HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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March 7, 2021

Good Interest Rate Rises & Inflationary Head Fakes

Bubble Trouble -

2020 saw world stock markets reach all-time highs at a time when economies were effectively closed down. 2021 is showing signs of year on year economic recovery, yet world stock markets are in reversal. This dilemma only makes sense if you factor in government monetary and fiscal policy and investors’ fear of deflation and inflation.

Growth Spooked -

 2021 to date has been characterised by a sharp bond market decline. This has spooked share prices, particularly for those companies on very high valuations relative to their sales. These include the tech giants of NASDAQ, but the most extreme examples of overvaluation are found in the biotechnology, green energy and software-as-a-service sectors with ratios of market value to sales commonly on bubble-like multiples of 10x to 100x.

Crying Wolf -

Financial market commentators tell us daily that this sharp increase in rates is an early warning sign for imminent and rampant inflation. (Some are saying that the bubble-like asset prices are prima facie evidence of inflation). However, while this cannot be ruled out, it seems premature. Rates have gone up sharply, but they remain broadly in line with the historic low levels seen over the past 10 years. Meanwhile, the classic inflationary bell-weather, the gold price, has actually declined over this period. While one can never be categoric, now does not seem like the moment to cry wolf regarding inflation.

Investors Doing It For Themselves -

What is happening remains consistent with the reopening trade, which is being allowed to play out by a Federal Reserve with a recently stated ambition to leave the punchbowl on the table, rather than its previous preemptive stance on punchbowl removal. To paraphrase, it is allowing the economy to have its punch and drink it. This more relaxed policy allows for a more rapid return to yield curve normality than we might otherwise expect. Another way to interpret the bond markets’ newfound strength is that fixed interest investors are telling the Fed: if you won’t do what is necessary, then we will.

Party Time -

This switch in investor preference for this year’s returns rather than those a decade or more hence can be considered a good interest rate increase. The economy has come out of the freezer; the price of money has thawed; the opening up trade is reaching maturity. Airlines, cruise lines, retailers and hospitality companies are returning to life. These are sectors where market value to revenue ratios are very often below 1x. The relative attraction of cheaply priced recovery has improved relative to the expensively priced long term structural growth. It is investors saying we like this party a lot more than we did last year and the punch tastes pretty good.

Failure Forbidden -

While the Treasury yields have swiftly increased from below 1% last year to a more normal 1.5% today, credit spreads have not. This is why smaller companies have significantly outperform larger ones. However, the opening up trade’s maturity implies that things will start to get trickier from here. 2020 experienced record low levels of corporate insolvency, which was effectively outlawed during the lockdown. Landlords were not allowed to remove tenants; companies were paid to retain furloughed staff, and banks were pumped with schemes to provide liquidity to marginal businesses. In 2020 it was almost impossible to fail.

Adjustment -

The next chapter of the reopening trade is our first opportunity to see what the new normal might look like. We might like to think about going to the cinema, but will we actually do it, and if so, how frequently? Of critical importance is the rate at which the economy can restructure to what we decide is the appropriate number of cinemas, restaurants, buses, and office blocks. Company insolvencies will all increase in 2021, as will restructurings and recapitalisations. The process of capitalism’s creative destruction has been put on hold. For the banks currently benefitting from a steeper yield curve, things will look less rosy when the new normal emerges, and companies are allowed to fail again.

America First -

As in the aftermath of the GFC, the US economy seems to be in the vanguard of recovery, stimulating a rise in the benchmark US interest rate. However, this process sucks capital away from other areas, such as the Eurozone, typically behind the US recovery. Crucially the ECB has fewer logs to throw on their financial fire. As with previous periods of financial distress and recovery, it looks like America will leave Europe holding its baby as the party moves into full swing.

Have a Drink -

Investors should remain alert to the risk of inflation. Still, for now, the deflationary forces of economic restructuring combined with the impact of (increasing) technological advancement, are likely to hold inflation sufficiently in check. The difference this time is that central banks are more determined than before to achieve retail price inflation rather than simply inflate assets. The key test is the future trend in real wage growth. Watch this space, but for now, have a party and enjoy the punch before the bowl is finally removed.

Jeremy

Ealing

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