Today’s topics

• Macro markets / OECD report
• China data
• US taxes

Macro markets / OECD report

The OECD provided their interim report on the global economic outlook.

As usual, there are a couple of iconic graphs to consider, in light of our DAA portfolios more broadly, and our Direct Equity carve-outs more specifically.

Fiscal stimulus

The first is a fairly blurry but nonetheless stunning graph depicting the size differential of fiscal stimulus across countries.

GDP growth

We care about this because the majority of our international equities allocation is to the US, in our diversified portfolios, and, the tradition of US GDP growth thumping that of European growth looks a) set to continue and b) has resulted in a marked outperformance of the S&P500 relative to the Euro Stoxx index in each of the below successive occasions.

We suspect this augurs well, again, for our allocations.

It is also generally supportive of a long USD short EUR allocation. At the portfolio level we are 50/50 hedged vs unhedged in international equities, and we are waiting for the Aussie dollar to move (decisively) into the 80s before making a switch to a predominantly unhedged approach.

You might immediately wonder why not make such a move now, if the growth differential is sufficiently compelling. The answer is that the AUD is heavily impacted by commodity prices, and even though we are bearish on those too (viewing them as unsustainably high), in the short run COVID related supply squeezes may well push the AUD through our trigger for the hedge ratio.

Emerging market divergence

The next compelling OECD graph is the updated March 2021 projections for growth. The advanced economies, in full “vaccine deployment mode” are seeing a return to the pre-pandemic growth trajectory.

The emerging markets, hit harder by a) denser, more difficult to isolate, test and trace populations, b) lower-access-to and standard-of medical care, and c) arguably most importantly, little-to-no access to the vaccine at scale, are seeing little convergence to the pre-pandemic projection.

The same story is echoed in the company updates from stocks with material Emerging market exposures. The below from Orica on the last trading day of the month (otherwise known as the “bring out your dead” day – no good news is ever released in the afternoon of the last day) matches the OECD conclusions.

The emerging markets are also particularly vulnerable to sudden stop capital flight. US treasury yields at pandemic induced lows of March 2020 was the impetus for material EM portfolio flows. Yields of c1.5% are now more than sufficient to induce flows back out, causing the EM region to sell off.

We can “eyeball” the relationship pretty clearly below…

…but we can also quantify the relationship econometrically. Importantly, the below model, which uses log differences, and then re-exponentiates the predicted change, shows the complex relationship between the level of rates [negative] and change in rates [positive], and the US dollar.

The higher the level of US rates, the stronger the USD dollar, which causes the EM underperformance, and the combined effect is strong enough to offset the change in rates affect, that is associated with stronger global GDP growth.

You might wonder why we are going on about the EM quite so much. Well, at the moment it is a consensus long, with many active managers positioned in longs to the region. We are underweight, across our diversified portfolios, and are happy to remain underweight.

A last graph to share; the US financial conditions index also correlates well (negatively) to the EM regional performance. Given financial conditions almost can’t possibly get more accommodative, longer run we’d suggest that there is clear downside risk to EM outperformance relative to the developed world.

China data

The monthly data dump of key economic aggregates was released.

We noted earlier that the release was not especially useful to the eye. Most measures came in far below that surveyed/expected, but the quantum of the number (30-40% + year on year) easily swamps the task of guessing correctly, so we won’t place much stock in a such a “miss” as we otherwise ordinarily might.

Normally you can get round such things by looking at the underlying time series of the data and doing some fancy statistical techniques…

..but on this the Bloomberg data proved somewhat uncooperative, with the February number printing at 1/10th the normal amount. Our model correctly “guesses” that this is an error (more formally, an outlier, and thus ignored) but it still isn’t helpful.

Overall, however, we stick to our view that the China data won’t be enough to keep commodity prices elevated, which are presently high because a) real rates are low and b) supply chain issues impacted by COVID.

The recent climb in yields clearly imperils the narrative outlined in a) and the supply chain issues in b) will themselves will prove temporary.

US taxes

We are starting to see the outlines of the Biden tax plan. Unsurprisingly, it centres on a return to the 28% corporate tax rate that prevailed pre-Trump.

This is partly why we struggle with the idea of remaining overweight equities, particularly overweight high beta names, despite the obviously very risky asset friendly combination of easy monetary and stimulatory fiscal policy.

Stock prices go up when the net present value of future corporate profits go up. Higher expected economic growth can drive forecast cashflows, but if wages, or in this case taxes, cause profits on net to decline than we should see unambiguously lower prices, as both cashflows decrease and discount rates increase.

We are modestly underweight shares at the overall portfolio level (~2%), which is not a large bet, but equally, is an underweight at a time when consensus positioning is overweight.

More to follow.