A review of equity-market returns for 2020 would make enjoyable reading for a buy-and-hold investor. But year-end tallies would clearly fail to tell the full story: within these numbers lives one of the more extraordinary years in market history. Those investors hoping 2021 would prove to be smoother sailing would have been left disappointed by the opening quarter. While we didn’t quite get the fireworks of the first quarter of 2020, there was still plenty to keep investors on their toes.
The government-bond markets were arguably in the driving seat. Safe-haven sovereign-bond yields bottomed in the second half of 2020 and began to steadily move higher, with yield curves steepening. Since the low point in yields, government-bond markets have steadily priced in a sunnier outlook as economies have gradually climbed from their Covid-19 lockdowns.
The move higher in government-bond yields accelerated with the turn of 2021, especially following the result of the Georgia Senate run-off elections in the US. With Democrats completing a clean sweep, and now controlling both the Senate and Congress, market participants began to contemplate the implications of a Biden administration afforded a much freer hand to implement fiscal stimulus – infrastructure investment in particular – on a much larger scale. The shift higher in bond yields accelerated as the quarter progressed, with February seeing the largest moves, by which point the rout in government bonds was truly global.
The fortunes of developed-market government bonds diverged in March. Yields continued to rise in the US alongside a number of other countries, including the UK and Canada. However, in other jurisdictions, notably the eurozone but also in Australia and Japan, bond yields declined. The varying fortunes appear to reflect the action, or inaction, of central banks. The European Central Bank, Bank of Japan and Reserve Bank of Australia all took steps to arrest the rise in yields for the government bonds over which they preside. Many market participants expected the US Federal Reserve (Fed) to follow suit and to take steps to prevent a further rise in US Treasury yields. They were left sorely disappointed. Fed members consistently noted that rising bond yields were reflective of the improving economic outlook, and as such they were to be welcomed. Perhaps the reason many market participants were expecting (hoping?) the Fed would intervene to stem the tide of rising bond yields was the pain being felt by those that were ‘long’ government bonds and growth stocks – a considerable portion of the investor universe.
Since the global financial crisis, investors have crowded into growth equities – those stocks able to grow revenues in a low-growth world. For large parts of 2020, investors pushed this trade further. Many of the companies that had outperformed in the low-growth environment of the post-financial crisis period were online businesses which were largely unscathed from lockdowns and in some cases even benefited. The continued decline of government-bond yields (until the second half of 2020 at which point many were unconvinced they could go meaningfully higher) justified ever higher valuations. The assumption seemed to be that bond yields were going to stay lower forever. However, as global bond yields began to rise at an accelerated pace, the lofty valuations of many growth businesses were subject to the scrutiny of a rising cost of capital.
The debate was lent a greater sense of urgency given the outcome of the Georgia Senate run-off. This looked like a considerable step towards modern monetary theory (MMT) – the monetary financing of fiscal deficits – in the world’s largest economy. Many (we included) have argued that the monetary financing of fiscal deficits is a necessary condition for faster rates of nominal growth and inflation. Should this come to pass, it would have profound implications for the 40-year bull market in bonds, as well as for equity markets.
A cyclical recovery?
Recent months may offer some insight into what these implications are. Equity-market leadership at the sector level was distinctly cyclical over the quarter. Energy, financials, industrials and materials made up four of the top-five performing sectors in the MSCI AC World Index,1 building on emerging leadership over the second half of 2020, while long- duration growth stocks derated.
While many commentators argue that the economy cannot stomach rising yields, equity-market performance over recent months suggests otherwise. Economically sensitive companies have not only outperformed in relative terms, but have delivered sizeable absolute returns. There is little in the equity market to suggest that the back-up in government bond yields is problematic for the economic recovery. Nor did the corporate-bond markets give credence to this idea. Credit spreads continued to tighten, with lower-rated issues outperforming. The message from corporate-bond markets over the quarter was one of declining credit risk. The inference is that economic activity at the global level continues to recover, and with it the nominal incomes from which debt repayments are serviced.
The commodity markets told the same story. Over the course of the quarter, price action was consistent with a continued recovery of economic activity. Economically geared commodity prices continued to advance in tandem with rising government-bond yields and a stronger US dollar until March. Industrial commodities were softer in March, coincident with the accelerated appreciation of the dollar. Given large gains, industrial commodities were overbought and due a period of consolidation. In our view, the March weakness should be seen in this context rather than interpreted as indicative of either rising systemic risk or a deterioration in the outlook for economic activity.
There was one conspicuous development over the quarter that prevents us from sounding the all-clear: the US dollar strengthened in broad-based fashion. As ever, a stronger dollar took its pound of flesh, as emerging-market equities struggled versus their developed peers.
The one area of the credit markets that betrayed some weakness was the high-yield market in Asia. Given this weakness occurred in tandem with rising US Treasury yields, a strengthening US dollar and a market repricing of Fed rate hikes, it is notable, and indicates the beginning of a tightening of financial conditions in the offshore dollar financial system. However, there were a number of idiosyncratic factors that must be considered, and as such we believe it is premature to conclude that weakness in the Asian high-yield market is a symptomatic of a tightening of global dollar liquidity conditions.
The new cold war
Those hoping that a new US administration would lead to a thawing of relations between the US and China have been disappointed. In fact, we have seen quite the opposite, as the Biden administration has upped the ante in short order. In late March, the US, along with the European Union, the UK and Canada, announced sanctions in response to what US officials say is a genocidal campaign against Uyghur Muslims in China’s western reaches. On 12 March, a highly public meeting between the US, India, Japan and Australia, known as the Quad Summit, took place, with the clear ‘topic du jour’ being to begin the process of contesting the scope of China’s sphere of influence within east and south-east Asia. In his first foreign policy address, President Biden identified China as America’s “most serious competitor” and expressed his intention to “confront China’s economic abuses”.2
Criticism has not been contained to matters economic. From Japanese soil, new Secretary of State Antony Blinken openly criticised China’s sweeping use of “coercion and aggression” on the international stage, warning that the US would push back if necessary.3 Blinken has repeatedly referred to Taiwan as a country – a move all but the most uninformed of diplomats know goes way beyond the line of acceptability in Beijing.
It is increasingly clear that the world’s two economic superpowers are now engaged in a cold war. The emerging geopolitical struggle has not been recognised as such officially – cold wars aren’t declared, after all. But the efforts of each country to thwart the interests of the other using all means available without resorting to direct military action certainly fits the bill. At some point in the near future, a US State Department official will state that this is not a new cold war, at which point everyone will know that is exactly what it is and we can be done with the pretence! As German statesman Otto von Bismarck once said: “never believe anything in politics until it has been officially denied”.
On the subject of officialdom, the outlook for monetary and fiscal policy has been an area of focus for market participants. Given the scale of monetary and fiscal easing over the last 12 months, there is concern that any tightening could upset the economic and market apple cart. In this light, as the scale of the Biden administration’s fiscal-stimulus plans emerged, investors began to consider the implications for the US. With the economy already exhibiting strong momentum, households in aggregate flush with cash, and vaccines being rolled out, the promise of an additional US$1.9 trillion in fiscal stimulus prompted market participants to ramp up already elevated expectations for growth and inflation. The International Monetary Fund, for example, forecast that a recovery would leave the US economy only around 1.3% smaller by 2022 than it was projecting prior to the pandemic.4
Against this backdrop, investors began to question whether the Fed would be forced into tightening monetary policy sooner than its own expectations. With the back-up in US Treasury yields, the market began to price in the first Fed rate hike in 2022, as well as debating when tapering of asset purchases would begin. While Fed Chair Powell and other members of the Federal Open Market Committee failed to push back against rising US Treasury yields, they were consistent in pushing back against tightening monetary policy any time soon. Powell acknowledged that a spike in consumer price inflation is probable later in the year but “that the effect on inflation will be neither particularly large nor persistent”. He went on to say that “we have been living in a world of strong disinflationary pressures – around the world really – for a quarter of a century. We don’t think a one-time surge in spending leading to temporary price increases would disrupt that.”5
The Fed has consistently stated that it has no intention of tightening monetary policy, either through rate hikes or tapering of asset purchases, until the economic recovery is firmly entrenched. Furthermore, it has noted that its move to average inflation targeting (AIT) means that an overshooting of inflation relative to its target is desirable and will go towards making up for undershooting its targets in the years following the global financial crisis. Looking ahead, the debate around how the Fed will respond to an inflation overshoot is likely to continue until it plays its hand. Perhaps seeing is believing when it comes to AIT.
Policy tightening has also been the focus of attention with respect to China. Of the major economies, China has recovered most fully from the decline in activity in the first half of 2020. Beijing has indicated that monetary policy will be tightened, with the People’s Bank of China ordering banks to curtail lending. Alongside a number of other headwinds, the prospect of tighter financial conditions has weighed on the Chinese equity market, which has gone from being one of the best-performing markets in 2020 to near the bottom of the pack in the first quarter of this year.
Sentiment wasn’t helped when Premier Li Keqiang announced at the National People’s Congress (NPC) that China was targeting 6% growth for 2021.6 Some consider this to be conservative and indicative of more concerted policy tightening over the year ahead. Having engineered an economic recovery through debt-funded spending in 2020, they expect Beijing to return to its objective of reducing financial risk by reining in debt. Given the scale of the credit expansion in 2020, year-on-year growth will inevitably slow. However, the five-year economic plan unveiled at the NPC outlined proposals to almost double the size of the railway system by 2035 and add 162 airports.7 State support for the economy is still firmly on the agenda, and with growing concerns over Chinese equities being delisted from US exchanges, it is perhaps unsurprising that the five-year economic plan had ‘self-reliance’ at its core.
Is the best already behind us?
Anxieties about policy tightening are giving rise to concerns that the best may be behind us. The tailwind of monetary and fiscal policy will inevitably fade, and many are suggesting that this, alongside a peak in economic momentum, spells more difficult times ahead for risk assets. It is unlikely that equity markets will continue to advance at the same rate at which they have risen from their March 2020 lows. The key question is how markets will react to a continued expansion of economic activity, albeit at a slower rate, with less monetary and fiscal support. While the worst of the Covid-19 crisis appears to have been overcome, investors continue to grapple with a rapidly changing investment landscape. Perhaps the greatest investment risk at this point in time is a lack of imagination.
1 Source: FactSet, 1 April 2021.
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