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Quarterly Outlook
Equity investors must embrace the commodity sector during reflation
Peter Garnry
Chief Investment Strategist
Summary: Last quarter provided a contested US election, yet the best monthly return in global equities since January 1975 with a 12.8% gain - Q1 outlook 2021
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.
The basket has delivered a 171% total return since 1 January 2016 compared to 78% for the MSCI World, highlighting the quality of these companies. The basket is up 7.5% year-to-date, being one of the best performing segments of the equity market and underscoring that investors are positioning for reflation. The commodity basket excess performance over MSCI World is also positively correlated to monthly changes in the inflation rate, with excess monthly return being +3.1% for months when the inflation rate increases and +0.3% for months when the inflation rate is declining. Part of the commodities trade during reflation is also the overweight emerging markets; these are more resource-driven economies and benefit from reflation, as long as interest rates rise slowly and the USD remains weak.
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.