Quarterly investment review – 08 July 21

July 08, 2021 - 13 min read



Risky assets performed well over the quarter with the focus turning to the reopening of economies and rebound in growth in an environment where central banks liquidity remains a tailwind. Long-term US interest rates have declined, the USD has stabilized and the equity markets have reached new historical highs, driven by the United States, while gold price has enjoyed a rollercoaster period.

The most notable change is on the US yield side. After several months of unchanged wording, the Fed has surprisingly made an abrupt shift. Powell positively switched-on growth and labor market recovery. While the Fed still believes the current elevated inflation will prove transitory, its concern has shifted to the upside. Most of the Fed governors are now favorable to higher Fed Funds in 2023.


A new economic paradigm is looming

Global Tax overhaul endorsed by 130 Nations. The world took a big step toward sweeping changes to global taxation as 130 countries and jurisdictions endorsed setting a minimum rate for corporations along with rules to share the spoils from multinational firms like Facebook Inc. and Alphabet Inc.’s Google. After years of missteps and setbacks, the deal brokered in negotiations at the Organization for Economic Cooperation and Development sets the stage for Group of 20 finance ministers to sign off on an agreement shortly.

President Biden reached an agreement with a bipartisan group of senators on a $ 579bn infrastructure plan, though passage is not assured. The bill will move in tandem with a larger Democrats-only reconciliation package containing tax and spending measures Republicans oppose. Nancy Pelosi said the House will not consider the former without taking up the latter.
Stock markets set again new record highs

After contracting 3.5% in 2020, the global economy is expected to grow 5.6% in 2021, 4.1% in 2022, before returning to its long-term potential in 2023 at 3.5%. The main factors behind this rebound will be basis effects as well as the numerous stimulus packages.

Global interest rates have reversed part of the upward move of Q1. The US 10-year interest rate has consolidated in a tight range between 1.40% and 1.70% and more recently the yield curve has sharply flattened on a more hawkish Fed.

The equity markets have continued their impressive rise. The S&P500, the flagship index of the New York Stock Exchange, has fragmented the previous quarterly top around 4000 points. It is now trading up by 15.2% on a total return basis since the beginning of the year. Even if during the quarter sectors’ evolution were very heterogenous, over the quarter performance were very similar.
Gold has also experienced two distinguish periods. In April and May, the gold has strongly appreciated before reverting the early quarterly gains.



Thanks to lower US long-end yields, several emerging currencies have strongly recovered from their last year lows. At the same time, the EUR has benefited from a much quicker vaccination process than in the rest of the developed world.



Most of segment have delivered positive performance. Emerging and Corporate bonds have lead the pack. Only European yields have increased over the quarter leading European government bonds lower.



The risk-on sentiment has helped risky assets to deliver positive performance. Coupled with lower long-end yields, high duration and high risk segments have outperformed amongst them Latin America stocks and Nasdaq.



Most of commodities have continued to improve driven by global risk appetite and shortages resulting form the Covid-19 pandemic



Global manufacturing economy reels from intensifying supply shortages

Although global manufacturing output growth ran at one of the fastest rates seen for over a decade in June, capacity constraints continued to develop, reflecting a lack of labor and a record worsening of supplier delivery times. Prices continued to rise sharply as a result.

The survey data also reveal a widening disparity between strong growth in the developed world and a near-stalling of output in the emerging markets; a divergence which can be largely attributed to differing vaccination rates and further waves of COVID-19.


Factory output still close to 11-year high

The JPMorgan Global Manufacturing PMI registered another strong rise in factory output during June, rounding off the best quarterly expansion for a decade. The upturn was largely attributed to surging demand as many economies around the world continued to open up from COVID-19 related lockdowns and restrictions, while rising vaccination rates also lifted sentiment and demand among businesses and consumers alike, notably in Europe and the US.


Shortages limit production growth

However, new orders rose even faster than output for a fourth month running in June, indicating that demand over the past two months is running ahead of production to a degree not witnessed since 2009 with the exception of February last year .

The scale of staff shortages was reflected in global growth of employment running behind order book growth to one of the greatest extents for 11 years in June. The shortfall of payroll numbers to new orders was especially acute in the developed markets.

Rising shortages of inputs were meanwhile reflected in an unprecedented lengthening of suppliers’ delivery times in June.

Average prices paid by manufacturers for their inputs continued to rise at one of the fastest rates for a decade in June, due principally to this sellers’ market environment.



Towards less Financial Repression and Asset Price Inflation?

  1. We are shifting from sanitary crisis and recovery to healing and expansion. The timing for global herd immunity remains uncertain. While developed countries should reach it by end-2021, a few large emerging countries will still suffer into 2022. While global growth will clearly remain above long-term potential in H2 21 and H1 22, the jury is out for the following quarters.
  2. The Biden administration is kind of a game-changer. It is clearly shifting to the left with a more redistributive policy. Complementary plans in H2 would exacerbate tensions of market’s (long-term) interest rates. The Democratic administration will continue to be a big spender, whatever the formula, in the run-up to the mid-term congressional elections. New taxes – less markets’ friendly – seem unavoidable. A different foreign policy is also in the making.
  3. Cyclical inflation will clearly remain above comfort level (say >2,5%) in H2. Input prices are heating up, because of the sharp rise of commodities and wages. This tension is not over, as supply chains bottlenecks will continue in Q3 if not Q4, re-stocking is just starting and labor market has experienced tenacious disruptions (closed schools, virus fear, generous checks), which will need time to disperse. While the pronounced Q2 base effect will gradually disappear.
  4. Bubble formation. Financial repression and ample liquidity have favored speculation and leverage. Anglo-Saxon and Chinese policymakers have become growingly concerned. The frontal attack by China against crypto-assets is serious and durable, as a) linked to the upcoming launch of the digital Yuan b) indirectly linked to the tightening of the screws on the FinTech / shadow-banking sector. The SEC is also preparing for a more stringent supervision of household financial transactions, including margin debt. The challenge will be to regulate without causing a financial crisis or a shortage of transaction liquidity.
  5. In the next 5 years, we will experience a broad adoption of digital – central bank – currencies. The launch of the digital Yuan will come first (Olympic games in Beijing 2022 latest). The global fight against cash is accelerating. Euro and Yuan will growingly challenge the supremacy of the USD.




Next Fed tapering will not lead to a tantrum

During the 2013 Fed taper tantrum episode, the USD only really started to embark on a rally 6 months after the Fed had started its tapering. In 2013, the USD on a real effective exchange term was relatively cheap and trading with a discount of c. 20% compared to its long-term fair value. At the same time, emerging currencies were at their most expensive level of the past decade and trading with a premium of 15%. The tapering led to higher US yields, both nominal and real, and drove strong inflows into USD-denominated assets, finally pushing the USD up.

The USD will remain dependent on the Fed’s speed of adjustment

Nowadays the situation across the FX space is by far different. Long-term valuation indicators are pointing to a different picture. Emerging currencies are still trading with a premium. Most of it can be attributed to the Chinese yuan. It is trading in real terms with a premium of 25%, while HUF, MXN, ZAR, RUB, and BRL are all trading with a discount of more than 20%. The USD is much closer to its fair value.



A new attitude from EM central bankers

The race to top of the EM currency pack will be determined by proactive central banks. The principle is singling out those ready to turn rhetoric into action. In this recovery period, EM central banks are surprisingly adopting another approach than in the past. They are already tightening their key rates to ensure inflation does not get out of hand, as it often has in the past. EM central banks aggregated rate increases reached 205bps in June, up from 109 in April and May. Recent winners are currencies whose central banks raised rates amongst them Mexico, Brazil, Russia, or Hungary. However, hawkish rhetoric alone is not always sufficient, as illustrated by Turkey, where investors remain concerned about the central bank autonomy from political interference.
Over the long-term, markets will favor the combination of currencies which are supported by responsive central banks in terms of fighting inflation, and solid balance-of-payments positions.



Will the 2013 tapering playbook work?

Looking at the 2013-2018 period could provide a good indication for the coming policy normalization. In 2013, the Fed tapering announcement drove markets into a long-term bond sell-off, as it came as a surprise. A few months in, the trends went the opposite way. The yield curve kept flattening even as the Fed reversed QE in 2018 amid rising rates. However, the expected labor market normalization should be more rapid this time. In 2013, near a year of internal discussions and 7 months of market communication occurred before the Fed formally announced a tapering in December. The tapering ran from January to October 2014 and then the 1st rate hike happened in December 2014.

This tapering cycle should start in Q4 2021. The Fed will be able to cease quicker its asset purchases over 6 months instead of 10 months in 2014. It should also lead the Fed to start the rate hikes with a shorter delay. Subsequently, if the Fed is right in its assessment that inflation will only be modestly above target in 2023, there will be no rush to push on with a string of rate hikes. Looking beyond, the 2.5% Fed longer-run projection suggests a peak in the coming cycle, in line with that of 2018.


High Yield at historical low dispersion

All the government and central banks stimuli bear fruit. Fitch, like others rating agencies, has lowered its 2021 year-end HY default forecast to 2% from 3.5%. It will be the lowest since 2017. It could potentially finish the year in a 1%-2% range, challenging the 1% mark from 2013. They also reduced their 2022 default forecast to 2.5%-3.5% from the previous 4%-5% expectation.
In such a context, HY spreads have strongly compressed. US HY spreads are currently trading at their lowest level since 2007, just a few bps above record low reached some weeks before the TMT bubble burst. Within BB, added spread comes with a duration extension and liquidity concerns. Almost 2/3 of the market is trading inside 300bps, including almost 28% that trades below 200bps. There are just 9% of the index, which is still trading wider than 500bps.

Few options remain in the fixed income space to achieve some carry as the market is very polarized and focused. However, history shows that once we reached lowest percentiles, risk reward on HY is no longer compelling even with a benign expected default rate. Credit is essential but often too expensive



The reflation trade has eased

The market will remain cautious in the run-up to the Fed meeting in late July and the Jackson Hole summit in late August, with weaker stock market volumes during the summer. We rather consider odds of higher volatility and sector rotations than that of an equity correction.

Equities move between relatively high, albeit not extreme, valuations and favorable short to medium term factors, such as the technical situation (although there is starting to be some divergence in participation), investor sentiment indicators, share buybacks, dividends, liquidity, low interest rates and rising profits.

The Buffet Indicator (BI) – the market capitalization of the Wilshire 5000 divided by the US GDP – shows an excessively high ratio at 236%, while it should be at 120%, in theory. Among other things, the ratio rose recently due to the temporary contraction of US GDP due to the pandemic. The BI is not a market timing tool, but its predictive value shows that returns tend to be negative over the next 5 years if overvalued (a ratio greater than 2 standard deviations) and positive in the event of an undervaluation (a ratio less than 2 standard deviations). Currently, the ratio stands at 3 standard deviations. But the correlation between BI valuation and future returns is weak. The first criticism of this indicator is that it does not take into account other asset classes, such as today with the very low level of interest rates; the US 10-year average is 6% over the last 50 years compared to 1.5% currently. The ratio is at about the same level as in 2000, but the US 10-year was over 6%. The current BI level does not signal a correction of equities. The BI can remain abnormally high as long as interest rates remain abnormally low.




Less compelling valuation indicators

The S&P 500’s 22x 2021 12-month PER is higher than the 17x average, but this is less dramatic at the start of an economic cycle, considering the pandemic disappears in 2022, as substantial growth in corporate profits is expected, +35% in 2021 and +15% in 2022 for the S&P 500, and +65% in 2021 and +12% in 2022 for the Stoxx 600.
The Equity Risk Premium is also less attractive. After being very favorable to equities in March 2020, the US 10-year US/Dividend yield ratio has returned to average.



Gold is a financial asset

Its price remains strongly inversely correlated with real interest rates.

However, the price of gold has weakened as the real US rate has fallen. The ounce of gold should have gone up, but its price also depends on the dollar, which appreciates, and the Fed. The Fed implicitly alluded to an increase in Fed Funds earlier than expected.

Gold has new competitors, cryptocurrencies, although they are more volatile, more speculative and less safe. Cryptocurrencies could also be a hedge against currency debasement.


Economic recovery supports oil

The Bloomberg Commodities Index is up 57% from the lows of April 2020, which was also a low since 1974 !, and 20% in 2021. The performances are remarkable. Since April 2020, the price of oil has increased by 270%, copper by 88%, the industrial metals index by 65%, the agricultural index by 56%, while gold is up only +2 %.

It looks like a post-Covid restart with a strong recovery in demand, coupled with disruptions in production and logistics linked to the pandemic. Producing countries have often been hit hard by the Covid, as in Latin America, where restrictive health measures have reduced production.

The current consolidation since May reflects fears of a delayed economic recovery due to the emergence of variants and the lack of a global vaccination strategy. However, this period of weakness presents long-term buying opportunities.


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