The party's just beginning

When I was young, I remember Dad telling me it wasn’t that long ago when the World was believed to be flat. Explorers were warned should they sail across the oceans they would fall off the edge of the Earth, into deep space. Never to be seen again. Dad held up a large coffee table book as the earth, with marbles rolling off the side to illustrate. I laughed, thinking Dad was joking.

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A few years later our economics teacher told our class the very same story. Dad wasn’t joking after all! Our teacher went on to say that the flat-Earth theory was promoted to attempt to control residents so they would not leave their country. To ensure population growth and community survival. Even today there are thousands of believers of the flat-earth theory.

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If someone apparently more qualified tells you something unbelievable, does it become more believable? People believe what they want to believe. If you refer to the list of landmark cases against social media firms, or seen the recent Netflix documentary ‘The social dilemma’, maybe as a society we have forgotten how to think for ourselves. President Trump never hesitated in condemning all the ‘fake news’. After all it was the existence of fake news which was the cause for the Trump administration’s unsuccessful campaign, apparently.

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I am not at all a conspiracy theorist. However considering the horrific news circling the World currently – are the World’s Central bankers and Governments nursing us all into a false sense of security? How are we ever going to pay back these trillions of dollars of debt? Will the generations who follow be burdened with this pandemic debt? Should investors sell everything, become goat herders, hide in the corner and wait for the next pandemic wave?

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If we heed the comments from both our RBA Governor and the head of the US Central bank, interest rates are supposed to be anchored at (near) zero for the next five years. If all this debt costs nothing, does it really matter? Debt is not at all a bad thing if used for efficient reasons.

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During March 2020, the pandemic threatened that the World was once again, on the brink of systemic failure.  For today’s note I’ll touch on how we see the World for investors post the pandemic. Ironically, the future ahead is about as good as we may ever see during our investing lifetimes. After such an historical event, investors are attempting to weigh up all the positives and negatives to attempt to make some type of informed decision regarding their portfolio positioning.

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Negatives? 159 million confirmed cases of Covid. Nearly 700,000 new cases daily. 3.2million deaths. More than 195million job losses for full-time workers. Global herd immunity will be many years away. Global travel and border restrictions will continue. (Source: BBC.com, as at 11 May, 2021).

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Positives? Stimulus. Stimulus. And more stimulus. Inflation. Or rather, reflation.

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Inflation is not a dirty word. It is a sign that asset prices are rising and wealth is being created.

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The ‘reflationary’ trade in my view is perhaps one of the most exciting events on the horizon. This highly anticipated reflation trade is in direct contrast to that being promoted by the World’s central bankers. We’ve recently seen a dramatic re-allocation of capital away from growth, rotating into the value or yield trade. Where to from here?

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I recently attended the highly anticipated ‘Annual Portfolio Construction Forum’ (PCF).  I would describe this annual investment seminar as one of the best in APAC, providing the opportunity to meet and discuss the outlook with a host of the World’s most influential fund managers, economists, research analysts and global bank heads. The Annual PCF has been in operation now for almost 20 years. Pre Covid, this event would host more than 1,200 delegates, with online tickets of a similar number. For 2021, this event only hosted 120 delegates, so I felt fortunate to have been offered the invitation to attend.

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I walked into the event feeling mildly optimistic. Admittedly a little uncertain as to what the commentary could be, post the most frightening stock market crash in history. Surely messages throughout the day would be mixed. Surprisingly not.

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I found it near impossible to find one slightly negative commentator throughout the day. Even the pessimistic ‘sky is falling’ bond managers had smiles on their faces!

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There was far too much commentary to cover today, which included a discussion from the ex-head of the CIA, who delved into the political risk regarding the likelihood of World War III, through to a worrying presentation from the Global head of infrastructure from JP Morgan (New York) and Barclays (London), surrounding the impending impact of the Paris Accord of 2015 and the World’s dramatic push to ‘net zero’ 2050.

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The World’s push toward net zero carbon emissions will however create not only great challenges, resulting in the death of a long list of companies and industries which are core components to investment markets. The reason why as a firm, we will always place a great emphasis on active investing over passive investing, to avoid being invested in a company just because it is a part of the market or index.

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The Paris Accord has seen countries globally committed to the agreement, which in time will drive a mix of tax incentives combined debt penalties should companies not comply to meet their net zero target. According to JP Morgan, this alone could see more than US$60Trillion in dormant assets globally by 2050, most of which will be large energy assets.

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Until recently there was more than US $22Trillion of global stimulus deployed, to generate the largest global economic expected. Ever. The most recent stimulus event to Covid was World War II. The financial crisis did not even compare. In inflation-adjusted terms, the pandemic stimulus has been more than three times that of the entire financial support deployed to repair the global economy post World War II.

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At a global level – the fiscal multiplier on stimulus is paramount, averaging nearly four times the average dollar spend. President Biden aims to immediately reverse decades of underinvestment. Once passed through the Senate, this amounts to a further US$3 trillion infrastructure spend, plus a US$2 trillion in climate change packages.

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The implications of this enormous wave of cash are still yet to be realised. Over the coming years there will be a major global tug of war between bond yields and growth. There will be inflation. This ‘reflationary’ story will be strong. The recent tremors across the long end of the bond curve was only the beginning of this major shift approaching. The result will be much higher growth than forecast, with violently higher asset valuations.

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The classic ‘M2 money supply’ chart has seen the largest spike in history. Based solely on M2, standard valuations for risk assets should be much, much higher today’s valuations.

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US inflation has now been under 3% for over three decades. Forecasts are 6% plus GDP growth within the US by the end of 2022. The US Fed Chair (Powell), has promised no shift in the cash rate until inflation is sustained at greater than 2% annualised.

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Inflation is like the genie in the bottle – once it escapes Central banks will find it very difficult to cram the genie back into the bottle. The short end of the yield curve is suppressed, signalling the Fed is sitting on its hands. When the Fed acts, they will move swiftly and hike aggressively. According to UBS, the US Fed will likely begin to talk about raising rates during late 2022 – several years earlier than expected.

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A key question is what is back to ‘normal’ for interest rates. US central banks have expanded their balance sheet more over the 6 months more than the previous two US Fed Chairmen expanded over an entire decade (Bernanke and Yellen). The US fed will be borrowing more than US $120 billion of bonds per month in perpetuity!

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The Covid recovery will be starkly different to the financial crisis recovery. Covid was and is not, an underlying economic problem. There is no long-term structural impediment. Post the financial crisis, it took seven years for the US to return back to full employment.

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The four most dangerous words to investors are ‘this time is different’. Corporate balance sheets will be swimming in cash. This sheer amount of financial support will in essence, create a put option (floor) under risk assets for perhaps as long a decade.

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The unprecedented level of stimulus, coupled with abnormally cheap valuations when compared to the cash rate will provide equity investors with a ‘free kick’ for many years yet.

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Investors are now trying to define normal in an abnormal world. Humans were not wired to be locked up. Confidence is only beginning to recover. We are on the verge of the strongest economic recovery and global growth ever recorded.

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The global economy is like a coiled spring. Bring on inflation. The party’s only just beginning.

(Source: Commentary and notes taken during the 2021 Annual Portfolio Construction Forum, University of NSW, 3^rd March 2021.)

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Best Regards

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Craig Emanuel

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