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Macro Outlook: The Power of Narratives

13 Nov 2020
By
It would be impossible to write a macroeconomic piece this week and not have US elections sit at the heart of it.

As was the case with polling experts, many market-watchers made broad assumptions about what a Biden versus a Trump win would mean for stocks. Both are examples of the difficulty of making forward-looking assumptions in today’s world of economics and politics, especially when they are superficial assumptions spread over highly intricate underlying landscapes.

Shortly after polls closed in the US last week, Shannon Rivkin drove home the important point that the make-up of the US Congress (a Democratic majority in the House of Representatives and Republican majority in the Senate) would likely remain the same, regardless of the change in presidential leadership. This means policy change under a new leader will take a lot of time and a lot of compromise.

Here is a quick example of some issues that will make you question ‘logical’ assumptions made amid this change in US leadership:

  • Assumption: Joe Biden wins so he’ll overturn Trump tax cuts / Challenge: But can he? Not without a Republican senate that agrees to them
  • Assumption: Democrats will spend big on infrastructure / Challenge: Same as above, Republicans campaign on ‘small government’ and will scale back the size of the Democrats’ $2.2 trillion package
  • Assumption: Joe Biden will remove China tariffs / Challenge: Although his views on China relate more to humanitarian issues than unfair trade, it would be wrong to assume Biden will go soft on China
  • Assumption: The economy was the election’s #1 vote-winning issue; Republicans will want to use their Senate position to make four years of Democratic leadership look painful for voters / Challenge: No challenge to this! However, the worse the ‘real’ US economy, the harder the US Federal Reserve will have to work – so perversely, a tough economy and high unemployment could be the best thing for ongoing stock market strength, as continued quantitative easing from the Fed supports stocks and bonds, while pinning interest rates close to zero
  • Assumption: A COVID vaccine is coming! Markets will rally! / Challenge: While this may be true in the short term, there are huge amounts of additional monetary and fiscal stimulus in place globally designed to cushion the negative impact of COVID (somewhere between US$15-$20 trillion so far); so as COVID is slowly overcome, so too will COVID stimulus be removed, potentially removing excess ‘easy money’ from capital markets
  • Assumption: Trump isn’t going anywhere and Republicans are backing him! So much uncertainty! / Challenge: Senior Republicans like Mitch McConnell do not want to alienate Donald Trump’s fan base by abandoning him and his legal attempts, so they are forced to play along – and while anything can happen in politics, no matter what happens, the Federal Reserve is going to have to continue working hard supporting markets if political agreement doesn’t emerge and create fiscal stimulus out of Washington DC

These examples highlight how precarious it can be to make high-conviction, forward-looking calls about the direction of global stock markets, which continue to take their lead from US equity strength and weakness.

We feel the title of this piece ‘The Power of Narratives’ is important because markets are fickle and while what people are talking about might seem unimportant to the valuation of stocks, it can actually lead to sustained changes in valuations, which can allow companies to radically transform themselves through the use of increased capital values. Just imagine if nobody ever talked about Tesla, it certainly wouldn’t have the power that a US$400b market cap commands.

Regardless of how profound or otherwise these narratives are in and of themselves, they are of great importance – they sit above stock markets like sunshine or dark clouds and drive the way we navigate hundreds of millions of dollars under management and advice at Rivkin.

In this piece, we’ll take the pulse on major capital markets and add perspectives to recent performance, while taking a reality check on whether the underlying drivers of performance have actually changed or not, which means analysing the different layers of narratives; for example, US elections vs. COVID stimulus vs. existing long-term zero interest rate policy.

Equities

The chart above illustrates some choppy but very strong returns from stocks in Australia and the US since the March correction, which have outperformed European stocks significantly.

 

Of note, the recent US stock recovery outside of the huge monoliths that make up the top of the S&P 500 has been significant – this is charted using the grey line labelled Russell 2000, which underperformed the main market by some 25% over the last five years. The Russell 2000 is actually the bottom 2000 stocks of a larger 3000-stock index, so it excludes the biggest 1,000 US stocks. Short-term performance of this index tells us that the ratio of money pouring into huge stocks like Apple and Microsoft vs. the money invested in smaller stocks is beginning to even out. It has easily been the best performing US index during the last six weeks.

While the noise surrounding global equity markets is strong and short-term volatility can hit at any time, the trends and underlying drivers of equity demand remain in place:

  • Zero and negative interest rate policy in developed countries discourages saving and fuels the indiscriminate search for yield, where many investors use equity dividend payments interchangeably with government and corporate bond coupons
  • A frustrated US Congress (where partisanship may stand in the way of fiscal stimulus) will continue to force the hand of the US Federal Reserve, resulting in the purchase of everything from government bonds to ETFs in order to maintain stable capital markets throughout a potential economic recovery
  • So too in Australia, savers are getting close to nothing from deposits and are also continuing to look to equities for income and growth, while the Reserve Bank of Australia supports this trend with 0.10% cash rates and quantitative easing

Stock market macro narratives that have or may change:

  • Pfizer’s 90% rate of infection prevention in COVID vaccine trials was met with optimism rather than scepticism (by the market and scientists alike) and this may mark the beginning of the end of COVID-19 as a global headwind
  • Should this prove to stick as a prevailing narrative, it could mean some rotation out of highly-specific COVID-centric technologies (not a big negative but some rationalisation for the ZOOMs of the world) and emerging information that allows investors to timeline the anticipation of COVID stimulus removal could see some sellers try to get ahead of the careful removal of the world’s huge monetary and fiscal packages
  • While there are no clear signs coming from the Australian government just yet, many OECD countries are preparing for a renewed focus on global emissions targets, which will likely drive stocks and sectors that aim for net-zero emissions

Bonds/Interest Rates

One of the most striking trends in capital markets over the last few decades is the fall in 10- and 30-year US government bond yields, known as Treasuries (this means that bond prices have been rising – a multi-decade rally). Irrespective of where short-term rates have been in recent history, investors have increasingly become more complacent when it comes to the risk of lending the US government money. It has been a one-way trade for 40 years, but with 10-year returns falling below 1% this year, there is little room to go further. And that little lip at the end of the two lines on this chart could be nothing, but it could also be the start of a trend higher.

These moves higher are important because they tell us a bit about what the market is expecting to happen in the future. Just remember these points:

  • Bond yields (the value of the fixed coupon divided by the floating market price) move inversely to bond prices – so this short-term rising bond yield trend means that investors are net sellers of the applicable bonds, even while the US Federal Reserve is buying them.
  • When buying bonds with long maturities (10- and 30-year bonds mature in 2030 and 2050), investors must consider what the central bank interest rates might be at those future points in time – your 10 year bond yielding less than 1% is going to be decimated in value if overnight rates rise to 5%.
  • So why would yields rise? Investors will sell bonds and yields will rise if it is anticipated that reserve banks will need to raise rates in the future, which would come from inflation, generally boosted through economic growth.

So these small moves higher in bond yields in the US are one or a combination of a few things:

  1. Long-term anticipation that there will be a US economic recovery that will see higher central bank interest rates in the future
  2. Short- to medium-term speculation that the removal of stimulus created by the US central bank buying their own bonds will cause bonds to fall in price
  3. A mere aberration on the path to negative rates (let’s hope not!)

Locally, the Reserve Bank of Australia sees inflation bottoming out at 1% in 2021 and then reaching 1.5% by the end of 2022 (underlying inflation finished the September quarter at 1.25%). With forecasts at these levels, this means the bank is not immediately concerned about inflation and therefore is doing anything it can to prop up employment, assist economic growth and curb a rising Australian dollar. This brings us onto currencies.

Currencies

The US dollar (orange line above) has weakened against most currencies since the March COVID risk-off event occurred. Despite crises like COVID traditionally prompting investors to buy US bonds (and having to buy US dollars first in order to settle them), the US dollar’s weakness does signal to us that there has been no ‘flight to quality’ trade driving investor sentiment. One only needs to take a look at the aforementioned post-March rebound in equity markets to underscore this.

One thing that has become notably absent in FX markets is the advent of any new ‘currency wars.’ Given the world’s largest economies are all playing the same policy game by pinning interest rates close to zero (and below zero for the likes of Switzerland and Denmark), there is little room to move for banks who might otherwise want to boost their economies through accelerated easing.

Nonetheless, the Reserve Bank of Australia is attempting to make the Australian dollar look as unattractive as possible to would-be foreign buyers – last week it reduced its cash rate target to 0.10% and will buy $100 billion worth of Commonwealth government and state bonds over the next six months to try and lower the rates of lending and eradicate hopes of positive currency returns sort by foreign buyers. Has it worked? No not so far – the AUDUSD in blue above shows the Aussie holding ground with a very high correlation to gold (blue line) recently.

 

Conclusion

In summary, while it is a preoccupation of many economists–and many of my fretting uncles–to predict massive market collapses due to pockets of excess, one can lose a lot of money sitting on the side lines and waiting for these major events to happen. In fact, while market ‘corrections’ occur every couple of years (most recent being the COVID sell-off in March this year), market ‘crashes’ or ‘bear markets’ occur far less frequently. And as the chart above illustrates, you can miss out on a lot of gains waiting for them.

Nonetheless, one must use one’s own judgements as they assess where they’re at in their investing cycle, how far away retirement is etc. when making decisions around capital preservation.

There are middle-ground investments that tend to grind higher throughout good and bad times. Rivkin’s Low Volatility strategy (which sits at the heart of our Capital Stable product) is a good example, typically experiencing 5%+ returns per annum with minimal drawdowns. You can read more about this strategy by clicking here.

I declare the obvious conflict of interest in mentioning Capital Stable, but it is a product relevant to these macro updates, as it has exposure to bonds, gold, equities, currency and money market instruments.

 

I hope you enjoyed reading this macro review.

Scott Schuberg
Chairman

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