Cyclical strength and the risk from the Fed, ECB, and China
The equity market recovery throughout October was even stronger than the decline in September. US equities continued up in early November, setting consecutive all-time highs. As we have held on to our US overweight and maximum equity and high yield weightings across our strategies, our mandates and funds have performed strongly. A full year has now passed since we established these weightings, moving from 60% to 100% equities in our Systematic Equity Allocation strategies and from 30% equities to 60% (and in some cases to the maximum 50% equities) in our Diversified strategies. As of early November, these strategies are up respectively 35% and 21% year on year and 18% and 14% year to date, with the exception of our Euro based strategies where the open Euro position of 20%-30% means returns are several percentage points higher.
The strength of markets are increasingly worrying commentators. In some cases, due to valuation and in other cases because they long ago reduced risk (or recommended reducing risk) and some because they have a different reading of the situation or a different process from ours. We are less worried and more alert, meaning that in our view, the strength in markets is as unusual or surprising as the strength in our algorithms. On average we implement 3-4 changes a year. Last time we had no change for a full 12 months was when we captured the recovery from mid 2016 and into and through 2017. A conceptual understanding of what is happening is that those who focus on one single driver of markets, such as valuation (P/E or other measures), will be well positioned when bubbles burst. They will also appear to be prudent, but they will often miss the big leaps forward due to technology, productivity, and changes in monetary regimes (and by mankind in general).
Figure 1. Financial market condition algorithm.
Our algorithms are designed to deliver a broader assessment of financial conditions, business cycle dynamics, greed and fear, risk aversion and corporate earnings. We only change positions when we see a compelling combination of reasons to reduce risk. This year, the strength in our readings has been driven mainly by corporate earnings. Recently, a more dynamic development of the market and an improving business cycle have taken over as the main drivers of a strengthened signal.
None of the above will prevent us from reducing risk when market conditions deteriorate sufficiently and none of it will prevent us from being concerned and analyzing what is likely to happen next in the markets. On the following pages we return to the risks building up in relation to China, the Fed and the ECB, all amplified by the developments in the otherwise very much needed field of sustainable investing. Since 2014, when we co-authored “Allocating for Impact”, an early stage contribution to the debate where we are giving examples of how to achieve desired Impact outcomes without suffering declines in expected returns, the area of ESG and SRI investing has become fuel for growth and investment to the same extent as BRIC’s used to be a decade ago. Independently of preoccupation with the boom in the use of the ESG acronym, or the share price of Tesla, this cycle is likely to unfold even though the unusually strong demand has now led to an unusually large spike in energy prices and in broader definitions of inflation (and possibly the early signs of the death of the Modern Monetary Theory). We outline the main risks to market on the following page, but for the time being we remain invested. Specifically:
We maintain a 100% equity allocation (40% overweight) in our Systematic Equity Allocation strategy and the associated ACCI SA fund with a US large cap technology and digital exposure. We note that our small cap position has rebounded and helped lift returns to 18% year to date and 27% year on year. Our unhedged Euro strategy is meanwhile up 31% year to date and 35% year on year.
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 5% year on year. We have reduced the allocation to emerging market bonds from 10% to 5% in the ACCI GFO fund investing the proceed from a same of emerging market government bonds into USD “Fallen Angle” high yield.
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 are now up between 12% and 15% year to date and closer to 20% year on year. We still see very little reason to add either emerging market or European equities to these portfolios and thus we maintain very small allocations to these regions both in our USD denominated and Euro denominated portfolios.
The increasing risks relating to China, the Fed and the ECB
As we often highlight the core risks lie, with the Fed and the Chinese government. Still more has been added to these risks. One the one hand, the White House has initiated uncertainty by inviting competing candidates to meetings or “interviews” about their potential role in the event of their leading the Fed. This is a typical way of demonstrating the thoroughness of corporate or political scrutiny and it might please some of the more left leaning or “liberal” parts of the Democratic Party. But it is not necessarily a very wise use of the scarce resources of monetary policy credibility that the Fed has. Independently of the degree of sympathy for the new mandate that the Fed has designed for itself, it is clear that such action creates uncertainty because it is far from explicit or clear and it has not been tested in practice (how could it be, when it is a long-term average of a not very fully specified inflation level?).
Additional risk is created by the fact that independently of what the exact inflation target is, it is clearly well below the current level of inflation. And to make the credibility situation even worse, the current level of inflation is clearly well above what the Fed had expected it to be when they put together their new mandate and when they published their inflation expectations in the course of last year. If we had been living in the old-fashioned world of monetary policy, this would provide an argument for sensibly looking for a way for the Fed to renew the credibility of the mandate. The Biden administration is not doing that by interviewing a potential candidate at a time when the term of the current head of the Fed could be extended. Through no fault of Brainard, of course, who is in many ways a well-qualified candidate, although if anything more dovish than Powell. These
Figure 2 US House price growth is at levels above the most recent bubble.
circumstances could lead to a lower Fed fund rate for a longer period, thus providing support to the market. In our opinion, however, there can be too much of a good thing. The world probably doesn’t need more monetary stimulus, and less so financial markets. As of today, the signal from the Fed that in the coming months there will be no hikes but only tapering is already playing with the dual fires of financial stability and irrational exuberance, in everything from liquid markets to private equity, infrastructure, and the whole green transition. As with all good ideas, the green transition will also end in financial trouble if it is implemented or rolled out without considering capital costs. Such things as enthusiasm, consensus agreements and good intentions, for all the sympathy that they may arouse, are also the ingredients that bubbles are made of. This leads us to the tempting and simple idea that the reason inflation is high might be that growth is so high, and so much higher than expected. This is not the view of the consensus, or of the Fed or the ECB. It is again worth remembering that consensus did not expect inflation at the current levels, nor did we, or the Fed, or the ECB. So, from a risk management perspective, it would be unwise to construct or manage portfolios with a lot of conviction that inflation will certainly come down soon. All of that said, we do expect a moderation in US CPI down to 2.5%-3% in the coming 12-24 months. This will not be because of words or actions taking by the populistic part of the US administration, but simply because growth cools down.
As for the ECB, there are two additional sources of significant risk. One is that the current head of the ECB said last year that is not the job of the ECB to close spreads. This was not a very smart statement as the core of the job is now reduced to keeping these spreads in. Slightly twisting an old Greenspan quip, in order to restore credibility, it would seem to be a good idea to keep anyone who makes such statements away from the punch
Figure 3. Bonds yields should normalize, but a new balance has to be found that Italy can afford.
bowl and away from the microphone. And such credibility will be needed in the early part of 2022, when the ECB will have to replace the current pandemic bond buying program with new “formulations”, reasons, and additional billions of euros, precisely to keep these spreads tight. In simple terms, the European recovery is dependent on three things, the return of optimism, continued export pull and tight spreads. For now, no-one seems to want to bet against the peripheral spreads while the ECB is buying seemingly unlimited amounts. In a like manner, there is no fundamental economic reason to expect that any investor would of free will want to hold any Italian government bonds if the ECB steps aside. This has its own internal logic, beautiful or ugly, depending on political leaning. This is exactly the reason the ECB will not step aside. It is still a risky balancing act, particularly when the head of the ECB keeps challenging destiny with unwise statements and claiming that the ECB knows better than the markets. There well may be a sincere wish to be right and to know better, but history shows a poor track record in predicting required action and more than once the overconfident ECB has erred, even in the face of severe crises.
Turning briefly to China, the situation with Evergrande and the entire construction sector is still a long way from being solved and market stress seems to be spreading very gradually through the credit sector. We expect this to be contained, but the fact that the Chinese President is not travelling abroad speaks volumes about the increasing priority placed on domestic issues, including a risk of the need for scapegoats. This leads to an increasing lack of clarity on the policy goals and measures of the Chinese government and an increasing risk of a further step towards prioritizing political and domestic stability over long term growth. From a few hundred years of history, and from more recent developments in both China and neighbouring countries, we know what kind of policies that the priority of national interest and domestic stability can lead to, and it is not always in the best interest of global peace and prosperity, let alone the general long-term welfare of the domestic population at large. As a final note we have with interest seen the list of conclusions and priorities released from the gathering of the Chinese leaders and the declarations that China, has reached a new “historic starting point” based on Xi`s. “original ideas” and “transformative practices”. This is the formulation taken from Bloomberg as reported by had led China into a new era, Wang Xiaohui, executive vice propaganda minister. There is little doubt that this represents a strengthening of power of the Chinese president. Our hope is that more actual power will mean less need to demonstrate that power, but for now that is not a given. To us the most encouraging part is the formulation of the need for a priority on hard work and entrepreneurship. But what this means, only time can tell.
In summary, and well aware that we are as repetitive as the year has been in terms of risk and return, we remain fully invested and encourage everyone to stay alert and well prepared for the next severe crisis. We don’t expect this in the next one to two years, but we also know that often we don’t get the timing right on such long horizons.
Best regards,
Mads N. S. Pedersen, Managing Partner and CIO