EDURAN NAVIGATOR

Quarterly Market Review with an Outlook.

Zurich, 8th Juli 2021

“Have a break”. With lockdowns being lifted in many places, the economy is recovering. Supply side delivery chains can barely keep up with demand, which has been substantial as a result of accumulated savings and pent-up consumer demand. As a result, prices are rising. Stock markets appear unconcerned yet. The situation is coming to a head: will low rates and fiscal stimulus result in untamed inflation or will deflationary forces come back? The markets, being undecided on this point yet, trended sideways in the quarter, with a slight inclination towards strength.

Market Review

The markets confirmed the upward trend in the first quarter and – once again – served as an augur of economic performance. According to the forecasts, the economy should continue to stabilise and – depending on the success of vaccination efforts – further return to normality. Whatever this normality may look like in detail.

The lockdowns imposed by governments and the burdens they caused contributed to growing debt levels: measured in terms of gross domestic product, the debt of the what continues to be the world’s largest economy – the USA – rose substantially over 100% and set a new and remarkable record of more than 130%, well above the 106% level recorded after World War Two.

As the economy reopened, unemployment figures quickly fell as well. At the current pace, unemployment should return to pre-pandemic levels by the end of 2022. Such a recovery would be about five times faster than the one following the financial crisis.

On the labour market, wages have simultaneously risen. Critics have complained that companies have been forced to pay higher wages to entice people back to the job market because of the relatively generous support offered by government.

The massive rescue operation carried out by central banks and governments has given the markets two crutches to stand on, so to speak. Critics of such rescue operations are growing scarce. While it may not necessarily occur today, there is a risk of a certain amount of hubris.

Markets review

The situation has calmed somewhat, after it looked like the markets were set to take a downward turn (in May and June). Volatility has returned. After it failed to drop below the low it reached at the end of March, gold commenced a new upward climb. There was a consolidation towards the end of the quarter and the price of gold fell again, as did most other metals and agricultural goods. Only energy sources, such as crude oil, continued their upward trend.

In terms of sectors, energy stocks rose substantially, but there were sectors that benefited even more. For example, the real estate sector saw the sharpest increase, followed by tech stocks. At the lower end of the spectrum are utilities, followed by consumer goods/staples, which are likely continuing to suffer from lower capacity utilisation.

Current Focus

There was a yield turnaround some 75 years ago. Measured in terms of longer duration US government bonds, yields reached their low in spring 1946, at just above 2%. Over the next ten years, the yield on these bonds rose to just over 3%. This was the beginning of the infamous bond bear market, which lasted from 1946 to 1981. While it may not have started with a lot of noise, it was emphatic nonetheless.

There is now once again a focus on yields. Put simply, current events allow for two (opposing) interpretations: Either inflation will rear its head or disinflation will return (or even worse, deflation will set in).

According to the official statements by central banks, what is occurring now is what is called transitory inflation. Prices are rising because i) a lot of money was saved during the lockdown and consumers are now making purchases they had put off before, and because ii) capacity was reduced during the lockdown and is now lacking on the supply side. Following a brief rise, inflation should level off again and climb slightly, entirely in line with the expectations of central banks. Those who are concerned about inflation view things differently: prices will remain high, which will in turn result in higher wages. An upward spiral is about to get under way. Those concerned about deflation are in agreement with central banks that the increase in inflation will only be temporary, but are worried that the deflationary forces of recent years (demographics, technology, debt pressure on economic vitality) will return.

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On the monetary side, there is a lot of talk of money printing and, as a consequence, rising inflation. Following the events of the financial crisis in 2008/09, central banks reduce interest rates and then, at the end of 2011, increasingly began buying up bonds on the market. As a result, central banks’ balance sheets rose substantially. However, the money used to purchase the bonds did not enter circulation directly, but was instead held as credit balances by commercial banks on the central bank’s balance sheet. Low interest rates are intended to motivate private customers to take up loans. This will help the economy gain momentum. But low interest rates also show that lending is sputtering: interest rates are reduced in order to bolster lending. Milton Friedman showed this in his work. If interest rates are too low, banks will increasingly only lend to the most solvent clients, as they have few reserves to cover defaults. With the shock of Covid, we may have reached this point – lending has declined, according to published statistics. The money that commercial banks have as a reserve with central banks remains caught up in the banking system and is not making its way into the economy. As a result, there is too little or at least less money in the economy; in addition, existing loans will need to be repaid one day, including interest. It could be said that lower lending will result in a shrinking money supply and that assets will have to be corrected downward. The result is deflationary pressure.

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The yield on 10-year US Treasury bonds has declined again somewhat, after rising sharply in the first quarter. Do the markets share the view of central banks – namely, that inflation is only temporary and/or that bonds will simply increase in value because banks are unable to lend the money and that they will therefore invest it in fixed-income securities?

Inflation-adjusted government bonds show no significant signs of rising inflation. Quite the contrary: A comparison of the current situation with the crisis in 2008/09 reveals similarities. Following an initial period during which yields rose, they eventually settled at a much lower level.

The yield curve became steeper over the course of the quarter. However, following the recent meeting of the Federal Reserve it flattened somewhat (though there is some speculation that short-term yields might be increased somewhat earlier than thought).

By contrast, in Europe yields have climbed somewhat. For example, the (10-year) yield on German Bunds has risen from -0.29% to -0.20%. In Italy, yields increased from 0.67% to 0.82%, and in France they rose from 0% to 0.13%. Industry is recovering and the euro has not managed to break out on an upward trajectory (next run to weakness against the US dollar?). In the UK, the yield fell from 0.85% to 0.72%.

Outlook

The Biden administration has big ambitions, with plans to spend USD 6-8 trillion (or a little bit less than that). This represents around a third of the estimate annual economic output of the USA. US citizens are receiving, via the American Rescue Plan, USD 1,400 – in addition to the USD 600 per citizen that has already been paid out – and the USD 1,200 sent by the former Trump administration. The “Build Back Better Plan” also includes the “American Jobs Plan” and the “American Families Plan”. It is clear that the state is taking matters into its own hands.

Politicians in other countries have taken measures and set up programmes to support private individuals and companies as well. Of course, they caused the damage with the lockdowns they imposed. But the programmes politicians initiate often stay in place long than expected. Dependencies arise, with the result that the state may gain influence at the expense of the private economy. This may be followed by regulations imposed by politicians. The economy may become less free. Those who suffer will be the ones who can (or have to) pay the bill and are not highly mobile: the middle class and industry. The Trump administration, in line with its slogan “Make America Great Again”, was in the process of coaxing capital and jobs back to the USA – at the cost of the winners of globalisation over the past 20-30 years, like China and other global and regional (Mexico) workshops. The Biden administration seems to want to work less emphatically in this direction and thus a portion of the global value chain will take place outside the USA. Without additional (well-paying) jobs and thus income the political situation will likely remain tense, both in the USA and in Europe.

In general, it can – or it might be better to say, it appears on the market it is assumed that what has occurred on the markets over the past ten years or so will continue. Central banks – and now since Covid, governments as well – are always attempting to prevent dislocations. Interest rates remain low, while capital is being driven towards risky investments. However, as the section about interest rates showed, the lower interest rates fall, the more lending falters (as banks become more selective in terms of whom they lend to because of lower margins). This could have fatal consequences, as deflationary forces would gain momentum and assets, including stocks, would then lose value. Thus, a close eye needs to be kept on this development, and investors need to invest in quality assets and, where possible, diversify (which can be a challenge, as many assets depend on interest rates).

“There ain’t no such thing as a free lunch.” Robert Heinlein, 1966, (The Moon Is a Harsh Mistress)

EDURAN AG

Thomas Dubach