Weekly Market Update - 17/05/2021
The week that was
Volatility was back with a vengeance last week, having been bubbling away for the last month or so - the Nasdaq has been down for each of the last four weeks but last week marked the biggest fall since October for the tech heavy US index. At various points in the last nine months since the Biden election and first vaccine announcements the market has started to digest the impact of a V-shaped recovery and, ultimately, a return to normal. The question is whether that ‘normal’ is the post-GFC normal of the last 10 years (sluggish growth and weak inflation that necessities low interest rates and copious money printing) or something else, potentially a more inflationary ‘normal’ (where those policies might prove disastrous). Increasingly there is a sense that the Fed is acting on the former assumption and markets are starting to worry about the latter. Two weeks ago, jobs numbers that suggested a stuttering recovery actually helped the Fed’s case and markets recovered. Then early last week higher than expected inflation numbers raised a question market over the Fed’s ability to maintain ultra-low interest rates for another 2 years. Within the more inflationary scenarios there is also the question of whether the ‘reflation trade’ lifts all boats or whether an unbalanced recovery with supply chain disruptions and areas of the US economy running extremely hot and other languishing could have a more stagflationary 1970’s feel. Last week the combination of a weaker jobs market and higher potential inflation drew the focus to the latter, less optimistic inflation scenario.
In microcosm this gives a good sense of how the market is likely to react to different inflationary scenarios in the short to medium term and the types of assets you would want to own in some of those scenarios. Suffice to say that companies with pricing power like consumer staples healthcare did quite well while tech (which now includes consumer discretionary as well as IT proved to be very volatile and interest rate sensitive). At some point all of this will be priced in but until the data gets much less noisy, this will probably be the market narrative in the way that ‘risk on/risk off’ became a thing immediately after the GFC. Let’s call it ‘reflation/deflation’ for now.
Later in the week several Fed officials stepped into the breach and sought to reassure markets that the Fed would need several months of inflation before ‘thinking about thinking about raising rates and markets made a partial comeback on Thursday and Friday. That left Asia and the US down by about 2% while Europe ended flat for the week. Similarly global ‘value’ stocks were more or less flat having been down 3% and global growth stocks were down 2.5% having been down 5% mid-week. The Australian stock market ended the week down 1% having followed similar trends at a sector level with tech stocks like AfterPay down by almost 10% and Consumer Staples and Healthcare remaining in positive territory.
The fizzier elements of the reflation trade also came off the boil throughout the week with lumber and corn futures leading the way down by 8 and 12% respectively, while industrial metals were off a few percent and energy prices edged upwards.
As one might expect government bonds also sold off and recovered somewhat but it was a 1% road trip for overseas government bonds and mere 0.5% for Australian government bonds, again indicating that for now tech stocks remain the lightning rod for inflation concerns rather than government bonds with their not so implicit central bank support.
What we'll be watching this week
Last week we enjoyed some extensive conversations with Andrew Hunt of Hunt Economics, and we may have gotten a few inches closer to understanding where the catch in all of this hyperactive monetary policy and government stimulus may lie. Last year Andrew made much ado about what felt like quite esoteric issues in the plumbing of the financial system and recently some of the mainstream financial press like the Economist, Bloomberg, the Financial Times and Wall Street Journal have laboured to shed some light on these issues. They include counterintuitive concepts like banks being fretting over ‘excess deposits’ and a ‘collateral shortage’ of US Treasuries (even though the US is increasing its debt at a record pace). And of course there is the now gigantic and mushrooming Repo markets. We and most in markets are probably guilty of obsessing about the calamities of yesteryear (and especially GFC) but we know the whole point about of the GFC was that few understood the specifics of leverage in the USA mortgage system but that is unlikely to be informative in the next crisis. The issues raised by Andrew seem to us to merit further investigating. When asked where the troubles could appear he said ‘follow the money (leverage), and much of it has ended its up with hedge funds and, even more so, in the hand of private equity. You heard it here early.
This and other observations in the current markets lend themselves to more nuanced scenario analysis - risk on/risk off, inflation/deflation, boom/recession, reflation/deflation and so on. Instead, there are a myriad of inflationary paths, some more positive than others, and things which could go wrong (given unprecedented government/central bank policies and COVID accelerated economics). There is certainly a lot of uncertainty and this makes us think about portfolio construction and manager research in more nuanced ways as well. 'Value’ portfolios look historically cheap given higher weightings in boring sectors like consumer staples and industrials. However, much of the ’cheapness’ also comes from relatively high exposure to energy and financials, where the ‘nuances’ could be quite important. We may, for instance, be asking some more pointed questions about what type of banks a manager owns and their sensitivity to some of the ructions implied by Andrew’s analysis. Another theme which comes to mind is emerging markets and those that remain particularly sensitive to US Dollar funding. And so on.
Lastly, we had a timely question last week about the use of CPI plus objectives. It is true that this can introduce an element of complexity but as Einstein is supposed to have said "Everything should be made as simple as possible, but no simpler". To answer the question, we dusted off an excel chart that it looks like we hadn’t opened in 5 years or so. It is a slightly scary 100-year chart that is now out of date. This week we will be updating that old chary and the narrative around it as we potentially approach an era when outpacing inflation becomes very difficult, but also much more in line with the historical norm than the last 20 years or so.
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