Eurizon Asset Management investment view for the month ended July 2021, discussing the four factors that are acting as headwinds.
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Long-term yields in the US and Germany dropped significantly from the highs hit a few months ago, raising questions among investors on the solidity of the economic recovery.
There are at least four factors that are acting as headwinds: the reacceleration of Covid infections, the reduction of purchasing power caused by inflation, the tightening of financial conditions in China, and the prospect of a less accommodative Fed.
This is a combination that implies a certain degree of uncertainty in the immediate term, but which should ultimately be resolved positively.
If the rise of infection numbers has a limited impact on national healthcare systems, or if the supply-side bottlenecks that are currently generating inflation are overcome, a less accommodative approach on the Fed’s part could be tolerated well.
By contrast, signals of an economic slowdown, possibly tied to reopenings being put on hold, could prompt the Fed to delay the tapering of stimulus, and China to ease lending conditions.
These are the main question marks weighing on the scenario, that will have to be cleared between the summer and the autumn.
- The acceleration of the virus in Europe casts doubts on the reopening process. All eyes are on the ‘‘UK experiment’’.
- The Fed has opened the discussion on tapering. However, if fears of a slowdown do not abate, the Fed could be forced to delay the start of the process.
- Low-directional-exposure approach confirmed, in light of a combination of themes that could fuel uncertainty in the near term.
- Underweighting of duration confirmed, combined with a neutral positioning on risk assets. Exposure increased to the yen (defensive) and to the dollar.
- Long-term rates in the US and Germany at risk of increasing if the economic recovery continues, as opposed to a modest downside margin in case of negative surprises.
- Spread bonds hold appeal compared to core government bonds but yields-to-maturity are historically low.
- The stock markets hold appeal in a medium-term perspective, although the swift upswing seen over recent months is already largely pricing in the macro improvement.
- Uncertainty over the solidity of the global recovery may give US stocks an edge over other equity markets.
- The dollar will be able to keep recovering if the Fed confirms its intention to taper quantitative stimulus. The yen may attenuate portfolio volatility should the uncertain combination of themes at play persist for longer than expected.
The rise back of Covid infections at a time when the Federal Reserve intends to start tapering monetary stimulus may represent a factor of uncertainty. Reduced the portfolios’ exposure to risk, taking neutral positions on the main asset classes, raising the weight of the yen (defensively) and of the dollar. Underweighting of duration confirmed for the US and Germany.
Asset Classes Compared
Long-term rates down by around 20 basis points in the month, both in the US (to 1.3%) as in Germany (-0.45%). The only stock market to keep scoring gains was the US, as opposed to profit taking on the European and Emerging indices. The High Yield and Emerging segments widened spreads, albeit with rather stable yields-to-maturity. Dollar strengthening against most of the other currencies and stable against the yen.
Theme Of The Month: Four Factors That Are Acting As Headwinds
Four factors are acting as headwinds, which in pairs are at odds with each other. Either the Delta variant and deflationary inflation recede, or the Fed and China will have to change their plans. This is the key variable that will have to pan out in the summer (and in the autumn).
- The Delta Variant: the resurgence of infection numbers in the countries that have already immunised most of their populations holds the potential to slow the reopening process and hold back the macro recovery. From this point of view, the “UK experiment” is of great interest, in order to verify the effects of a full removal of restrictive conditions, based on the bet that the most vulnerable portions of the population are protected by the vaccines. If the experiment proves successful, this source of uncertainty will be removed, and reopenings will continue. The opposite will be true otherwise.
- Deflationary Inflation: the recovery of inflation, in the US in particular, is due to supplyside bottlenecks in some sectors of the economy and is not accompanied by a corresponding increase of wages. Therefore, it is acting as a tax on consumers. This headwind could keep blowing for some time, until the reopening of the economies in individual countries, and among countries, will have been largely completed.
Four Charts For The Summer
- The Fed’s Tapering: the Federal Reserve has declared its intention to bring forward its first policy rate hike from 2024 to 2023 and has opened the discussion on the tapering of quantitative stimulus at the beginning, envisaged to start early in 2022. For the time being, the Fed’s intentions as represented by the DOT plot market expectations (as represented by fed funds futures) are aligned. However, if at some point concerns over the sustainability of economic growth were to increase, the Fed’s plans would in all likeliness be considered inappropriate in a still rather fragile global context.
- Tightening In China: over the past few months, the Chinese economic authorities have implemented a progressive tightening of credit conditions, to prevent an overheating of the domestic economy, that has started to slow down as a result.
- Lately, measures have been put in pace to contain the tightening (reduction of compulsory reserve requirements for banks) but are still insufficient to offer reassurances on the strength of Chinese growth.