The US was dominating global finance long before the Covid crisis and the situation is clearly not changing to the advantage of the euro-zone. The monetary unions economy is again slowing down while politicians are infighting about how to distribute and use vaccines and closing down boarders. Even though these euro-zone topics are as interesting as they are controversial, they are luckily not yet the primary drivers of either equity prices or bond yields. Since Chinese growth is in the fine-tuning stage of gradual moderation of growth, typical of a post crisis recovery, we will therefore turn to the US. Looking at the data over recent weeks, month, and quarters, it is clear that the US is going through a very strong recovery. In the light of the Fed's communication and US politics, it is also clear, in a broader sense, that this is not enough for the Fed, for the Treasury or for the President and the Democrats in general. We are therefore facing a supercharged recovery, with wide implications for macroeconomics, markets, and the wider world.
A little more than a year ago the Fed saved financial markets in general. Then, repeatedly, it came to the rescue of USD fixed income markets to an extent that on some days it looked as though they were trying to ensure that not a single private equity tycoon or real estate developer would have to sell even his golf-cart second hand. Since the hey-days of firefighting, QE+ and the global recovery have taken care of lifting the riskier parts of markets. This process left many active managers frustrated, while passive portfolios performed well to an extent that the ways people communicated often reminded of why Talab named is most famous book "Fooled by Randomness".
Figure 1: The US Fixed income sell off in Q1 2021 has taken prices of high-grade bonds down:
Our funds and mandates have benefited from the boost in markets and continue to do so into 2021, but something important has changed. The happy market days of 2020 have now been replaced by the fast-changing narrative of the new US administration. As in many recoveries, the first casualty has been longer duration fixed income securities. As illustrated in Figure 1, high yield has held up, while there has been something akin to a blood bath in long duration high grade bonds in general and in government bonds in particular (as the FT puts it, the first quarter had been the worst start for fixed income since 1980). As an example, we show a US 7–10 year ETF. This broad instrument has fallen since August and is down close to 7% since then and close to 4% year to date. Until now a good explanation of why this cannot continue has been that the world cannot afford to see yields go up much further. This is correct, all else being equal, as economists like to say. But what if all else is not equal. What if the positive spirit of the US dream is alive and well. This we will not know for a long time, but something important seems to be going on in the US administration and the world seems to be coming to terms with it only gradually, so please allow us to spell out the obvious. The US administration, from the President, over to the Treasury and the Fed, and all the way to AOC and other left wing or progressive members of the US Congress, want strong growth. A jump above trend is not enough, they are looking for a supercharged recovery.
The final restraint on the fiscal spending boom is going to be the limited majority that the Democrats have in the House and the Senate. But for now, it looks as though the most important institutions are now pursuing stronger growth, all in their own, somewhat coordinated ways, and that every time there is a success in the one area it encourages the other parts of the administration to push ahead. If all the stimulus and easy monetary policy seems to some like a "left wing dream", it is worth remembering that no other than Warren Buffett has repeated again and again that the US economy is a fantastic, wonderful, thing which keeps renewing itself? For the time being, we align with this view. The signals from our algorithms are positive (see the last page of the publication) and we therefore maintain our "Positive" positioning across multi-asset and fixed income portfolios. Specifically, across the strategies, we hold the following positions:
- In our Systematic Equity Allocation strategy, we maintain a 100% equity allocation. This helped us capture the rise in the market through the second half of 2020 and into 2021. This strategy and the aligned fund are now up more than 7% year to date and maintains its US bias partly because this is inherently less risky than betting on a value recovery in Europe.
- In our multi-asset mandates and funds, we maintain a full allocation to equities (50%-60% depending on restrictions) and an enhanced 30% allocation to high yield bonds with duration of around 3 years. These portfolios are up 3-5% year to date.
- In our Global Fixed Income Opportunities strategy, we hold mainly high yield bonds, supplemented with smaller positions in emerging market debt. With duration of slightly more than 3 years, the strategy and the associated fund have avoided most of the duration-induced losses in fixed income markets year to date and are up 0.5% year to date and close to 4% over the last 6 months. We still expect spreads to tighten further as the hunt for yield continues and as cyclical growth pushing up government bonds will also support spreads.
One of the things making the situation so special is that Powell has proven to be one of the most flexible central bank governors in recent history. Having headed the FOMD into what looks like overtightening in 2018, he has now conducted his review with the US public and he has clearly communicated that he is happy to see inflation expectations rise and that the FOMC see bond yields moving up as a sign of success. As always with political choice and policy changes, it is an individual choice whether one agrees or not, but since it is the Fed we had better all accommodate to the situation and try to make sense of the changes, not only as seen in recent months but also as likely to play out over the coming years. It looks to us as though an outstanding environment is being created for active management, not only as a communication discipline, but also in terms of actual investment opportunities. From a more academic point of view, it is also in line with our 30-year-old thinking that the inflation target of the ECB, from the day it was introduced (long before the formation of the ECB), has been too narrow and is a direct constraint on the growth and flexibility of the Euro zone economy.
Figure 2: US house prices inflation year over year is back up and close to record levels
Before we take a closer look at the market implications, it is worth noting that what we have seen the last 9 months, from an economic point of view, is in a sense a "textbook" recovery. A deep recession followed by enormous amounts of fiscal policy and monetary stimulus should be followed by very strong growth. And this is exactly what we see in US job creation, US house price increases and business confidence at record levels. As the balance between an initially strong recovery and a double dip recession is rather fine, there is no need to blame those who initially erred on the side of caution and overdosed the stimulus a bit. However, as we now know, a slightly extra stimulus became a large stimulus, and a pattern has now been forming for months. The recent stimulus bill is therefore best understood as a decisive drive to go all in both on monetary and fiscal policy. The first casualty of this is the supposedly "New Normal", a term popular with marketing economists, but which had a very short life, and which is not coming back anytime soon if Yellen and Powell have things their way.
From a market perspective, the question is if this is now all priced in? We do not believe that this is the case. First of all, markets don’t spend much time at equilibrium, if such a thing even exists outside of classrooms, so the term "priced in" is more useful as a concept than as an actual target or level for prices. Secondly, economists and portfolio managers are stubborn and stick to their views. Thirdly, no-one knows where the stimulus stops, or exactly how it will affect the economy and markets. Yellen has made this clear, with both the most recent and the new 2bln+ stimulus plan (so has Biden, but we do not think that many people in markets care very much what he thinks about economics). On top of the uncertainty about what will be included in the infrastructure plan currently under negotiation, and how the stimulus being rolled out will work, there is also supposedly a new plan on its way and no one know how the stimulus will trickle down and whether it will lead to a fairer and stronger long-term growth.
Figure 3: US 10-year and 5-year break even rates
Until now, however, what is clear is that both US treasuries and USD corporate investment grade credit have lost more than at any similar periods in the last decade and yields are now back at levels seen in the early days of 2020, so from this point of view it is tempting to think they have run far enough. This does not account, however, for the changes to the Fed's view of inflation and its own broader role in society. This role is still changing. Again, at the March meeting, Powell found it appropriate, and possibly necessary, to highlight that the target is not to get inflation to 2% but above this level and to keep it there, but to go beyond for some time. To be precise, the statement reads "With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well anchored at 2 percent".
This is significant for a 10-year bond yielding approximately 1.7%. After the release of the statement, Powell followed up on the press meeting and pointed out that he and his colleagues do not know when these goals will be met. The uncertainty is so large that he advised not to take too seriously the dot-plot with the hiking forecasts of individual FOMC members, whereby the Fed Chairman has signalled that he wants us all to know that the Fed does not know when it will hike.
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