Last quarter provided a lot of drama with a contested US election, the best monthly return in global equities since January 1975 with a 12.8% gain, and a new surge in Covid-19 cases in the US and Europe driven by winter weather conditions and a new, more virulent mutation. This year will be all about inflation and whether it forces the hand of central banks, about ‘bubble stocks’ continuing their meteoric rise, about policy mistakes, about a successful vaccine rollout, and about whether the ‘green transformation’ trade will continue to define financial markets.
If inflation comes, investors should get exposure to the commodity sector
The inflation rate bottomed in June 2020 and has since steadily risen, with a notably higher rate of change in November (this is the latest figure available from the NY Fed Underlying Inflation Gauge Index, which measures both offline and online prices). This new inflation index hit -0.72% in July 2009 during the financial crisis, as the credit crunch caused a deflationary environment. This time around the inflation rate bottomed at 1.05% and with a much higher degree of both monetary and fiscal stimulus (policymakers have learned lessons from 2008), this will likely push the economy into red hot in late 2021. The key thing to understand is that policy has moved to a goal-based objective, which means that policymakers will continue to stimulate aggressively until low unemployment is restored across all major economies. Social unrest, or trying to prevent it, dictates this modus operandi. We believe that it will lead to inflation because the real cause of inflation is most likely fiscally moulding the public psychology into one of expecting higher prices, which then starts the feedback loop.
The Institute for Supply Management (ISM) Manufacturing Prices Paid and China PPI Index y/y are volatile series, but smoothed out they are good leading indicators on future inflation. The US is showing a degree of pricing pressure not seen since mid-2018 when inflation peaked the last time, while China so far is more modest but showing an increasing rate. The container freight prices and commodity prices excluding energy are also moving higher.
The classic hedges against higher inflation are gold, inflation-protected government bonds and energy, but the equity market also offers interesting alternatives. Earlier this year we launched our Saxo Commodity Sector basket, which is a list of 40 stocks with exposure to the commodity sector across the agriculture, chemicals, energy, and metals and mining industries, with a global diversification objective. This list should be viewed as an inspiration and not investment recommendation.
Will rising interest rates impact equity valuations?
Global equities reached a new all-time high on a 12-month trailing valuation in December beating the old dot-com record. While maybe an unfair rear-view mirror indicator given the collapse in economic activity during February and March, it highlights to investors the level of optimism baked into equities. S&P 500 earnings have recovered most of the decline during the early months of the pandemic, down only 10% in Q3 2020 from the Q4 2019 level; those were the easy gains, and in 2021 the real earnings growth will become clear. Based on 12-month forward P/E, the S&P 500 is getting awfully close to its historic peak in December 1999 during the dot-com bubble.
The closest we get to a law in investing is that higher valuations drive lower future returns. In early December 2020, Robert Shiller justified the current equity valuations even though his famous CAPE model has flashed a warning signal for many years. His change of mind was related to the concept of excess earnings yield, in other words tying the earnings yield to the yield offered in government bonds. This excess yield shows no bubble in equities and that valuations are fair, highlighting a troublesome reality for investors: if you want any return you have to play the game in equities, regardless of the high equity valuation.
But if we take Shiller’s words at fair value then a rise in interest rates, which could happen under reflation, would lead to rising earnings yield and lower equities, assuming that equities maintain the same earnings yield spread to government yield. Some of this decline of course would be offset by growth in earnings in 2021 and higher growth expectations, but likely not enough to offset the entire move. According to our calculations, assuming growth in free cash flows in 2021 and unchanged spread between government bond yields, corporate bond yields and free cash flow yields, then a 100-basis points upward move in the US 10-year yield could translate into a 15-20% decline in Nasdaq 100 stocks, the most rate-sensitive of all the major equity indices.
Can the ‘green transformation’ bull market continue?
In early January 2020, we published an analysis stating that the green transformation of the economy towards a less carbon-intensive economy would be a megatrend over the coming decade. When we wrote our analysis, we never imagined that this theme would take off like it did. Global green energy stocks rose 142% in 2020 (see table) outperforming all other major equity themes. The relentless bull market in clean energy stocks have been driven by strong policy signals from the EU and China, in addition to the US president-elect. The dark side of this strong trend are very high valuations with the largest holding in the iShares Global Clean Energy UCITS ETF, Meridian Energy, trading at a 12-month forward P/E ratio of 83. That’s quite an aggressive valuation for a state-owned utility with 90% of its revenue in New Zealand, a low-growth economy, and negative revenue expectations. The big question in 2021 is whether the bull market in ‘green transformation’ can continue.
The political capital in the green transformation is intact and will get another tailwind from the new Biden administration, assuming it fulfils its ambitions of clean energy and of making the US carbon neutral by 2035. Despite political willpower and subsidies, the green companies will have to justify their valuations. As we believe this is the year of reflation and a rise of the physical world, our view is that old energy sources will outperform clean energy, and that the green transformation trade will split into that of ‘quality green’ and ‘speculative green’, with the potential for the latter segment to experience a dramatic sell-off.
Outrageous Predictions 2023: The War Economy
- The constantly growing global need for energy drives the world's richest to huddle up and launch a R&D project in a size the world hasn't seen since the Manhattan Project gave the US the first atomic bomb.
French President Macron resignsThe political stalemate in France and the rise of Marie Le Pen following the 2022 elections corners President Macron, forcing him to give up on politics and resign from his position. At least for now.
Gold rockets to USD 3,000 as central banks fail on inflation mandateAs markets and central banks realise that the idea that inflation is transitory is wrong, and that prices will remain higher for longer, gold is sent through the roof, hitting a price tag of USD 3,000
EU Army forces EU down path to full unionWith continued challenges in the region and a US military that isn't aggressively enacting its former role as global policeman, the European Union agrees to create its own armed forces, bringing the whole region closer.
A country agrees to ban all meat production by 2030In an effort to become one of the global leaders on the path to net-zero emissions, one country decides to not only put a heavy tax on meat, but to ban domestic production entirely.
UK holds UnBrexit referendumFollowing a recession and domestic pressure, the United Kingdom is thrown into political turmoil that will end with a vote to wind back Brexit.
Widespread price controls are introduced to cap official inflationHistory tells us that with the war economy comes rationing and price controls. And this time is no different, as policymakers introduce strict price controls that lead to a range of unintended consequences.
OPEC+ & Chindia walk out of the IMF, agree to trade with new reserve assetSanctions against Russia have caused widespread turmoil due to US Dollar moves in countries across the globe that don't consider the US an ally. To relieve themselves from this, they leave the IMF and create a new reserve asset.
USDJPY fixed to the USD at 200 as Japan overhauls financial systemFollowing the challenges that faced the Japanese Yen in 2022, the Bank of Japan attempts to keep the currency from sliding. Unsuccessful on the long-term, Japan will launch a reset of its entire financial system.
Tax haven ban kills private equityWith the war economy comes an increased focus on national interests and sovereign nations' ability to assert themselves. In that regard, the OECD countries turn their attention on tax havens and pull the big guns out, banning them altogether.