From the autumn and into this year, the later moves coincided with the more and more elaborate changes to the Fed's policy targets, the change of government, and the increasing evidence of a supercharged recovery being engineered. Looking ahead, the drivers of higher yields are likely to be more traditional factors.
Figure 2: The US bond market sell during Fed tapering and tightening vs the GFO strategy drawdowns.
As most people in general have adaptive expectation, recent evidence will have an influence on expectations and the current inflation development is therefore important for expectations: the recent debate about inflation should be seen in this light. As shown in Figure 3, below, the most important inflation index, the so-called US Core Personal Consumption Expenditure (Core PCE), comes in well above expectations and has now moved above 3%, where it last was in the 1990s. According to the Fed and the US treasury, this upward movement is mainly driven by base effects. Furthermore, as there is supposedly no general shortage of resources in the US economy, the number is expected to decline again. There are good intentions and reasonable arguments supporting this expectation of a decline in inflation, but as shown in Figure 4, we have reached a point where the level of inflation priced into inflation linked US government bonds is signalling a risk to the bond market and thereby to debt financing in general.
Figure 3: US Core PCE inflation, the Fed’s preferred inflation number has rebounded forcefully.
This new "inflation threat" is partly a success story for the Fed, because the worst enemy of a central bank is deflation. Still, the Fed also pursues stability and if these inflation expectations increase much further from here to, for example to 3.5-4%, it would be both a sign of a reason for instability. In an example of self-referencing "The market" is therefore nervously watching what "The market" itself is pricing.
However, before becoming too nervous, it is worth remembering two things. First, this is the year of the great rebound. And like so many other things, inflation should also spike in line with the strength of the recovery and after this spike is likely to recede again. Not least because there is no price indexation of wages and transfer of income of the magnitude known from previous periods of persistent inflation. Secondly, while the consequences of persistently high inflation can be as unpleasant as deflation, inflation is far easier to deal with than deflation. All that has to be done is to follow Volker’s example and hike interest rates. Such a policy would run directly against the Fed's perceived and declared priorities, and also those of the new administration. And judging by the rhetoric of the Fed, the Treasury and many Democrats, it is clear that there is a strong desire for the Fed to help
Figure 4: Inflation break even in US government bonds have reached new highs.
normal Americans and what the Fed often describes as monitory groups and people of colour. Still, if we are right in our analysis, the coming years could be as volatile as normal when the Fed prepares to hike, or at least as unproductive for traditional fixed income investing as the period 2016-19. For investors looking for a relatively low volatility area to place their money in a world of zero or negative interest rates, the GFO strategy can therefore be a good alternative; particularly if such investors either have enough equity exposure by other means or if for any reason they do not want any equity exposure at all.
This obviously does not mean that a pension fund or other long term investor using government bonds to balance or off-set ALM risk are advised to invest government bonds in a GFO strategy, but for those institutional investors with such a set-up, the active GFO strategy can either be used in a fixed income total return allocation, a replacement of investment grade bonds which proved very risky in 2020 or a less drawdown prone allocation than High Yield or EMBI investments. In the same way, the GFO strategy and the ACCI GFO fund with its daily liquidity and short duration could be an attractive strategy for the increasing number of investors on the European continent facing negative interest rates.
Multi asset portfolios in the context of strong growth and higher inflation
A recurring theme in markets, linked to the return of both inflation and inflationary expectations, is the run up in US equities and the high price level. This has led both to talk about an outright bubble and what looks like a hankering in the specialised media for European equities to outperform US equities. We note that MSCI EMU have underperformed the S/P 500 by about 60% over the recent 5 years, surely it should be possible to regain a bit of the lost ground. This however does not mean that the profit outlook is necessarily better in the long run and there remains a risk case for Europe to generate a self-made recession once again or underperform in a cyclical slowdown.
Figure 5: Performance of the GFO strategy and US government bonds during the recent 6 years.
Secondly the outperformance consists of only a few percentage points since the beginning of the year, and less if measured in the same currency. What is true though is that Nasdaq have lagged this year, a phenomenon we expect to abate as the post hype correction in Tesla plays out, the associated price correction in the more wishful parts of the green revolution, and the brighter than bright future for biotech, space tech, and innovation technology gets prices out.
This leaves us with the question about equity market bubbles. We look at this in two ways. Firstly, over the last 20 years we have noticed that valuation works far better for marketing than for investing and for economists who typically talk and write, than for multi-asset portfolio managers, who typically manage investments. Not buying equities when price earnings ratios look expensive sounds very reasonable, but it would have prevented buying at the end of both of the two largest recessions in recent decades. Secondly, corrections typically come when credit conditions are tight and getting tighter. This is not currently the case, at least not as it is measured in our algorithms. Thirdly, earnings have grown faster than usual recently. As mentioned, 495 of the companies in the S&P 500 have reported Q1 2021 figures and earnings are up 50% year on year. The market trades on a P/E ratio of above 30 when measured on 2020 earnings, but 22 times when measured on full year 2021 earnings, which are now expected to be up 36% in 2021, driven by a 12.6% growth in revenues. Importantly, these figures have not yet been adjusted after the blockbuster Q1 2021 earnings season when earnings surprises came in at above 20%.
Figure 6: Performance of the SEA strategy vs its 60%/40% equity bond benchmark and vs. global equities
In summary we maintain a full exposure to equities and high yield with the intentionally largest exposure to the US economy and global growth and explicitly recognising that we are benefitting from the support of the US administration in general and most explicitly from the Fed. The risk in the new political context is that the Fed and the Treasury are inadvertently "supporting the rich" and the equity market while pursuing what they themselves describe as a "fair recovery". Still the upside and potential of this policy is based on their own priorities and binding necessities as expressed in the following points:
The Fed under Powell and the Treasury under Yellen prioritise a strong recovery and growth above inflation concerns, not least because of Yellen’s unusually strong economic and monetary policy credentials and her long standing alignment with what is now the policy of many Democrats.
Letting US interest rates move up will hamper recovery and a significant further increase will most likely hurt the very people the Fed and the Treasury wish to help, more than the middle class and the wealthy.
The Fed cannot stay cool and let the risky part of the credit market find its “fair market price” because a transition to such levels is inherently unstable. This makes even the recently announced desire to sell the Feds investment grade bond portfolio an interesting experiment.
The Fed will nevertheless have to work as a tranquilising factor on markets inflation fears. If inflationary expectations increase, the Fed will have to try to talk them down at the same time as ensuring that no one expects the Fed to tighten dramatically.
Since high yield is the gateway to equities, it is likely to prove necessary for the authorities to defend credit and high yield bond prices also in the lead up to the next crisis and to try to prevent those spreads from blowing out to defend broader financial stability.
Mads N. S. Pedersen, Managing Partner and CIO