Investors will surely agree: we have been experiencing the most interesting financial environment in decades … maybe a half century and more. The old adage of “may your life be interesting” never had anything to do with best wishes. Not only are the latest secular trends completely transformational, we are also dealing with one-time factors that may have produced significant distortions to economies and financial markets.
Lately, investment factors have been rotating hard … rocking back and forth. This has had a major impact on portfolio returns. Generally, growth has been “out” and value “in”. At times, it has seemed as if value and cyclicals have been on a run-away train in recent weeks. Do we need to signal the brakeman?
We think not yet. Our view is that there is still a long open track for these trends to stoke further. After all, value sectors had been rail-roaded to oblivion for many years. Now, it is again their turn. Only a fraction of their past suppression has been reversed.
That said, trends are rarely linear. Therefore, while we hold to the reflationary view, we do nonetheless expect a bit of a breather … some of which already appears to be underway.
INFLATION OUTLOOK/CONSUMPTION/INTEREST RATES INTERTWINED?
Whither interest rate trends? This is an intensely debated topic at present. We have been underweight fixed income-related exposures and clients have been rewarded.
For now, the key question to ask in this matter is this: how long and deep will there be a recovery consumption boom? As do most, we expect a rapid resumption in consumption and discretionary spending. The key question is what is already discounted in financial markets.
The biggest “loose cannon on deck” is household cash levels which have soared and are likely are to build further with the new Biden stimulus package now being dispensed. These cash hoards are not easily channeled by policymakers and are liable to have a mind of their own. We are closely monitoring this situation … will households spend as sailors on shore leave, or hunker down with higher savings?
Longer-term, we could differ with the consensus view. In the short term, however, there is still a strong case to be made that the recovery spending boom can be expected to be relatively powerful.
ARE WE EXPERIENCING A BUBBLE?
We make a case that we are now living in a bubble-prone environment that can be with us for quite some time. We will call this a period of “effervescence”. It is a secular and structural development we think.
There are likely to be a few mini bubbles underway at any one time. A number of these are “scarcity plays” and others, such as Bitcoin and EVs, are outright speculations. However, we would argue that none of these bubbles would shake the financial system were they to bust.
We anticipate that a “structural” bubble environment can continue for some time. Why?
The bottom line is that policymakers must create asset inflation in order to supplement and overcome low income yields for present and future retirees (what we call the Global Income Famine).
All of this bubbles up to financial markets being emboldened by the huge “put” that is endorsed by central banks. It would be an ideal environment for middle class households (namely those, who have meaningful savings and capital).
CASH AND CURRENCIES
The threat of rising inflation makes holding cash unattractive, as an acceleration of purchasing power erosion could play out over the next couple of years.
However, with equities vulnerable to a “cooling off” period and longer-term bond yields rising in response to higher growth and inflation expectations, cash has become a critical diversifier and risk offset in the current macro environment.
Cash and equivalents have been raised above benchmark this quarter in balanced and growth-oriented mandates, with a view to deploying excess cash into market weakness.
Reducing US dollar hedge
Given the structural overvaluation and counter-cyclicality of the US dollar (not to mention the US government’s burgeoning fiscal deficit), we remain bearish on the currency from a longer-term perspective.
Conversely, on a shorter-term time horizon, the dollar has been oversold and rising US treasury yields will encourage capital inflows from “carry trade” and yield-starved fixed income investors alike.
We remain underweight the US dollar in client portfolios, but have materially increased exposure to the currency this quarter.
Trimming overweight equity exposure
Global equities are in a bull market, rebounding significantly off of the lows reached in late-March of 2020.
The “initial burst” recovery phase is likely nearing an end and underlying fundamentals (earnings growth and cash flows) now need to catch up to expectations.
Equities could be in for a bumpy patch as the market reconciles predictions against realities. Given a constructive economic environment, we remain modestly overweight equities, but have further trimmed exposure this quarter.
Adding defensive and high yielding exposures
In addition to the aforementioned broad equity market vulnerabilities, rising bond yields throw a stick in the spokes of growth stocks, which thrive when their future earnings streams are discounted at ever lower interest rates.
We have added defensive and high yielding exposures this quarter to lower portfolio beta, boost income and pivot away from the most vulnerable segments of the equity market.
Positions in US utilities sector and emerging markets (EM) high dividend yield equities have been initiated in client portfolios.
GLOBAL FIXED INCOME
Increasing fixed income exposure
Bond investors appear to have come to terms with our hypothesis of a multi-year economic expansion, as yields at the longer end of the curve rose sharply last quarter.
While momentum could potentially continue to fuel the sell-off in the near term, our view on bonds has improved, given higher yields and less vulnerability to positive economic surprises.
Fixed income exposure has been increased in client portfolios this quarter, but remains modestly underweight.
Selling high yield, buying hard currency EM sovereign bonds
US high yield bonds are trading at historically low yields and tight spreads versus US treasuries, despite somewhat elevated default rates.
In comparison, US dollar-denominated EM sovereign bond spreads are also tight, but not at extreme levels. With their superior credit quality, EM sovereigns offer a more attractive risk/reward trade-off.
We have rotated out of US high yield bonds and added to hard currency EM sovereign bond exposure this quarter.
OPPORTUNITY INVESTMENT HIGHLIGHTS
Liquidating metals and mining equities
Our expectations for rising industrial metals prices was rapidly affirmed by financial markets.
With disruptions in mining supply chains during 2020, substantial fiscal stimulus earmarked for infrastructure projects and surging global growth expectations, metals and mining equities have staged an impressive rally.
With much of the “good news” now discounted in the price, we have elected to take profits and step aside for the time being as the asset class is showing signs of overheating.
Adding to Chilean equity exposure
As the world’s top copper producer and second largest lithium producer, Chilean equities offer a more cost-effective exposure to industrial commodities.
Both copper and lithium are critical components in electric vehicles, which aligns Chilean earnings with a long-term growth driver as automobile manufacturers pivot en masse away from internal combustion engine vehicles.
Despite strong recent performance, Chilean equities are still reasonably valued and do not fully reflect the terms of trade boost exporters have received from rising commodity prices. We have increased exposure in balanced and growth-oriented strategies this quarter.
Gross-of-fees performance ($CAD) as of February 28, 2021. Returns for periods greater than 1 year are annualized.