Risk premium repression
In 2021 the pandemic should be over, Trump will be gone and Brexit done. But one thing will still be with us and that is the overwhelming influence of monetary policy over financial markets. As long as rates remain very low and real yields remain negative, risky assets will deliver, and markets will bounce back from any news related dips. Income flows from bonds will be paltry so equities will remain dominant. Investors have been squeezed out of risk-free assets and the demand for securing access to the only cash-flow that can grow – corporate earnings – will underpin strong equity performance. For many that won’t compute. For me it remains the core view until there is any evidence that central banks are willing to let risk-free premiums rise again.
Back on the road
This is very likely to be my final blog of the year. With impeccable timing, I am moving house next week and so will be largely off the grid. In a very 2020 way, the house that myself and family are moving to (or to be exact, apartment) is not ready and is not likely to be so until the end of January (COVID-19 delays!). So, I will be nomadic for a few weeks. From spending a large part of the year confined to home I will have no home to be stuck in. It’s actually quite liberating, especially as I am lucky enough to be spending the first part of this nomadic period on the beautiful island of Mallorca (social distancing of course). My next few notes will be written from there. Salud!
Is it wrong?
Throughout the last ten months the comment I have heard the most is that risky assets are overvalued relative to the fundamentals. I struggle with that. First, I struggle with the idea that there is an equilibrium valuation for every set of fundamental circumstances. Second, I struggle with the idea that collectively investors know what that is. Third, the notion that markets are rational and price in all available information does not hold when we consider that not everyone knows all the available information, that individual actors process the information differently and that the information changes all the time. Fourth, all of this is time varying. The information about what lies ahead in the next three months could be quite different to the information or expectations people have about what the world is likely to be like in a years’ time. How can today’s pricing equate to both? Fifth, if valuations are inconsistent with the fundamentals and everyone knows that, then rational expectations do not work because there must be some other force distorting the system.
My own view is perhaps a variant on that last point. Markets are at these levels even though everyone in the world can see economic problems today (lockdowns, unemployment, businesses closing) and uncertainties and challenges ahead (economic scarring, debt, changed consumer and corporate behaviour). The key is that risk premiums have been squashed. The risk-free rate is close to zero and in real terms is -1% in the US. That is the result of quantitative easing and interest rate policies that have challenged the effective lower bound. If the risk-free rate is the foundation for valuing all other financial assets then when it is repressed, the risk-premiums on other assets are repressed. Private investors have been crowded out of risk-free assets (government bonds) and have been forced to take on more risk as a result. Thus, investment grade credit spreads have been brought down to almost pre-COVID-19 levels. High yield spreads are not far behind. Equity yields have been reduced as the multiple attached to future earnings has increased. You can only get real long-term growth in income from equities when bond yields are so low and the demand for that earnings stream has increased, pushing up equity prices. Even bombed out assets are coming back, now that the left-tail of credit events has been cut off by central banks and the path to increased activity in travel, hospitality, retail and real estate has been partially cleared by the vaccine news.
Little change of things changing
So, the biggest risk to markets going forward is not necessarily weaker growth or disappointment on the efficacy of and take-up rates of the vaccine – although these would be negative forces – but it would be the readjustment to higher risk premiums. Higher risk premiums would come from central banks backing away from financial repression. Are they going to? No, it is very unlikely that they do in the year ahead. The stance of the major central banks is well known. No rate hikes. Limited reversal of balance sheet policies. The continued provision of liquidity facilities. If the economy gets bad, the central banks will just turn the taps on again. Inflation moving high enough to cause a significant change in monetary policy is very unlikely in the next few years. Moreover, given where government debt levels are, why would central banks want to let bond yields rise? Amongst policy makers there is broad consensus that fiscal policy has to be used to support the economic recovery and central bankers will do their best to keep borrowing costs down. The 10-year Portuguese government bond yield turned negative this week. What more evidence do we need about repressed risk-premiums and the willingness of the global investment community to adapt to that world.
Buy the dips – there will be some
On balance I see nothing else but for credit and equity to continue to perform well. I juggled with the idea that credit spreads might test pre-global financial crisis levels in the note last week. I am getting even more convinced that this could be one of the key surprises of 2021. That means decent returns from high yield and emerging market debt. Investors are still searching for yield. Of course, risky assets are volatile and there are periods when prices will weaken – by a lot and quite quickly under certain circumstances. But as long as the central banks are there with zero rates and “unlimited” purchasing power, the strategy should be to buy the dips (the spikes in yield). If we do get the realisation of pent-up demand being spent and more fiscal spending, equity markets should respond to the improved growth prospects. It will be interesting if we hear then that markets are overvalued relative to fundamentals with more than 5% global GDP growth.
The themes that will determine the narrative in 2021 are fairly obvious, yet we don’t know quite how they play out yet. The US has to get through the drama of the transition and see Donald Trump leave the White House and then to see what policy initiatives the Biden Administration can act on quickly. The central view is that any stimulus package being discussed right now in Washington will be followed by a bigger one next year, with a broader range of ambitions – many of them climate change related. In the European Area, it’s a similar picture with the enactment of the multi-year budget process and the ability of countries to access the Next Generation fund. All of this adds up to fiscal stimulus – although not quite as high-powered as in the US. The UK narrative will be how the deal or no-deal plays out for the UK economy and whether the Johnson government can start on a path of fiscal retrenchment. I doubt it personally given domestic politics and the need for the Conservatives to retain the goodwill they were given at last December’s election. Buying UK assets could be one of the trades of next year if the uncertainty is lifted but there is the danger of a value trap if it turns out that the new arrangement is, at the margin, worse for the UK than what would have been the case if it had remained in the EU.
If there are regional differences to focus on it is likely that US yields will rise more than European government bond yields. Economists are more bearish on the growth outlook for Europe given that fiscal policy will be less effective. That means it takes longer for Europe to close its output gap. This in turn means it will be harder for European inflation to pick-up and for markets to start anticipating some future change in monetary policy. However, without the Fed tightening before 2023 I struggle to see the US Treasury – Bund 10-year yield gap reaching the 280 basis points it got to in 2018. For equity markets I suspect it will be the other way around with the US outperforming on growth grounds. Asia might be a better play for both equities and fixed income given stronger growth, less scarring from the pandemic and higher yields.
Finally, for investors, sustainability will dominate as a theme. Diversity & Inclusion is an increasingly important discussion in all walks of life and investors have to increasingly discern which companies score well and which don’t on these issues. The environment will be put into further focus in the months ahead of the COP26 gathering in Glasgow. Beyond ESG scoring, asset managers will increasingly have to demonstrate how they are shaping investment portfolios that are consistent with net zero ambitions through re-allocation, engagement, best-in-class selection and allocations to new low carbon technologies. After the pandemic and with the ongoing rise in carbon emissions, the search for alpha can only be viewed through the prism of what is good for people and what is good for the planet. Investors can make a real difference as a result and there could be cleaner times ahead for our children and their children. But we are only at the start of the journey and there are arguments that still need to be won, particularly in terms of the a priori assumption one needs to have that a sustainable approach to investing will deliver better long-term returns.
It’s harder to be a football manager than a fund manager. A 51/49 winning ratio is not good enough in sport. Bad single decisions have potentially huge competitive, financial and reputational implications. I fear that Ole Gunnar Solskjaer made one of those mistakes in Leipzig this week. He set the team in the wrong formation, one that the defence was clearly not comfortable with, and within 15 minutes his Manchester United team were losing 2-0. A giveaway goal in the second half preceded a spirited attempt to get back to evens and save Champions League participation. To no avail. The final score of a 3-2 defeat leaves United facing a Europa League campaign. More importantly, it has put the development of the team back. Fund managers can rely on diversification and markets providing opportunities to claw back performance. Football clubs often have to take more mercenary decisions. I’m not sure Ole will still be in his job by the time I am in my new apartment.
Finally, well done everyone for getting through 2020. And thanks to all your good wishes during what has been a difficult year for me, especially during the period when my wife faced a major health issue. While we have not been able to meet in person and there have been very few lunches, dinners and after work drinks, I am comforted by the thought that the industry that has been my adult life is still one characterised by immense respect and mutual support. We all are responsible for helping our clients achieve their life ambitions and as colleagues – even as competitors – it takes a lot to shake us from that mission. Stay safe and have a fantastic holiday season!