“River deep, mountain high”
Tina Turner, River Deep, Mountain High
Over recent weeks, we have discussed the concept of a relative shortage of suitable risk assets and how we feel that this could lead to an extended rally in those assets that qualify for this select group of securities. Last week, we suggested that, while these assets may already have surprised many (especially relative to historic correlations), given the alternatives, their outperformance could have a long way to go yet! I would not go as far as to say that There Is No Alternative (or TINA); rather something slightly more nuanced and, well, English. Perhaps - There’s Effectively a Real Exiguity of Suitable Assets (or TERESA)!
Over recent weeks, markets have been very complex, given the implications and interactions of COVID (both recent waves and the continued ruminations from past waves and even past combat measures), the Russia/Ukraine situation, and of course inflation (both supply chain driven, as a function of COVID, and or commodity price driven). Each of these factors have different impacts on different economies, as we outlined last week, and thus the policy responses across different parts of the world are driven by different objectives and different (potentially conflicting) priorities. In short, the world has a broad supply of uncertainty; we should therefore expect volatility.
Uncertainty and complexity; however, as we have seen over recent weeks, do not have to be synonymous with negative price action in risk assets. For example, we believe that the US economy is more insulated from the global commodity boom (and resultant inflation wave), due to its high payroll and wage growth, and that there are a number of large US companies (predominantly, but not exclusively tech), that have both pricing power and demonstrable future cashflows. Against this backdrop, we can make the case for US equities as an inflation hedge and add them to the relatively select group of assets that could well at some point attract a significant portion of the wall of cash on the global investment side-lines.
Another major discussion point this week, has been the fact that the US yield curve (notably 2s10s) inverted, and the historic precedent that this suggests - namely an impending recession. Indeed, many have taken this (albeit so far brief) inversion as confirmation of their (persistent) suspicion of late cycle dynamics in the US, and thus (again persistent) USD negative bias. We have a different view.
From our perspective, the US economy remains strong, excess demand is clear, and it is likely that the US labour market is currently at least as strong (if not stronger) than it has been since the end of WWII. Against this backdrop, the Federal Reserve System (Fed) have, with increasing urgency, signalled their intent to raise rates, most recently describing its desired pace of accommodation withdrawal as ‘expeditious’ . Many analysts have looked at the desire of the Fed to remove the punch bowl rapidly, perhaps with COVID, Ukraine and the commodity cycle at the back of their minds, and concluded that the logical outcome is recession - not a good place for equities, or indeed any other ‘risk asset’.
However, inflation is not just an input, but it is also likely a mitigating factor. Firstly, the extent of inflation and the shape of the inflation curve (inverted), means that the real yield curve is a much healthier, not inverted, prophecy of the US business cycle. Furthermore, if we think about neutral rates as a level of real rates (as makes more sense), then it is difficult to argue that the Fed will be hiking anywhere close to contractionary territory, even given the pace of hikes priced into 2022 and 2023 - relative to the expected level of inflation.
Lastly, from an equity standpoint, US real yields remain deeply negative and equities provide positive real yields. As we have argued before, equities that can see real revenues rising at a faster rate than nominal interest rates likely continue to outperform. If they offer dividend yields (real) above nominal yields (as per the S&P 500), then the point is exaggerated.
There is another asset that fits with our current TERESA framework, and that is EMFX. BRL, MXN and ZAR are obvious examples, but there are others that could also be thought of in a similar light. Emerging Market (EM) central banks were very quick to get ahead of the inflation dynamic, with sharp and persistent rate hikes. At least in part this was to shield the respective currencies and economies from the potential capital flight of a potential Taper Tantrum, akin to 2013, while at the same time getting ahead of the pernicious nature of unchecked inflation.
However, as the COVID emergency appears to subside, inflation appears to be nearing a cyclical peak and a number of factors including a geographically distant war, and a resultant commodity price boom become dominant.
At the current level of yields, EMFX – particularly, those that benefit from the terms of trade boost from the commodity cycle - have become very attractive. After what could potentially have been described as a move that took equities and risk assets ‘river deep’ during the COVID crisis, there is a case now for a select group of risk assets that their valuations could go ‘mountain high’!
Simply put, there’s Effectively a Real Exiguity of Suitable Assets - TERESA!
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