We wrote an article in May 2020 entitled ‘V for victory?’ which made the case for a V shaped recovery for both markets and (later) economies. Our arguments were the level of monetary and fiscal stimulus being provided to counter the pandemic.
One year later, risk assets have indeed ridden up the other side of the V and it is clear to us, from data such as business confidence and shipping rate indicators, that economies are doing the same. Yet central banks’ monetary taps are still turned full on. The end-March data from our friends at CrossBorder Capital shows that overall liquidity stands at 80 (0-100 range) and that central banks in aggregate are at 95.
For us at Linchpin that implies that risk assets are strongly underpinned. Equity markets’ total market capitalisation stands at 0.57 (again, thank you CrossBorder Capital) of overall liquidity relative to a long-term average of 0.51, with peaks of 0.85 during the dotcom bubble and 0.71 just before the GFC. Valuations may be high but they are not yet in bubble territory.
However, it raises the questions why the authorities are still being so generous and what happens when they stop. Does the explanation go back to the root of the problem in March 2020, when there was an acute shortage of high quality collateral to back short-term credit markets (see Linchpin articles passim)? Are they erring on the side of safety for political reasons? Are they looking to generate some inflation to reduce the real value of their debts?
I think we can discount the third for the moment. There are indeed some increasing signs of inflation but, as after the GFC, they are mainly in monetary assets (housing, equities, Bitcoin) rather than high street inflation. However, the collective memories of institutions like the Federal Reserve and the Bundesbank is quite long enough to be wary of the dangers of excessive inflation.
So I fall back on the first two reasons. Credit markets are not at the centre of investors’ radar-screens at the moment and liquidity is clearly plentiful. But liquidity is not fungible, ie. it often does not flow to where it is wanted and it might not take much for repo markets to freeze up again. However, I suspect the real explanation is the second, that politicians and central banks are (in our view wrongly) terrified the recovery might not happen and have therefore left the taps running.
We shouldn’t be surprised that bond yields have risen as a result. Yield curves always steepen at this point in the economic cycle and term premia a year ago were abnormally low. The question is how much more they will rise. In my view they are not yet sending any signals about inflation but simply reflecting a greater appetite for riskier assets. CrossBorder Capital’s analysis suggests that US ten year Treasuries could reach 2.5% (currently 1.7%), which sounds a reasonable short-term target.
The corollary of greater risk appetite is that money eventually moves out of financial assets into the real economy. It starts with rising bond yields but sooner or later equities also suffer from lower demand. That is why they usually perform better in anticipation of economic recovery rather than the actual event. So at Linchpin we would expect a gradual rolling over of equity indices later this year, driven partly by these fundamentals and partly by the impact on the main equity indices of the growing preference for lower duration cyclicals over the mega-stocks which have dominated the last ten years.
I will finish off with brief comments on China and gold. The PBOC has been markedly less loose than other central banks but its current policy stance is certainly not tight. The economy was first into the pandemic and is likely to be first out. We can see that in rising commodity prices. Even if the trade friction increases, it is now a superpower with influence similar to the US on the world’s economy and markets. Overall investors - despite concerns over human rights, ESG etc - cannot afford to ignore that.
Gold is the dog which is not barking. Owning it has historically been a generally reliable hedge against monetary inflation but in the last nine months the price has declined despite other asset valuations rising. Some will attribute that to the rise in cryptocurrencies which have some (but not all) of the attributes of gold. However, we doubt that five thousand years of humans valuing the glint of gold will disappear so suddenly if monetary inflation continues. CrossBorder Capital’s target price is $2,600.
In summary, it remains a mellow environment for investors, primarily because of the monetary stimulus being exerted. I will make the usual caveat about political events upsetting the apple cart, and I have long argued we are close to a major change in the direction of markets. But, in the short term, it looks like investors should stay invested in risk assets.
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