Over the course of the last twelve months, the world has progressed through three broad phases of the recovery. The first, occurring in Q2 and Q3 of last year was around the growing understanding of the virus and its management through social distancing, etc. Large cap, growth biased stocks benefited at this time.
The second phase, around Q4 of last year, centred on positive news on the efficacy of multiple vaccines. Optimism grew that the very “event” that caused the global recession was in the process of being addressed. This helped to lift cyclical sectors like small cap stocks and emerging markets.
This month entered the third phase – the reflation phase. Vaccination programs have begun in earnest, case numbers are coming down and confidence has grown in the ability of economies to reopen. The recovery is now being priced by other asset classes including commodities and fixed income.
Naturally, being forward looking, the market will look toward the fourth phase, inflation. We believe this is premature and is more a story for later this year, or into next year.
The biggest vaccination campaign in history is now underway. So far, more than 181 million doses have been administered across 78 countries at a rate of 6.2 million doses per day. A total of seven vaccines are now available for public use.
Case numbers are declining significantly, and vaccines are working. Data from Israel, the leading country in vaccinations, shows that vaccines play a role in reducing cases. Israel has reported a 94% drop in symptomatic Covid-19 infections among 600,000 people who received two doses of Pfizer’s vaccine.
Israel is also seeing a sharp decline in hospitalisations and there is no indication that protection against severe illness is compromised by the new variants.
Chart 1. Vaccine doses per 100 people
In the U.S., more Americans have now received at least one dose than have tested positive for the virus since the pandemic began. At the current rate of 1.6 million doses per day, it will take an estimated eight months to cover 75% of the population with a two-dose vaccine.
Up to 15 billion doses are needed globally to protect 80-90% of the global population. This target is expected to be met by 2022 even though most vaccines require two doses.
Vaccination programs are also well underway in emerging markets. India has inoculated over 8m people while Indonesia’s tally stands at 1.6m, according to Bloomberg’s Covid-19 Tracker.
Run rates are expected to ramp up in coming weeks and months: manufacturing capacity is expanding, new vaccines are being added to the pipeline, regulators are endorsing longer intervals between doses, and the final mile is getting more efficient. And importantly, public attitudes toward vaccines are improving, not least in notoriously sceptical countries such as France.
There is likely to be a virtuous cycle between rising vaccination coverage and falling hospitalizations: the more pressure is taken off the healthcare system, the more capacity there will be for vaccinations.
The political and scientific consensus is seen shifting towards reopening the economy once those most at risk are protected, rather than waiting for herd immunity. In any case, herd immunity could be reached sooner than vaccination rates imply – seasonally lower transmission rates in the northern hemisphere summer months will offer a bridge until even young people are vaccinated, and up to a third of them will have built natural immunity anyway.
All this bodes well for the reopening of economies.
Reopening means the pent-up demand that has been so well supported by record fiscal and monetary stimulus can start to be released. The recession appears to be behind us in most countries, and the early stages of an economic expansion are taking shape. We have noted previously how small cap stocks tend to do better than large cap stocks at this point in a recovery phase (see “Monthly Agenda: Time for small to shine?”, October 2020).
A reopening allows the real economy to begin growing again. Unlike during the global financial crisis, fiscal policy is now mainly targeted at the “real” economy – business investment and consumer spending. Together, these two sectors make up around three quarters of a developed economy’s total GDP. The policy is aimed at bringing about so-called ‘multiplier effects’, whereby stimulating growth automatically leads to a further acceleration in growth.
The boost to household balance sheets alone has been significant. In Australia, the current saving rate is sitting at 18.9%, almost four-times its level twelve months ago.
Chart 2. Household saving rates for selected countries (%)
Some of that pent-up demand is already being spent on goods. This is helping to boost production activity in places like China, South Korea, Vietnam and Taiwan. There is a very strong correlation between consumer demand in developed economies like the US and production activity in Asian emerging markets (see also “Monthly Agenda: The emerging recovery gets a tick”, November 2020).
Chart 3. Asian exports (yoy %)
Will we see a rotation from growth to value?
There is a lot of talk about whether we will see a rotation out of growth biased equities into value as a result of the economic recovery.
The outperformance of value over growth has been relatively modest so far despite a positive cyclical outlook. Year-to-date value stocks are up 5.8% while growth stocks are up 3.7%. It is important to note that both value and growth biased stocks have historically responded positively to rising bond yields, at least initially, because it implies faster economic growth and hence faster earnings growth.
Trying to time when to rotate out of growth into value is difficult and imprecise. Looking at the performance of US value versus growth stocks since 1980 we find that during tightening cycles growth outperforms value 50% of the time and during easing cycles growth outperforms 56% of the time. During periods of stable monetary policy, growth outperforms value 59% of the time.
A clearer picture is revealed when we look at the magnitude of the outperformance. The return from US growth stocks during a tightening cycle is on average 13.8% versus 10.0% for value stocks. During an easing cycle, the average performance from growth is 26.2% versus 13.8% for value. During periods of stable interest rates the average return from growth has been 23.4% versus 19.7% for value.
Chart 4. Growth versus value style during easing/tightening cycles
We believe it is too difficult to try and time the market based on value or growth style. Unlike the case between large cap and small caps or emerging markets and developed markets, the thesis to rotate into value is not compelling to us. Instead, we try and select fund managers than can perform well in any cycle.
Reflation occurs when the recovery becomes more broad-based and widespread. This is when the recovery draws in other asset classes, not just equities. Reflation is therefore associated with higher costs – higher input costs, financing costs, labour costs. In this phase we tend to see profit margins either stabilise or grow at a slower pace depending on how rapid the increased cost pressure is.
We can see from Chart 5. that manufacturing activity in China has resulted in a surge in imports.
Chart 5. China imports from the top 5 import partners (yoy %)
This is not only boosting economic activity among China’s trading partners, it is also lifting commodity prices. Many of the goods China imports are commodities – crude oil, petroleum gas, coal, iron ore, aluminium, nickel, copper, gems, soy beans and precious metals to name a few (see Chart 19.).
Emerging markets have been performing well since late last year but in the reflation scenario, when commodity prices begin to rise as well, emerging markets more broadly begin to take the lead over developed markets like the US.
Chart 6. Emerging markets outperform when commodities lift
Reflation now, inflation later
The reflation trade is powering assets tied to economic growth, including commodities and cyclical stocks, and price pressure is emerging. This is exactly what policy makers want to see. Nothing sends a chill down the spine of a central banker more than the word deflation. Deflation (falling prices) reduces the effectiveness of monetary policy by putting upward pressure on real interest rates.
The consequence of higher commodity prices is a weaker US dollar. A weaker US dollar will put upward pressure on import prices and hence inflation more generally. There is still a long way to go on this front however (import prices are growing at just 0.9% yoy) and the link into consumer prices is not straight forward.
Inflation is something that needs to be watched closely, however. And as the reflation phase continues, we expect to see inflation move up as excess capacity in the economy is depleted.
All about the US dollar
Eventually, the reflation trade will come full circle as rising bond yields put upward pressure on short-dated bond yields (via higher inflation expectations), putting upward pressure on the US dollar, tightening financial conditions and so putting downward pressure on equities.
The trade-weighted value of the US dollar has a fairly consistent inverse relationship with risk assets like equities. That is, a higher dollar tends to be associated with lower equities. One explanation for this is that many large U.S. companies earn a good proportion of their revenue from offshore. Overall, for the S&P500, the share is around 30% but for Apple for example the share is more like 60%. As the dollar rises, the domestic value of their income earned abroad falls.
It is not just U.S. shares that suffer when the dollar lifts. A higher dollar reduces the demand for dollar-priced commodities and so lowers the benchmark price. Commodity-producing nations and companies are negatively affected as a result.
So for equity investors, the key to watch is the impact of higher bond yields on the US dollar.
Which bond yield is the most important?
Historically, the US dollar is most sensitive to shorter term bond yields. Over the last 20 years, there is a statistically significant positive relationship between the US dollar and the US 2-year bond yield. That is, higher 2-year yields are associated with a higher US dollar.
The explanation here is in the close relationship between 2-year yields and the official interest rate (the Federal Funds Rate) (see Chart 16). As the chart below shows, the 2-year bond yield in the US is extremely well anchored right now thanks to the words and deeds of the US Federal Reserve.
Chart 7. US 10-year and 2-year bond yields (%)
While we may see bouts of US dollar strength, the overall direction of travel appears more likely to be down given the ongoing participation of the US Federal Reserve in debasing the currency and keeping interest rates low. This will be supportive of higher commodity prices and hence emerging market economies.
We maintain our underweight positions in cash and fixed income and overweight in Australian and Emerging Asia equities and overweight in Alternatives. Allocating part of your equity allocation to small cap companies also makes sense at this point in the cycle.
Two points are worth making.
First, we note our current thinking has become consensus, after being contrarian for much of the last six months. The crowd is very much moving into equities right now with global macro hedge funds favourable toward equities again.
Now is a good time to remember that just because a position is crowded doesn’t mean it’s wrong. However, history does tell us that when strong consensus expectations and crowded positions build up, the room for disappointment grows and a potentially sharp re-pricing can follow if things don’t play out as expected. Compressed springs have a habit of flying open unexpectedly.
For this reason, we like to ensure we have airbags in our portfolios, just in case. Right now, our airbag is to be 100% unhedged in international equities. If we do see the spring fly open, the US dollar will likely rise and act as a cushion under our returns.
Second, we are conscious of the speed at which this recovery is travelling – faster than any recovery that has come before it. The size and shape of the stimulus together with the soundness of underlying economic fundamentals suggests excess capacity may be depleted faster than expected. We will be watching for signs of this and what, if any, impact it has on policymakers this year.