A rising tide lifts all boats. When the tide goes out, you can see who’s been swimming without trunks.
Two cliches, both apt for investors.
The first depicts how most stock, bond, real estate and commodity prices rise when markets are awash in liquidity and underpinned by improving fundamentals. The second, attributed to famed value investor Warren Buffet, warns how quick reversals in monetary policy, or the fundamentals, can leave exposed swimmers high and dry.
After nine months of spectacular market gains and heavy consensus positioning in risk assets, investors are now right to question which way the tide is headed.
For reasons we outline below, it is still hard to argue against the rising tide thesis. But the higher the tide rises, the more it is worth asking, what could precipitate a sudden reversal that could leave investors marooned?
The first reason to believe that equities, commodities and credits will remain supported is US politics. With an acquittal in former president Trump’s impeachment trial a foregone conclusion last week, Democrats in Washington opted for a quick conclusion to the Senate trial. Their motivation was to ‘clear the legislative decks’ for President Biden’s Covid-19 relief package, which totals some $1.9 trillion in new spending. That legislation will be introduced as a reconciliation bill, requiring only a simple majority in the Senate, which the Democrats will be able to deliver.
Accordingly, the US and world economy will very likely receive a further large dose of fiscal stimulus in the first half of 2021. Meanwhile, recent comments from Fed Chairman Jerome Powell suggest that he and the Federal Open Market Committee (FOMC) are satisfied with the US inflation outlook. The Fed surely took comfort from the latest benign consumer price inflation data. Similarly, the Lagarde-led ECB also shows no signs of deviating from its expansionary monetary policy.
Global reflation, therefore, will remain the dominant macroeconomic factor influencing investor decision-making. Although stretched equity and credit fixed income valuations pose a higher threshold for positive earnings surprises, it nevertheless will be difficult for investors to abandon their pro-cyclical stances. At the asset allocation level, there is simply no compelling alternative.
The only genuine choices facing investors today regard which equity factors, regions and sectors to overweight. An improving global outlook favors more cyclical sectors and regions, such as financials, industrials, basic materials and emerging markets. Those growth stocks that increasingly dominate cyclical sectors, such as consumer retail or advertising, are also likely to do well. Defensive sectors, such as utilities or consumer staples, will probably lag.
Still, some real challenges still remain for investors to discern.
First, where does endogenous risk reside? What wheels are being set in motion that could ultimately derail the current happy state of affairs in markets?
Second, what exogenous risks could suddenly arise that would shatter market optimism?
Third, how should portfolios be diversified in order to improve return per unit of risk?
Accelerating inflation is the key endogenous risk. Motivated by campaign pledges, the Biden Administration is ignoring warnings by some fellow Democrats that its Covid-19 relief package may be too large. According to most forecasts, inflation will bottom by the second quarter of this year.
It is important to remember that the pandemic is not a mere demand shock. Combined with disruptive trade wars, the pandemic has impaired supply – along extended global trading routes, as well as in labor markets. Excess aggregate demand may not be as far away as backward-looking output gap estimates suggest. Oil, food and other commodity prices have recently surged. Companies may not absorb rising costs in profit margins.
The pandemic and geo-politics remain the key exogenous risk factors. Viral mutations or unanticipated conflicts in various ‘hot zones’ could dramatically change current optimistic investor expectations for global growth.
Finally, investors face a daunting task of finding assets with uncorrelated and lower volatility returns, given portfolios gorged with equities and credits. Private equity and private credit are often touted as such diversifiers based on historic return premiums for manager skill, but the craze of funds flowing into special purpose acquisition companies (SPACs) – seeking to play in the same space as PE – is worrisome. After all, over-investment typically results in under-performance. Finally, the other ‘alternative’ in hedge funds may not be the answer. On average, their returns have lagged market indices badly for more than a decade.
For those concerned about inflation, crypto currencies might be appealing, but their volatility is not for the faint of heart. Inflation-linked bonds may be a sounder instrument. Yet after a steady rise in market-based expectations of inflation, ‘linkers’ are no longer cheap.
In short, the tide continues to rise, yet there are few diversification ‘life-vests’ available for investors bobbing along the waters of market euphoria.
Swimming against a tide pushed forward by massive policy stimulus seems likely to leave contrarian investors with little to show for their efforts, except depleted resources. For now, the best option may very well be to suit up…but not to go in over your head.
