03/03/2021 | News release | Distributed by Public on 03/03/2021 05:51
With a new stimulus package on its way as well as an accelerating number of the global populace receiving vaccines, we decided to drill down further into key topics we explored at the start of the year in our 2021 Outlook: Another Voice. To review, our base was that faster nominal GDP growth would force investors to shift more assets into beaten down areas of the market that may have lagged ahead of and during the onset of the pandemic. Said differently, we were encouraging investors to 'make a new beginning' in terms of portfolio construction towards more hard assets and more cyclical exposure. In this follow-on piece, we detail in depth why we have increased conviction about our Another Voice macro overlay. In fact, to borrow again from T.S. Eliot, it will be a time when '...only those who will risk going too far can possibly find out how far one can go.' To be sure, upward inflationary pressures and rising rates are transitory risks to consider, but structural deflationary forces, including technology and demographics, should ultimately outweigh the increase in money supply and supply chain tightness that we are seeing in the goods segment of the market. So, when we pull all the macro pieces together, we see a constructive environment, particularly for collateral-based cash flows, where we get reflation without runaway inflation, as this synchronized global economic recovery continues to unfold.
...and only those who will risk going too far can possibly find out how far one can go.
T.S. Eliot poet, literary critic, dramatist, and editor
When we penned our macro outlook, 2021: Another Voice, in December 2020, we challenged investors to 'make a new beginning' with their portfolios. Specifically, our macro models were all pointing towards a broadening of markets that required portfolio managers to make a major shift away from defensive growth portfolios towards more cyclical ones that could outperform in a faster than expected nominal GDP environment.
In this latest Insights note, we are - once again with the help of T.S. Eliot - encouraging investors to lean in further to our Another Voice framework. Indeed, as Eliot puts forward, '...and only those who will risk going too far can possibly find out how far one can go.'
To this end, we have updated our latest thinking on our macro framework around two areas, both of which are key underpinnings to our 2021 Outlook. Our thoughts are as follows:
Looking at the big picture, we remain constructive on many risk assets across much of the global capital markets, particularly those investments that dovetail with our Another Voice framework. Without question, there will be setbacks along the way, including concerns about growth, stimulus, rates, and geopolitics. However, our primary message is that we are entering a new economic cycle, not stuck in an old one. The breadth and speed of the global economic growth we expect will soon make its way into the markets. As such, a new 'voice' will be required to succeed. Indeed, investors will need a different investment playbook to thrive in a world of faster than expected nominal GDP growth. To this end, we continue to favor the following mega themes that we laid out at the beginning of the year:
Why are we so adamant about embracing our macro themes? Because our strong view is that investors will need a structured roadmap to outperform in a world where both nominal and real returns are going to be much more modest than in the past. Also, there are now already some excesses in the system that need to be considered - and potentially avoided. In particular, easy financial conditions during the second half of 2020 have led to a potentially unsustainable boom in new issuance activity (Exhibit 25).
Overall, though, we think that the environment for 2021 is a compelling one for the investment strategies we are pursuing. The illiquidity premium is likely to expand further, dispersions are wide within the liquid markets, and we expect more stimulus, including both consumer and infrastructure packages. So, we enter the spring of 2021 confident that - given the shifts we are seeing across our macro models - now is the time to 'risk going too far' in terms of repositioning one's portfolios towards our Another Voice framework.
In the following section we respond to two of the most pressing macro questions that we have been discussing of late with our global deal teams and thoughtful clients.
It was almost thirty years ago, in the fall of 1991, that I started in the financial services industry. As I reflect back on the journey, it certainly has been rewarding, albeit with lots of mistakes made along the way. Importantly, though, I have also used those mistakes to learn, and one of my most profound learnings is that the sizing of positions - not always having the best idea - can often be the deciding factor in investment outcomes. What I have learned is that when you are wrong, often your best course of action is to cut your losses and move on. But, when you have the wind at your back, it often makes sense to increase the size of your position until the market catches up to you. As legendary investor Stan Druckenmiller (also a Richmond, Virginia native) said, 'I like putting all my eggs in one basket and watching the basket very carefully.'
At this point in 2021, Druckenmiller's aphorism fits neatly into our 2021: Another Voiceframework. 'Risk going too far' is not only Eliot's advice but our advice too. Said differently, we do not think it is too late to lean in to our thesis about a surge in global nominal GDP leading to reflation without troubling inflation - at least in the near term. As part of this backdrop, we see a broadening of the market beyond big capitalization tech stocks. I am not a chartist, but I would argue that the Russell 2000 and the MSCI Emerging Markets indexes are just coming out of bear markets that started back in 2018. A similar story holds true in the commodity complex. If we had to mark a day that their bear markets ended, it would be the day Pfizer's vaccine received emergency use authorization from the U.S. Food and Drug Administration on December 11, 2020.
Implicit in our outlook is that the vaccines will make a positive impact on spending behaviors, even with the diseases mutating into new forms. As such, we think that we are now transitioning from the 'square root' part of the recovery we outlined in our July 2020 Insights note The End of the Beginningtowards a faster than expected rebound in corporate profits and economic growth that could extend well into 2023 and beyond. Against this backdrop, we believe that this recovery will be quite different than the one that followed the Global Financial Crisis (GFC). This viewpoint is critical, as most investors tend to compare the prior downturn and subsequent recovery to forecast where we are headed. That would be a mistake this time around, in our opinion.
There are four points of differentiation, we believe, that make this recovery path different. They are as follows:
Point #1: Central banks acted with greater intensityand there was less bank de-leveraging during the pandemic Investors often forget that, although central bankers embarked upon quantitative easing (QE) fairly quickly in November 2008, they did so with much less conviction and intensity. Some work by my colleague Brian Leung highlights that during the GFC, G4 (U.S., Euro Area, the U.K., and Japan) central bank balance sheets increased by $2.4 trillion (or seven percentage points as percentage of GDP); by comparison, balance sheet expansion has been three times bigger in response to COVID, increasing by $8.5 trillion (or 21 percentage points as percentage of GDP). Today, G4 balance sheets stand at about $24 trillion compared to around $15.5 trillion at the start of 2020.
Incredibly, the U.S. Federal Reserve bought more bonds under Jay Powell's leadership in the six weeks after the pandemic hit the U.S. than it did during the prior 10 years under both Bernanke and Yellen combined. Another point of differentiation is in regards to bank leverage. In 2008 the ratio of assets-to-equity at banks was inordinately levered from fueling a period of extreme excess. In the run up to the GFC, the median bank leverage ratio was 32-to-1; however, bank leverage at the onset of COVID was a much healthier 11-to-1. Rate cuts have also happened much more aggressively post pandemic, as during the GFC it took eight months for the weighted average developed market economy policy rate to reach a trough, while it took just one month to cut rates to the low of zero percent during COVID. During the GFC, developed market central banks' policy rates reached 0.6% in May 2009, down from 3.2% in September 2008. While developed market central banks completed 70% of the rate cuts during the initial three months, the remaining 30% were spread out over the subsequent five months. In 2020, the policy response was much more quick and decisive as it took just one month for developed market central banks to cut the average policy rate to the low of zero percent in March 2020 from 0.75% in February 2020.
It's also important to consider fiscal stimulus as well. The global fiscal response to the pandemic has been approximately three times greater than the support provided during the GFC. The type of stimulus provided is also very different. Back then, tax cuts and public investments accounted for the lion's share of the assistance, whereas this time it has been about direct support for the private sector in the form of cash payments, unemployment insurance and job retention programs as well as business loans and grants.
Point #2: China will likely lead the world in global growth again, but this time with much less debt accumulation In 2008 China's government, fearing a major, sustained collapse in the U.S. consumer, overstimulated its economy to bolster the world economy. While it worked in the short-term, China spent much of the decade trying to rein in its debt load, which ultimately dented productivity. One can see the impact of these challenges in China in Exhibits 9 and 10, respectively.
This cycle, however, China has barely spent to reignite its economy. One can see the significant delta in approach in Exhibits 11 and 12, which shows how much the U.S. has had to use its central bank balance sheet to improve financial conditions relative to China. A similar story holds true on the fiscal side. Indeed, according to my colleagues Rebecca Ramsey and Frances Lim, fiscal spending in the U.S. since the pandemic started is now approaching five trillion dollars, dwarfing the one trillion dollars that the Chinese government has spent to reignite growth following the onset of the pandemic.
Point #3: Direct Deposits Unlike during the Global Financial Crisis, governments have been much more aggressive around the fiscal impulse required to re-accelerate the economy. According to some work by my colleague Dave McNellis, the average U.S. household had an expansion of disposable personal income of 4.6% in 2020, despite the U.S. experiencing a recession that was five times as bad as the average recession. Moreover, we forecast disposable income will grow by almost five percent further in 2021. Driving this unusual outcome is direct deposits issued by the government. As one can see in Exhibit 13, consumers have been able to increase their disposable incomes during the pandemic with the assistance of government transfers, despite high unemployment.
So, the net result is quite positive. First, savings is ballooning because of this increase in disposable income. In fact, we now estimate that consumers will have banked about $2.5 trillion in extra savings by year end, equivalent to fully 17% of pre-pandemic annual consumption spending. Second, unemployment is coming down much faster than in prior cycles, which should further lend support to our thesis that this recovery will be more robust relative to the prior recovery in 2009.
Our bottom line: While we are still troubled by the unemployment trends with low income and minority workers, the middle and high income consumers in the United States appear poised to significantly bolster their spending habits heading into 2022. They have saved, paid down debt, and improved their cost of capital on what debt remains. Moreover, there is pent-up demand that we think could lead to something akin to a 'Roaring 20s' if our base unfolds as expected.
Point #4: Austerity and rate increases have given way to more dovish frameworks like AIT Unlike the aftermath of the Global Financial Crisis, there will be no debates about austerity post pandemic. There will be no rogue bankers or traders taken to task for their association with COVID-19 - only human tragedies, and as such, politicians will feel emboldened to spend more than normal when and where they can find any agreement. Consistent with our viewpoint, we note that Vitor Gaspar, the head of fiscal policy at the IMF, recently acknowledged that the austerity plan implemented during the European sovereign crisis was a mistake. He then went on to encourage more spending, giving assurances that 'The [public debt] ratio in our projections stabilizes and even declines slightly towards the end of our projections which shows that COVID-19 is a one-off jump up in debt and with low interest rates, the debt dynamics stabilize.'
Meanwhile, on the monetary side, the Fed has become amongst the most dovish of the central banks by introducing a totally new framework that should hold rates low for a much longer time. As we discussed in October 2020's The Road Ahead, average inflation targeting (AIT) is likely the biggest shift in U.S. monetary policy since the introduction of quantitative easing at the end of the Global Financial Crisis. As a refresher, this shift by the Fed will allow inflation to run above the target of two percent (to make up for periods when inflation is below the target) for some time before hiking interest rates. Indeed, we are of the opinion that the lion's share of central bank committee members now believe inflation is so structurally low that the committee's shift reflects their view that 'a robust job market can be sustained without causing an outbreak of inflation1.' This statement is important because it reveals two things. First, it suggests that, despite the Fed's dual mandate, it appears to be intensifying its focus on employment relative to price stability. In fact, Powell recently stated that, 'This change (in the inflation mandate) reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities.' Second, when it comes to future inflation trends amidst further downward pressure on wages, he certainly sees a negative skew.
President Biden in the United States is also charting a course that is heavily reliant on fiscal initiatives, many of which we expect to bolster growth. Against this backdrop, we are using this update to further bolster our GDP forecast. Our 2021e U.S. Real GDP goes to 6.5% from the 5.0%, while 2022e goes to 4.0% from 3.0%. Consensus has been ticking higher, but is still at a relatively modest 4.9% for this year. If our forecasts are directionally correct, 2021 will be the best year for U.S. growth since 1984. There have been three key developments since our last GDP update in early December that influence our thinking. They are as follows:
In terms of investible implications, we are focused on the rising stock of savings, the falling unemployment rate, and the ongoing inventory cycle.
Against this backdrop, we think macro investors and global asset allocators should be leaning into the following five themes:
In terms of what could derail our thesis, we believe the single biggest risk is that something unsettles the bond market. Were that to occur, valuations could prove quite challenging, as we show in Exhibit 24. What could do that? Most likely it would be a potential misstep by the Federal Reserve, or one of its global peers around tapering in the second half of this year. Another risk could be if inflation increased faster than we expect. As we discuss below, we don't see either the Fed or inflation ruining our Another Voice thesis in the near-term. Regardless, as we mentioned above, we would be underweight government bonds. Finally, financial conditions appear attractive - too attractive? Indeed, as we show in Exhibit 25, the new issue market seems to be at extreme levels.
Overall, though, our bottom line is that we think investors should double down on our Another Voice framework. In fact, as our T.S. Eliot quote suggests, we would 'risk going too far' in terms of adopting our macro themes and approach relative to booking some of the substantial gains that have occurred so far in 2021. In our humble opinion, these changes towards faster nominal GDP are more secular than cyclical in nature. If we are right, then the success of our Another Voice thesis should be measured in quarters or years, not days or months.
…to me, a wise and humane policy is occasionally to let inflation rise even when inflation is running above target. Janet Yellen, former Federal Reserve Chair and current Secretary of the U.S. Treasury
If there was ever a time to talk about inflation, now is that time. We have record money supply growth, a dovish Fed, and a new Secretary of Treasury who may be even more dovish than the current Fed chair. Not surprisingly, at almost every client meeting in which I participate, the conversation turns to inflation and some variation of the question of whether the Fed and its central bank peers have it all wrong. Specifically, a growing number of investors are increasingly concerned that central bankers are re-committing their dovish stance just as growth is re-accelerating around the globe. Interestingly, this prioritization of market risks is quite different than just a few months ago (around the election) when we conducted our survey of Ultra High Net Worth investors. At that time, the focus was squarely on geopolitics, i.e., U.S.-China trade tensions, not inflation. Fast forward to today, and inflation risk is clearly the issue most heavily weighing on investors' psyches.
Why is this happening? Beyond new leadership in Washington, inflation concerns are rising to the forefront today because inventory shortages are rolling through multiple supply chains. Demand - while in many instances still weaker than pre-pandemic levels - has snapped back faster than producers anticipated, and/or faster than they are able to resume production. This tension, in turn, is squeezing purchased goods prices considerably higher in many instances. At the same time, consumers in aggregate find themselves holding considerable excess savings, with more support on the way via further stimulus. In addition, wage growth has, to date, remained surprisingly resilient, due at least in part to ongoing support to the lowest wage tiers via widespread minimum wage increases at the state level.
While the headlines sound somewhat alarming, the current backdrop of a heated inventory cycle unfolding amidst abundant consumer dry powder is actually a fairly typical early-cycle pattern. In both 2003-04 and 2010-11, for example, inflation surged early in the economic recoveries, driven by inventory cycles and consumer resilience. Interestingly, Treasury markets historically have overestimated the persistence of early-cycle inflation, as 10-year yields and breakeven inflation expectations peaked in the early years of the last two recoveries.
When we pull all the facts together, our bottom line is that, while we do not necessarily expect nominal rates to spike to cycle-peak levels in the near term, we do think inflation concerns will remain at the forefront of investor attention. What's different this time is the unprecedented level of Fed QE and - maybe more importantly - extended rates guidance. So, while we do think inflation breakevens could hit near cyclical peaks in coming quarters, we believe real yields will stay low relative to history, helping to suppress nominal rates too.
Central to our thinking is that, as shown in Exhibits 33 and 34, the flow-through effect of input cost increases and disposable income surges into core consumer inflation tends to be rather limited. Importantly, consumer goods make up less than one-quarter of the overall core consumer inflation basket. We believe goods inflation is the primary transmission mechanism through which input cost spikes and inventory squeezes are translated into core consumer inflation.
Moreover, the pandemic continues to dent pricing power in a few key categories holding outsized CPI weights, including apartment rentals, health care, and education (Exhibit 35). These categories have not recovered in the initial economic bounce, and in fact have come under increasing pressure in recent months (Exhibit 36). We think capacity and regulatory overhangs likely will restrain any major resurgence of pricing power in these categories in coming months, thereby dampening the rebound in core inflation.
There are also secular forces to consider. Indeed, despite the cyclical inflation we are forecasting, we maintain a high degree of long-term conviction that structural forces around demographics and technology are set to continue exerting long-term downward pressures on aggregate prices. As such, we are not concerned that inflation gets out of control this cycle. Ongoing moderation in large services-based inflation categories such as rents, healthcare, and education are also moderating forces. Remember services account for roughly 60% of inflation inputs.
If we are wrong in our long-term outlook, we think it will be because growth in money supply actually leads to a sustained increase in the money multiplier. Under that condition there would likely be too much money chasing too many goods and services. However, as Exhibit 40 shows, the money multiplier is actually contracting, not expanding. Moreover, my colleague David McNellis highlighted for me some interesting work by UBS, an investment bank, there has been essentially zero relationship between inflation and money supply growth. Importantly, the inflationary impulse from an M2 surge is usually offset by the deflationary impulse from the economic weakness that the M2 surge is intended to offset. One can see this in Exhibit 41.
Given the huge surge in sovereign debt that we are seeing to pay for pandemic relief, we also looked into whether outsized government debt loads result in higher inflation. What we found is that there are actually no good examples of debt-related inflation surges outside of wartime conditions. Cynics could argue that governments like the United States and Europe have approached the current pandemic with wartime-style stimulus and spending. However, we do not believe that is an apt analogy based upon our research. Postwar inflations are typically 'back door' defaults by governments that are offloading war-related debts via currency depreciation. Often it is the losing side that does this, and/or a successor government that repudiates the policies of the prior government. A critical aspect to remember is that a country that seeks to inflate away debt will face highly constricted access to capital markets, and therefore will likely need to run a balanced budget. Debts from war are one-time in nature, so it is more straightforward for a country to balance the budget after wartime expenses go away. For a country like the U.S. today, which is running persistent deficits due to demographic and entitlement issues, balancing the budget is much more complex. In fact, the debt is mounting because voters do not want to balance the budget. So, in our view, history suggests that the surge in pandemic-related debt will not in itself generate higher inflation (Exhibit 42).
Putting all the pieces together, we are making modest increases to our near-term outlooks for inflation and 10-year yields, but no changes to our longer-term forecasts for inflation. Specifically, our CPI forecast goes to 2.4% from 1.9% for 2021e and to 2.0% from 1.8% for 2022e. Consistent with this view, our 10-year targets go to 1.5% from 1.25% for 2021e and to 2.0% from 1.5% for 2022e. Finally, there are no changes to our outlook for the Fed, which we continue to think will keep the funds rate pinned at zero through 2023.
Our Bottom Line:Reflation Without Structural Inflation With the Democrats now fully in control, and the stimulus outlook rising, we forecast that a yield curve steepening may play out faster than market participants are currently anticipating. One can see this in Exhibit 45. Importantly, though, the lion's share of the yield increases we now anticipate will play out via higher inflation breakevens, not higher real rates, as we show in Exhibit 44.
This backdrop is actually a constructive dynamic for markets, we believe, particularly given we do not see a structural outbreak of inflation in 2022 and beyond (Exhibit 43). In terms of specific investment considerations, it reinforces our overweight to Global Public Equities, particularly those with some cyclical bias, relative to Sovereign Debt. It also supports our view that owning collateral-based cash flows including Asset-Based Finance, Real Estate, Real Estate Credit, and Infrastructure all make a lot of sense. As a 'soft' hedge, it also supports owning more Financials, which benefit from a steeper yield curve and lower provisioning amidst faster growth, from a sector perspective. We too favor owning more floating rate instruments, including Loans, across Fixed Income portfolios. EM currencies too make sense.
The measure of intelligence is the ability to change. Albert Einstein
Unlike in some of our pre-pandemic Insights notes, we have leveraged more of a question and answer format since March 2020 to better address specific queries that are coming up in deal team and/or investor conversations. To this end, we want to make sure that our readers have a clear understanding of our overall macro conclusions. They are as follows:
Importantly, these aforementioned 'tactical' suggestions all support our larger conclusion that portfolio managers, even the most bottom-up oriented ones, must now change their approach. Specifically, what worked last recovery - and gained momentum throughout the decade - will not lead to the same outsized returns this cycle. Given how tilted most portfolios are towards the 'old' regime, we think that our Another Voice framework may emerge as a differentiated prerequisite for success in the macroeconomic backdrop that we now envision.
In terms of our concerns arising from global growth being too hot, we think that the biggest risk is actually what we laid out at the beginning of this piece. It is that investors don't lean in enough to what our macro models are saying about future growth and return prospects. We do not typically make these type of table pounding statements, but the early indications across the global capital markets in 2021 suggest that we are at the early stages of a secular change in portfolio construction that warrants attention from all globally-oriented asset allocators and macro traders.