Last week witnessed the return of the ‘reflation’ trade in financial markets, with global bond yields challenging twelve-month highs and rotation into more cyclical sectors underpinning equity market gains. Gold spluttered against the backdrop of higher yields and a stronger US dollar, while cryptocurrencies such as Bitcoin advanced. Other commodity prices were mixed. Emerging currencies were mostly weaker ahead of central bank meetings this coming week in Brazil and Turkey, where investors expect to see the first interest rate hikes of this cycle in response to building inflation pressures.
Investors have much information to digest in the weeks ahead. As US stimulus checks arrive, online retail analysts will report on first signs of fresh spending. The lifting of Covid restrictions in US states, such as Texas, will be watched for signs of resurgent economic activity as well as for rising Covid infection rates. Chinese data on industrial production and retail sales will be scrutinized for evidence of improving domestic demand.
For investors, reflation remains the dominant theme. This weekend, Treasury Secretary Yellen offered reassurance that inflation risks are ‘small’ and ‘manageable’. She may be correct, but her words will carry less weight with investors, given her partisan position in the Biden Administration and her distance from the tools of the Federal Reserve, which must ultimately decide how ‘small’ and ‘manageable’ inflation risks are. So far, Yellen has a like-minded Fed Chairman down the Mall from her, but that could change.
Following the signing of the Covid relief package, US domestic politics will increasingly constrain fresh Democratic legislative initiatives in Congress. Voting rights, immigration reform, healthcare reform and hiking the Federal minimum wage, among others, are unlikely to survive Senate filibusters. President Biden will probably resort to the tactics of his two predecessors, using executive orders to make changes to regulations and laws, where permissible. Before long, he will also turn his attention to foreign affairs, highlighted by difficult tariff negotiations with China and the shifting politics of the Middle East, which pose obstacles to a renewed nuclear deal with Iran.
The Biden honeymoon may not be over, but things will get more difficult and contentious, domestically and internationally, in the weeks ahead.
Covid also remains a ‘known-unknown’ risk for investors. Slow immunization in Europe, Africa, Latin America and parts of Asia creates opportunity for viral mutation, which could yet upset the hopeful narrative of global immunization based economic re-opening. Election setbacks to moderate European parties, including Germany’s CDU, could change perceptions about the ability of centrists to provide strong leadership in Europe.
Still, these risks and obstacles are unlikely to soon challenge the markets’ fascination with reflation and rotation. The pace of immunization in the US is accelerating. Europe probably will get its act together and improve rates of vaccination. Central banks in developed economies will remain accommodative. US fiscal stimulus will be powerful.
Hence, the base case remains for growth and earnings recoveries to support global equity and credit markets, accompanied by rotation to more cyclically sensitive sectors, styles and regions. Beaten up ‘value’ stocks will garner more attention.
Yet even as market participants pivot to new favorites, wizened hands express disquiet. Returns can be bolstered in the short run by fortuitous market timing, but just as often chasing the ‘shiny new object’ turns out to be unsatisfactory, or worse. Long-term wealth preservation is underpinned by robust diversification, not tactical re-allocation.
But in a world where the traditional mainstay of diversification—government bonds—are hopelessly overvalued, what are long-term investors to do? Logic and evidence overwhelmingly suggest that bonds will diminish, not enhance, portfolio stability. Look no further than Warren Buffet on that point.
The fundamental challenge for portfolio construction and risk management in the years to come, therefore, is not about extracting extra returns via well-timed rotation. Rather, it is finding an appropriate substitute for bonds to provide proper long-term portfolio balance.
Do we know what will replace bonds?
Yes and no.
We understand the attributes a bond substitute must have. It should be weakly correlated with, and less volatile than, global equities, particularly if it also offers lower expected returns.
But the precise substitutes are difficult to identify. Candidates include inflation hedges (such as inflation-linked bonds or liquid exposures to real estate), as well as long/short baskets of securities that don’t rise and fall with stock market performance. Alternative risk premium strategies based on relative factor returns are also worth considering. But all of this is virgin financial territory, accompanied by more sales hype than established, compelling performance.
In short, navigating markets in 2021 will have its challenges. But the skills required to tactically dip in and out of what works are modest in comparison to what’s required to offer durable solutions for wealth preservation in the decade to come.
Fundamental rebalancing, not short-term rotation, is what really ought to matter to investors.
