Summary

The current market narrative is:

• Biden stimulus package (Est ~$1.9tn) will lead to strong growth, with modest inflation

Most market participants agree that’s the outcome of such stimulus at a time in which the economy is normalising post COVID.

The split of consensus for market positioning, however, differs quite notably

• Some are anticipating a much higher move upwards in rates and inflation, and are concerned about bonds and equities

We lay out the maths behind this concern shortly below.

• Others expect that inflation expectations are very well anchored, as they have been so for almost 15 years, and are unlikely to move too far upwards. They believe that the strong growth outcomes will support corporate profits and therefore markets

The clear support to stable inflation expectations is that neither the GFC nor the COVID crisis materially raised or lowered long run inflation expectations. If those sorts of exogenous shocks can’t do it, not much else will.

Markets

Things get a little trickier when we think of the US dollar, and the outlook for equity markets ex US (i.e. Rest of World) and for commodities and emerging markets.

Our view

Fixed income: underweight fixed income (~4% across our portfolios) and position at market duration. This protects if rates do rise, noting that we expect the cycle highs for the 2yr to be ~2.5%, at which point we’d be happily overweight and long duration.

Equities: we are fractionally underweight, and, post reporting season, see good grounds for moving more modestly underweight.

Narrative

We examine the constellation of asset prices below. The 10yr yield has marched higher, as have inflation expectations (BE’s). The result is that real rates haven’t moved appreciably, and remain well below 1%.

It is difficult to gauge the stance of policy by simply looking at rates alone, even real rates, and so noting the rally in risky assets like equities and commodity prices, and declines in credit spreads (reflecting lower anticipated defaults) we conclude the drivers are a mix of fiscal (the noted Biden package) with accommodation via monetary policy (which is keeping real yields lower). That is a fairly potent “risky asset friendly” backdrop.

The US dollars’ recent rise (i.e. past couple weeks) in a period of risk on certainly suggests that the market views the $1.9trn to be sufficiently large so as to move rates (eventually) and the dollar rises in anticipation.

Returning to our point about rate expectations.

Some are worried about the following maths.

The congressional budget office estimates the output gap at $900bn. The current pool of “excess savings” by households is approximately $1.6tn (with the money largely saved through a mix of prior stimulus packages, and the inability to spend due to COVID restrictions).

If consumers deploy half of that, in a “pent up – catch up” demand lift post COVID, that’s $800bn. The just delivered CARES package of December added $900bn. The Biden package is $1.9tn.

That makes for $3.6tn, which is a number much larger than the original output gap.

Such spending would be the largest increase in spending relative to potential outside of wartime conditions.

That’s where fears of inflation, and the interest rates needed to tame it, arise.

Our view

It is possible. We are in unusual times. Such spending, until it swamps potential production, is likely to be good for corporate profits, until swamped by wages growth (which is a profit margin negative) and mixed pricing signals that result from inflation. As such, it is unclear that we would want to be substantially underweight before the fact, before we see evidence of the negative impact from wages-inflation.

So, we will watch wages growth with great interest. In the interim, expect companies to complain about shortages, but, until they raise wages, there isn’t much cause to worry re: profit margins.

It is, however, unambiguously bad for fixed income, as such we are underweight. But, given the correlation to equity market risk is still -.42, we maintain a sizeable absolute exposure as a hedge against equity market risk.

And, that’s especially required given we are already “late cycle” as suggested by market valuations and inflation expectations.

On the dollar, we are less certain. The return to normalcy in US politics suggests the dollar should fall. The stimulus package suggests it should rise. The monetary policy accommodation suggests it shouldn’t rise too much.

The US strength bleeds over into rest of world sales, particularly emerging markets, which should be good for their currencies (including Australia).

As such, the picture is very muddied. Hence, we are sitting at close to our strategic weight relative to the portfolio hedging level.

Supporting charts

We are keeping this graph in the back of our minds.

The equity risk premium is a bit above the average of the past decade. That’s not a case for “equities are cheap” but does suggest that you might not want to stray too far from your SAA weight.

But there are many ways to calculate the ERP, and you want to mindful that not all of them are so complementary to Valuation support.

And that a more fancy, econometric effort to account for level and rate shifts in real interest rates that explicitly incorporate growth expectations suggest a much more notably degree of overvaluation for the market.

Commodities

A quick note on commodity prices. We are long commodities in our direct portfolios through stocks like ORI, AWC, SGM, BHP.

Those exposures are doing well on direct movements (such as the price of scrap steel, iron ore, copper etc) and indirectly, for downstream mining service providers (ammonium nitrate in the case of ORI).

Equally, the driver of commodities, at the moment, is entirely the monetary and fiscal stories outlined above. The idiosyncracies of each market (i.e. carefully parsing demand and supply, that sort of thing) are entirely out the window.

That means careful bet sizing, and consideration of the overall portfolio is very important, rather than simply “allocating to FMG” on the back of strong prices. It is all the same trade.