View From The Top

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

View from the very top: Regardless of who wins the Presidential Election, the main priority remains reigniting the economy. An effective vaccine would help, but the bigger task is how to stimulate aggregate demand. Fiscal policy is going to play a markedly more significant role – this will be the new playbook. With monetary policy still very loose, rates (and yields) at close to record lows and significant spare capacity in the economy, it may be possible for policymakers to engineer a mini boom for 2021. This could lead to an abrupt rotation in investment styles in the near-term, but such an outcome would also create clear opportunities for more fundamental investors. For as long as growth proves scarce, longer duration assets should benefit, particularly in an environment of such accommodative policymaking. The case for active management remains compelling. 

Asset Allocation: 

• Equities: We continue to favour allocations to this asset class, underpinned by relative valuations, solid earnings (the Q3 reporting season to-date has generally surprised to the upside) and general tolerance towards more risky assets. A highly active approach remains crucial in our view. Clear opportunities exist both stylistically and regionally. We note that whereas MSCI’s Growth Index has gained ~20% year-to-date, the Value Index has lost ~10%. Separately, we see a growing case for allocations to China (and its A-share market). The country is witnessing a mini boom underpinned by strong economic data and valuation looks attractive in both a relative (versus developed markets) and historic context. 
• Fixed Income/ Credit: We continue to see large swathes of the debt market as offering return-free risk. Consider that investors get little compensation even for owning longer-dated debt, with fewer than 50% of securities with over 10 years of maturity now yielding above zero, even when adjusting for inflation. Some $16.5tr of global debt offers yields of less than zero (all data per JP Morgan). Such an outcome is pushing investors towards riskier segments of the market (i.e. high yield), potentially at their peril, in the context of high debt/EBITDA levels and worryingly low levels of interest cover. Do not rule out possible defaults. 
• FX: If the new US policymaking playbook chooses to embrace higher fiscal spend and a correspondingly larger budget deficit – as we expect it to – this would imply further US Dollar weakness. Such a view is increasingly consensual, but a lower Dollar may endure for some time. Such an outcome would be positive for Emerging Market currencies. 
• Gold: All roads continue to lead to gold. The asset remains a hedge against political uncertainty. It would also likely benefit from further Dollar weakness. Finally, do not forget the supply-side of the equation: discoveries are at record lows, reserves are falling, and mine production is flattening. With demand robust, the pricing set-up is attractive. 
• Alternative Assets: We see a clear role for such assets in portfolios. Low yields generally strengthen the case for private assets. Infrastructure assets may also benefit from the increased role fiscal policy is expected to play. Elsewhere, we see selected opportunities for business models with strong balance sheets such as seniors’ housing or logistics REITS. 

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation. 

To suggest that 2020 has been a year full of surprises so far would be an understatement. We expect little different for its final two months. At present, there are two major considerations: the bigger picture and the US Election. The result of the 

latter may be known shortly after this month’s publication. To take these significant topics in reverse order, our most important learning about politics (which was reinforced in 2016 after both the troubling Brexit vote and Donald Trump’s equally troubling Presidential victory) is simply to be deeply wary about predictions, the inference of causality and the danger of complacent assumptions. 

All this said, were Joseph Biden to win the Presidential Election (and the Democrats to gain control of the Senate), then we do have a sense of the likely playbook; or what might constitute Bidenomics. The best possible outcome would be a clear-cut victory and the avoidance of a long and potential messy legal battle. Investors should at least prepare for the possibility of a contested vote. In terms of what a Democrat clean sweep might imply, it is not simply a matter of more taxes. Sure, these would likely increase, but such an impact – at least in the eyes of the market – might well be offset by a significant package of fiscal stimulus. Beyond this, there is clear scope for America’s relations with the rest of the world to improve, and a reduction in (trade) tensions should almost certainly be seen as a good outcome. 

Importantly, however, regardless of who wins on 3 November (or at some future stage), the virus will still be present. Winter in the northern hemisphere may only deepen the problems that arise as a result of it. Against this background, the arrival of a vaccine, arguably, remains the biggest potential catalyst for financial markets. Remember, this is not a normal cycle. Owing to an exogenous event (i.e. the pandemic), recession has been the result rather than the cause of the current economic downturn; businesses were forced to shut and consumers told to remain at home. The downturn cannot, therefore, be cured simply through the use of stimulus. Rather, the root cause needs to be addressed – hence the importance of a vaccine. The good news is that over 170 research teams are at work currently, and 9 vaccines are currently in Phase 3 of the approval process, with results potentially known by the year-end. Even then, of course, a vaccine should not be considered a panacea. When approved, its production and distribution will be a major logistical challenge where the constraints on air freight and temperature-controlled delivery should not be understated. 

Although a vaccine will undoubtedly help, let us not forget that people’s behaviours have changed – the world is never (or at least no time soon) going back to how it was. Consider then that recovery is contingent on controlling the disease, but fiscal (and monetary) policy can and will have a major role to play in the near-term. To mitigate the threat of a long and drawn-out period in the economic doldrums, policymakers must avoid making the mistake of withdrawing their accommodative stance too soon – we all want to avoid another taper tantrum. In other words, policy is here to stay. 

Financial historians may well look back on this period as the moment when regime change occurred; a new playbook became the norm. We are seeing a clear and distinct handing-of-the-baton from monetary to fiscal policy. Think of this as an inflection point in capital markets. Although a shift had been building for some time, the defining moment may have been the speech given by Jerome Powell, the Chairman of the Federal Reserve, at the Jackson Hole symposium in August. Here, he argued that “monetary and fiscal policy need to work side by side” and that too much stimulus is better than too little. 

At the heart of Powell/the Fed’s concern is anaemic growth. For sure, US (and global) GDP estimates have tanked this year. Pre-pandemic, consensus had assumed 1.8% GDP growth for the US in 2020; currently -4.3% is discounted. In this environment, worrying about the risk of inflation hardly seems top of mind. Arguably, disinflation (declining inflation) or 

deflation (falling prices) are bigger concerns. This explains the shift in the Fed’s stance – its biggest since the introduction of quantitative easing after the financial crisis – to average inflation targeting (or AIT). Such a policy constitutes a distinct reversal of the mindset entrenched by Paul Volcker (Fed Chairman from 1979-1987), seen largely as the individual most responsible for bringing inflation under control. Of course, neither the European Central Bank nor the Bank of Japan has been successful in its pursuit of AIT, so it would be fair to wonder whether the Fed will do any better. 

Aggregate demand – or more precisely, a lack of – lies at the heart of the problem. A stagnant economy will fail to put people back to work who have lost their jobs as a result of the pandemic, and it certainly won’t provide employment for a growing population. Consider that US jobless claims stand at 11.7m vs 1.6m pre-pandemic, with unemployment at 7.9%, compared to just 3.7% in February. Further, don’t discount the arising/arrival of pandemic anger and fatigue. For sure, financial fragility and widening inequalities are nothing new, but they have certainly been recently exacerbated. 

Do not forget that deflation is something that has been building for some time. The combination of the Great Financial Crisis, adverse demographics, the growing importance of technology and an increased savings rate has exerted significant downward pressure on both prices and expectations. Not all the above can be cured by monetary policy alone. Further, it’s hard to take interest rates any lower than where they are today. With interest rates at (close to) zero, monetary policy has no place to influence aggregate demand. 

As a result, we will now see a shift towards ultra-loose monetary policy being combined with expansionary fiscal policy; call it modern monetary theory by another name – this is the new playbook. Global cumulative fiscal support year-to-date has totalled $11.7tr, or 12% of total world GDP, but to provide some more context, government debt as a percentage of GDP is expected to grow from 83% last year to 100% by the end of next year (all data per the IMF). With output gaps set to endure for some time – Alpine Macro estimates that America’s may currently be equivalent to as much as 10% of its GDP – inflation is not presently a worry. Even when it does pick up, inflation’s progress is rarely linear. Expectations will have to adjust first, and this may take some time. 

What does all this mean for 2021? We see the possibility of a mini boom, particularly if any acrimony around the Presidential Election is swiftly resolved. Under this scenario, the presence of an effective vaccine and the release of pent-up economic demand would act as effective catalysts. The endurance of the broad rally in risk assets perhaps implies that capital markets are already looking beyond the current dip in the economy to better times. Liquidity will be plentiful in a world where fiscal and monetary policy are extremely loose and yields (both real and nominal) are near record lows. A weaker Dollar and low energy prices also help. Such an environment is supportive to increased risk tolerance. 

Although a powerful rotation towards value may be possible (particularly under a clear Democrat sweep), this may create an opportunity for more fundamental and longer-term investors to access assets that were previously considered too rich. For as long as growth remains scarce, fiscal and monetary policy remains aggressive and rates remain low, long duration assets can benefit. Long live active management, especially with so much dispersion in earnings. If nothing else, the path forward will remain bumpy and non-linear. 

Alex Gunz, Fund Manager, Heptagon Capital