Friday, May 28, 2021
The maxim regarding a frog’s not recognizing the danger from the slow heating of water (until the frog is cooked) has broader applicability. Conditions are changing but it is difficult to recognize that change and probably even more difficult to react and benefit from the changes. For better or worse, the markets are driven now by forces not experienced other than to a far lesser extent, during global wars. In response to the credit crisis of 2008, the central banks of the developed countries were granted powers via multiple programs to back-stop the economy, buy assets, and ensure reasonably low interest rates. Those programs have been and continue to be successful to the extent few could have imagined. For example, few if any economic textbooks mention negative interest rates and as this article is written, approximately 60% of the sovereign debt in Europe carries negative rates. Meanwhile, governments are engaging in massive fiscal spending, creating money and then giving it away in a manner “Helicopter Ben” could only muse about. The upshot is a distortion in the markets: significant unemployment while jobs go begging, inflated housing prices while apartments are unrented, negative or low interest rates while debt to GDP and government deficits increase.
While it is easy to bemoan the current situation, such is not our typical approach. We aim to understand the current situation, assess the likelihood of a continuation, and perhaps most importantly, identify areas presenting attractive risk/ reward ratios. Regarding the current trends, we see little probability that the current trends are going to abate anytime in the near future; central banks will continue to support the markets and central governments will continue to incur deficits. In the case of the U.S., the push of the Progressive wing is to accelerate spending and under the MMT doctrine (Modern Monetary Theory), government debt is less relevant. Hence there are a few givens that are rapidly emerging from the supposed chaos:
1. Inflationary Pressures - inflationary pressures are real and persistent. As can be seen from the below chart, the markets have been shocked by the demand levels. We have our doubts about Mr. Powell’s stance that the pressures are transitory.
2. Low Interest Rates – if the central banks continue to purchase federal obligations, lower yields are the natural outgrowth.
3. High P/E Levels – if low interest rates persist, the natural corollary is that of high P/E ratios; investors are willing to pay more for the same level of earnings/cash flow/eventual dividends.
4. De Facto government support - With the central banks suppressing interest rates, and in some cases going much further than that with support of the money market industry and directly purchasing corporate debt, the federal government is to a certain extent, backstopping selected credits.
Figure I: 5 year, 5 Year Forward Inflation Expectations
Providing support, albeit extreme, are copper prices; as can be seen in the below chart, prices are at a ten- year high:
Figure II: Copper Prices
It is interesting to note, that while inflation expectations have risen, interest rates for the most part, have not, presumably because of central bank actions:
Figure III: 10 year Treasury Yields
Before moving on to the beneficiaries, it is worthwhile addressing some of the counter arguments against the wisdom of the current path. While many will argue that societies have found a brilliant new approach and that few lose. Unfortunately, it is rare to locate a completely new idea in the annuls of governments and in fact the current approach has been undertaken previously. In the case of currency printing in excess of normal GDP growth to pay debt, the best examples are Germany’s Weimar Republic, and various South American and African nations, which have succeeded with such measures in the short run, but normally are reined in when they attempt to attract outside capital (see This Time is Different: Eight Centuries of Financial Folly). The central banks of the developed countries have succeeded because of the vast monetary reserves of their citizens and institutions and the fact that the central banks have coordinated their actions (i.e., there are few alternatives).
Assuming we have properly identified some of the major forces driving the market over the next couple of years, it appears the forces leading to increased inflationary pressure outweigh those on the deflationary side:
Figure IV - Changes in Major Market Forces
A major assumption in the above chart is whether the current administration is going to continue its approach; our view is that despite the protestations of the Republicans, the current administration is likely to be remembered as one of the most progressive since FDR and will succeed in advancing a variety of pro-spending legislation. For those Milton Friedman followers, the expansion in currency beyond the growth in the economy, normally results in inflation. (In retrospect, the first few quarters of 2021 might be remembered as a major inflection point in the economy.)
Regarding the identification of winners, assuming the economy is opening, and interest rates remain low, then it is the capital-intensive industries that will see a return to more normal demand which are the largest beneficiaries. (Note, for some industries, the demand is there, but problems are on the supply side such as autos with computer chips, and to a far lesser extent, home builders with lumber prices.) Below are some promising areas:
Aircraft & Equipment Leasing
Energy Equipment & Services
Hotels Restaurants & Leisure
Textiles Apparel & Luxury Goods
Regarding domestic interest rates, the broad theme of declining rates appears to be intact with little relief for fixed income investors (other than the private markets). While recent rates are up a bit nearing 2.0%, they are still down massively over the past 40 years. Below is a summary of our expectations for the various economies:
Figure V: EJR Normalized Economic Expectations (next 12 months)
Regarding interest rates, the EU countries and credits cannot afford significant increases in rates. The periphery EU countries (e.g., Italy) are likely to see continued pressure because of increased credit quality concerns. Regarding trends, we had expected a slight rise in rates as economies recover but the central banks’ money creation are depressing rates.
Figure VI: Current and Expected Interest Rates
*expected to trade in 12-month time
Below are our expectations for major currencies:
Figure VII: Currency
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