Themes and trends going into 2021
The year 2020 ended on a positive note for markets with equity and sub-investment grade credit moving up and with the US S&P 500 at an all-time high. We have a full allocation to these asset classes across our mandates and funds, which therefore also experienced a solid end to the year and a good start to 2021, with the Systematic Equity allocation strategy and the associated ACCI SA fund moving up 20% during H2 2020. For the time being we are maintaining the maximum allocation to equity and credit across all strategies and expect this decision to be supported by continued global recovery, easy financing conditions and rising corporate earnings and a further compression of high yield and emerging market bond spreads.
We expect that the vaccines being rolled out will have the desired effect of pushing back and helping to eliminate the pandemic. This should pave the way for the continued global recovery. China, which was the first to come out of the recession, continued to lead with a strategic focus on the environment and new technology and with a willingness of the government to step in if there is a lasting lack of demand. The other main driver of the demand side, as so often, will be the US consumer, supported by the positive trend in income and supported by financial asset and real estate prices. The Case-Shiller house price indices are now up more than 7% YoY (see Figure 1 on the following page). This is important because it is a vindication of the positive effect of QE+ on the wider economy, and thereby also lends support to the continued trend towards abandoning the separation of fiscal and monetary policy. With the Democrats having won both chambers of Congress, we expect to see more fiscal support. In Europe, the ECB supports this trend via asset purchases.
The simultaneous decline in mortgage rates and increase in house prices and equities is a global trend leading to exuberance in these markets, in the sense that people are "buying for the upside" rather than "fearing the downside". We expect this trend to continue and note that during a multi-decade technological revolution, as the one we are going through, only time will tell when this exuberance proves to be irrational. This does not mean, of course, that nothing can be done about the risk is creates to portfolios. Both the run up and the collapse in the Tech Bubble and the Housing Bubble are explained well in Robert Schiller's books "Irrational Exuberance". If the next collapse is anything like the previous two, it will come in the form of a self-reinforcing contraction in economic and financial optimism, sending risk premiums up, credit spreads out, and equity prices down deeper and for longer than the pullback we saw in Q1 2020. Timing of such calamities is difficult, but the key factors are well known and coded into our algorithms, which currently point to a likely continued move up in asset prices. With support of the above-mentioned factors and a recovery in the trend in corporate earnings, a traditionally lagging indicator which mainly helps signalling, a bull market can continue like it did in 2016-17. Our positions remain as follows:
In our systematic allocation strategies, we remain fully invested. After shifting some of the allocation to emerging market equities, the associated ACCI SA fund increased 20% over the last 6 months of 2020.
In the multi-asset mandates and funds, we maintain a full allocation to equities of 50%-60%, respectively, dependent on restrictions. In these funds and mandates we also have a 30% allocation to high yield bonds, protecting them from the continued selloffs in duration-driven fixed income products.
In our Global Fixed Income Opportunities Mandates we hold an unchanged allocation of 80% high yield bonds and 20% emerging market debt. In the ACCI GFO fund the allocation is now split between 90% high yield bonds and 5% in each of EMBI and CEMBI bonds. The fund is up 7% over the last 6 months.
The foundation of the recovery:
The global recovery is well on its way and, as always, progress is accompanied with widespread discussion of what has caused it, how sustainable it is, and who is benefiting. All this spills over into political discussion around the world of whom has got too much and who has got too little support and benefit from the recovery and, therefore, where policy adjustments are needed and justified. As mentioned in the introduction, we expect the Chinese to maintain their focus on the broader benefits of a continued recovery to society and the environment. This focus supports the legitimacy of the regime as it addresses the key concerns of the population.
Figure 1: US Home prices are moving up significantly lending support to consumers and wider economy
One can reasonable without much controversy, that the rapid growth of the Chinese population, together with economic progress, has put pressure on natural resources at least for a few centuries as far back as during the Qing dynasty, and probably before. As China has again become a global power and is now a lot wealthier, there is the will, the need and the resources to focus on a more sustainable transformation of the economy. In the US, the debate is likely to be a lot more intense. The recovery that is now in progress coincides with a political transition from a Republican leadership, which was less concerned about the environment and economic equality, to a Democratic leadership much more focused on these topics and one of the most notable features of 2020 was the effect and success of macro political measures. While the details are up for debate, the aggregate intervention from the Fed and the Treasury were more successful than expected by both markets and politicians.
Figure 2: US mortgage bond yield has been pushed down dramatically by the Fed and Treasury’s QE+
Some of the most effective, indirect levers of policy are the asset markets. As seen in Figure 2 on the previous page, US mortgage yields have declined significantly both from 2018 and into 2019 Fed cut rates and on the back of QE+ after rates were cut to zero. This has been a key driver behind the resilience and subsequent recovery, for example, of the US housing market, which is again a strong support for the economy. It is also an indicator of the effectiveness of what we call QE+, meaning traditional QE plus certain other measures and specific assistance to sectors of the economy and financial markets (like MBS and IG and HY bonds). This means there is more to play for in terms of the perceived effects of macro policy (spending). With the Democrats in control of both chambers of the Congress, there it is now time to decide where to put in the effort in terms of spending. Without much agreement inside the Democratic party of whom secured the victory, we should expect numerous continued claims on additional direct and indirect government support for constituencies and interest groups. As there is a feeling that what has been done in terms of monetary policy and fiscal stimulus had largely positive effects. Especially since there is a growing consensus that all the money spent has come at a low or even close to zero cost.
Figure 3: 2-year and 10-year US treasury bond levels
Whether this is true or not is less important than the straightforward consideration that if the effects have been larger and the costs smaller than expected, then there is greater reason for everyone to demand the support or bail out of their own favourite cause, sector, or constituency. With Yellen at the Treasury and a relatively liberal, albeit declared Republican, Powell, at the Fed, we are likely to see a return to the policy toolbox, not only to deliver on the immediate agenda of election promises and additions to the current stimulus plan but also, as and when economically and politically needed during the coming months. And also in the event that the economy slows down. Active fiscal policy is here to stay, at least if yields can be kept under control. We think they can, but as shown in Figure 3 on the following page, the cyclical recovery and the expected additional fiscal stimulus are reflected in the US government bond market, where the 2-year yield remains low while the 10- year yield has shot up above one percent. This move is small enough, however, to minimise the effect on financing costs in the US. And as explained in previous editions of this publication, we expect that the Treasury under Yellen, in collaboration with the Fed, will keep rates within a range in which they do not interfere with the Democratic political agenda. A situation similar to that which we see, in the Euro zone, where "the ECB policy" seem to have be developing into a "ECB guarantee" (of rate controls) opening up for continued bail outs. For now, this is from Covid, but tightening macro policy does not seem to be on the agenda in a serious way in any of the larger economies in the foreseeable future. The interesting part of the action is therefore in the fixed income market. And as the ECB seems to control European rates tightly, more specifically in the US where the move up in yields illustrated by the US 10-year yield moving above 1% in figure 3, means that US government bonds have delivered negative return since June of last year.
In Figure 4 and 5, we replicate the key features of Figure 1 from last month’s edition, but this time showing the data until the end of the first week of January. We have set the reference as the full US bond market in the form of the iShares ETF of the Bloomberg Barclays US Aggregate. The purpose is to highlight that since the most exceptional time of the recent monetary easing ended about 6 months ago, aggregate US bonds have delivered a negative return. Figure 4 shows how this is nothing different from when Yellen was chair of the FOMC. Figure 5 shows the recent situation close up. The prospects for long duration high grade bonds, which dominate this index have only gotten worse as the Democrats won first the presidential election and then the House of Representatives, then appointed Yellen as Treasury Secretary, and finally won the Senate, even if this is by the smallest margin.
Figure 4: Total return of the GFO Strategy vs. the US bonds market represented with the US Agg index (ETF)
For almost 40 years since Volker squeezed inflation out of the system, returns in long duration government bonds, investment grade credit and the like were somewhere between good and great depending on risk preferences. If one supplemented such a portfolio with a bit of US high yield bonds and EMD over the last decade or two, the returns were even better, both outright and risk adjusted. This was exactly the background for our introduction of a Global Credit Opportunities portfolio at our previous employer in the summer of 2015. After the 2018-20 move down in yields the only thing which can save the real inflation-adjusted returns of such relatively static portfolios is if yields stay stable with a small drift down or if inflation goes completely away. To see this as unrealistic is not a forecast, it is simply to not bet against the Fed, for the simple reason that the Feds declared goal is to get inflation permanently back and to reach this goal they have as their boss the most dedicated liberal and socially conscious of the former FOMC Chairs, Yellen. To overcome these challenges the Global Fixed Income Strategy will be moving between "Positive", "Balanced" and "Defensive" as the market risk and environment change. This is illustrated by the grey bars in Figure 4 and figure 5 (where there is only a small dip down to a "Balanced" risk level in early November). If we want to be "out of risk" during the worst market conditions and at the same time achieve a positive return of cash + 4%-5% going forward, we need to be holding sub-investment grade bonds for most of the time, and primarily entering the market for these "risky bonds" in the earlier parts of any recovery and holding until the outlook deteriorates ahead of a recession. In the same way we will need to step out of the market before it collapses.
Figure 5: Total return of the GFO Strategy vs. the US bond market represented with the US Agg bond index (ETF)
This means that we will sometimes step out before it is necessary, thereby missing out on performance; but it will also mean that we will have the chance of achieving the goal of smaller drawdowns than both high yield and investment grade credit. We obviously cannot guarantee that we have the winning formula for such an unprecedented environment, but we have a
Figure 6: Total return of the Systematic Equity Allocation Strategy vs 60/40 equity / bonds and MSCI World
process for generating returns by changing asset allocations when the market environment changes and we think there is a better than average chance that the environment will be mainly positive for credit risk, until it finally changes, and it becomes necessary to get out more or less completely. Looking across our multi asset strategies, we remain fully invested at the highest risk level, which means that each fund and mandate that we manage is positioned in its respective "Positive" portfolio. For both the Diversified strategy and the Systematic Equity Allocation Portfolio, this means that we had a full round of risk reduction and re-entry into the market in March and May-June, respectively, of last year. We also had a very brief risk reduction from "Positive" to "Balanced" in the days around the US presidential election. The latter led to a loss of returns coinciding with positive news about vaccine results.
Figure 7: Total return of the Diversified Strategy
The Systematic Allocation Strategy, with its movements between zero and 100% equities, gained approximately 20% in the second half of the year. The former move contributed to a significant reduction in risk just as the global economy and financial markets collided and, in that way, delivered significant investor utility in terms of reduced correlations to other assets and reduced stress. Looking ahead, we maintain that the next global recession is likely to be much worse for risky assets and may therefore be expected to be more rewarding for active allocation strategies than in 2020, in both an absolute and relative sense, in spite of the good intentions of central banks and treasury departments around the world.
Our Diversified strategy, which moves from zero to 60% equities and holds up to 30% sub-investment grade bonds at the highest risk level, followed a similar allocation pattern to the SEA strategy. The strategy and the associated ACCI DMP Diversified funds were up by a little more than 12% in the last two quarters of the year. Measured from the time when the first of our Dynamic Allocation strategies were launched, back in the middle of 2015, under a larger wealth management institution, the strategy is significantly ahead of its Balance benchmark. As mentioned in the introduction we remain fully invested in Equities and sub-investment grade bonds: we hold 60% equities and 30% high yield in this strategy. As seen on the following page this is supported by our algorithms which are well into positive territory. The latest positive contributions come from market trends and the increasingly positive earnings momentum.
Mads N. S. Pedersen
Managing Partner and CIO
Switzerland, 10th of January 2021
+ 41 765 878 979