Reflation trade may struggle in the second half of 2021
The reflation trade may struggle in the second half of this year, in my view. Money supply growth is slowing down sharply across all the major economic regions. The pace of expansion of central bank balance sheets, which has been a big driver of risk assets, has also slowed down materially since last year. They are up only 4% so far this year, compared with 34% between March and December of last year.
The credit impulse (the regular flow of credit into the economy) in China is another factor, as it has rolled over pretty sharply and in fact has now gone negative. Europe’s credit impulse has also recently gone negative. This has implications for commodities and for global growth generally, and the latest soft industrial production number from Germany could be the first sign of China’s slowdown beginning to impact Europe.
Elsewhere, Biden is facing a lot of push back to his big spending plans, perhaps putting paid to the idea that he would keep handing out blank cheques. The US is not China: if China says we’re going to spend a trillion they face no resistance, but in Washington the political landscape is completely divided.
Markets are currently pricing in three rate hikes by 2023, against the Fed which is saying they’re not going to raise rates until 2024. Also, if you look at US5Y5Y – that’s what the market thinks 5Y rates will be in five years’ time – that’s currently at 2.4%. You need to bear in mind we got to 2.5% in the last rate hike cycle that finished at the end of 2018. With the world so much more indebted this time around, with demographics continuing to go the wrong way, I don’t think the Fed this time are going to get anywhere near 2.5%, if they manage to raise rates at all.
Positive ESG change is key for Value investors
The last 18 months have been a wild ride for Value investors, initially very challenging and latterly with much more of a tailwind. Something I really want to emphasise, though, is that despite a rally for Value the valuation dispersion in the market remains significant. For example, the US market is on a Shiller P/E of 37x and according to Shiller’s data since 1871 it has only been more expensive than that for 1% of the time. By contrast the stocks we favour have a Shiller P/E of more like 11x-12x.
The range of attractive Value opportunities we can find in the market is quite broad, ranging from a Brazilian bank to a US computer chip manufacturer. After all, Value as a characteristic can be found across all industries and in every region – not concentrated in any one particular area.
One big question we often hear is whether a Value investing style can hold up on ESG metrics. Our view is that ESG risk factors, and especially climate factors, are a major potential risk for any investment. But we see time and again how positive change in ESG for a company gets rewarded by the equity market, and we are very focused on identifying opportunities that – although they may not score highly on backward-looking metrics – have the potential for significant positive change.
Why the future looks bright for EM
Despite a positive start to the year from emerging market (EM) equities, to date the MSCI World Index is up around 11.5%, while the MSCI EM Index is up ‘just’ 7% (in US dollar terms). So, why has EM lagged?
We believe there are three key reasons. The first is related to Covid-19 waves and vaccine momentum. As we entered 2021, the market acted like the vaccine breakthrough meant that the pandemic problem was solved. But there have been extremely serious second and third waves in some EM countries like Brazil and India. Thankfully, the situation seems to be improving now: India, for example, is reporting around 85,000 new daily cases, which, while still high, is the lowest since the start of April. These waves have sapped investor confidence, though we maintain the view that they have postponed EM growth, rather than cancelled it.
The vaccine rollout has been slower to take off in EM, too. In Asia, this is arguably because of some level of complacency, as some countries experienced relatively low Covid-19 cases compared to many other parts of the world. However, following recent outbreaks in Taiwan and China, we’ve seen a jump in vaccine take up: in Taiwan, there’s been a tenfold rise in recent weeks, and China is now vaccinating 40m people a day, compared to 5m a month ago.
Second, EM countries haven’t been using “helicopter” money – there haven’t been any extraordinary stimulus efforts in EM (with a couple of notable exceptions), while the US has been handing out cheques to its citizens. Optically this looks good for the US right now, with it achieving a degree of economic momentum, but we believe it’s just bringing forward future consumption.
The final reason is China. China represents around 40% of the EM universe and the performance of its equity market has been flat year to date, after being among the best performing markets in 2020. It’s a very tech-heavy market, an area that has struggled recently, and credit growth has been significantly slow, and in fact has just turned negative. The Chinese economy probably looks the most “normal” of the major global economies: it started tapering in mid-February, slowing down the credit impulse and extraordinary stimulus implemented mid-pandemic. We expect China to start to ease off the brakes and to gently tap the accelerator again, which would lead to some normalisation.
Typically, EM equities perform best when there is a significant growth differential versus developed markets, so when the vaccine rollout has more critical mass across EM countries, we expect this to return. While the US and Europe is arguably looking better at the moment in terms of the data, developed market stimulus is at maximum levels, and EM hasn’t been able to show its true growth colours – yet. We expect the backdrop to be much more favourable as we move into the second half of the year and into 2022.
Watching the Fed, and thoughts on LatAm Elections
The state of play for gold and silver is we are waiting for the Federal Reserve meeting next week. We think the direction of travel is toward gold accumulation with the central banks and largest ETFs (exchange-traded funds) all adding last month. We see little chance of taper talk.
From a mining perspective it is worth us watching elections in Latin America. In Peru, we had anticipated the election potentially getting messy since, with the socialist candidate Pedro Castillo in the lead, there will be a lot of talk about higher taxes. Actually, I think we are going to see higher taxes irrespective of who gets in. The alarm bells don’t seem to be going off right now because people understand that Peru has a sliding scale royalty system for mining that means the higher the prices the more taxation gets paid to Lima.
In Mexico, AMLO (President Andres Manuel Lopez Obrador) lost his two-thirds majority in the lower house so he cannot change the constitution. He previously agreed with the mining sector that in his first three years as President he would not impose any changes to the tax regime. We are thinking he might now make changes. Mexico does not currently have a sliding scale royalty system for the mining sector. We think it is a good thing to have because if prices do rise it is helpful to have this mechanism which allows the government to gain as well, rather than to have windfall taxes discussed at inappropriate times.
The value of active minds: independent thinking
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