Markets’ mood is positive again. After a pause in January, the optimistic trend that had prevailed in November and December, is back since the start of February. And with an identical pattern on the movements of the different asset classes and industries (see Chart #1). Thus, it seems that, nowadays markets are moving in just two ways: “full recovery mode” or “something is still wrong” mode, with February falling on the former type so far. There is a subtle but important difference though: Latam stocks are still falling behind as the long-term effect of the pandemic is only starting to be felt in such vulnerable countries. On the contrary, in the EM space, Asia is clearly outperforming.
Three factors constitute the main drivers of markets to make one mode or the other prevail. First is the pandemic itself. The acceleration of contagions, particularly in Europe, and the ensuing hardening of government measures to prevent them was the main factor pausing markets in January. By then, vaccination was still far away, and expectations of economic activity started to fall. But all of this proved false promptly. And now, investors assume the same idea they did in November: that the economic damage of the pandemic will be lower each day. There are three main reasons for this: vaccines are coming; governments are less willing to implement economic damaging measures and all agents are adapting very quickly to the new situation. This reasoning seems to be confirmed by the relatively good evolution of economic indicators all around the world, but particularly in the Eurozone, where the so called “Third wave” hit the most.
The second factor behind the recovery of the good mood is macroeconomics. As stated above, figures are much better than expected in general, and we still can’t see a significant negative impact of the latest wave of contagions. As an example, some European countries, like Germany or Spain, which are among the worst hit by contagions in December and January, are surprising to the upside in activity (though with weak figures, but better than expected still). China is also growing significantly and driving up demand for western exports and its neighbors’ activity. The US finds itself in a similar situation, with the added circumstance that with the new administration, massive monetary and fiscal stimulus is anticipated. In general, the good macroeconomic perception can be seen clearly in a summary of the evolution of the consensus forecasts (see Chart #2).
This leads us to the third factor: liquidity. Which is turn the most important and the most difficult to evaluate on its long-term impact. During November and December, we grew used to a constant provision of an average of more than USD 200 Bn per week coming from central banks and USD exchange rates. That is purely new money coming into the markets. Such thing stopped in the last week of December and the first weeks of January, as central banks activity decreased, and investors readjusted portfolios. This happens every year, but normally it goes unnoticed. Now, being liquidity such an important factor for assets pricing it impacted negatively. It seems that this flow is going back again to that “normality” of a weekly huge injection of dollars and other currencies. And, anyway, central banks commit themselves completely to maintain this process even in inflation runs higher than targets for a while.
Are we living in the mother of all bubbles? Just a semantic discussion
With the above factors running at full steam, markets positioning seems one-sided: risky assets prices moving higher, fixed income flat or slightly negative (yield curves moving upwards, but slow enough to avoid a slaughter), and a flight to real assets and more complex types of investment. Also, the participation of retail investors is higher. Valuations are getting richer each day and casino-style investments like cryptocurrencies make headlines in the media. I know: this paragraph sounds like the perfect recipe for a bubble-burst process. So, is that the case?
Well, “this time is different” is the most dangerous statement in the investing world. So, we cannot rule out we’re in a bubble. But that depends on what a bubble is. In other words, what is really fueling the increase in prices. In this case there are, at least, three factors that may lead us to think that either we are not in a bubble, or if we are, it still has a long way to go.
The first one is the debasement of the currency. In the last eight months, the joint monetary base of the US Fed and the ECB has risen by more than 70%, let alone if we account for other central banks or for the expansion in broader concepts of money. For some people this is a bubble itself, but for me it is not: it is another thing. A change in the measuring unit, in the very concept of money. That may have other unintended and even worse consequences over the long term, but for the short term, makes up a solid support of asset prices. In other words, with such a huge amount of money around, and more coming in each day, where would it go, should we fire sale everything? With such an oversupply of money every asset seems cheaper, regardless of it risk. Of course, this is a problem itself, as it makes price discovery useless. But makes an eventual burst less likely, as long as the liquidity supply keeps flowing.
The second idea is that valuations themselves are not as far-fetched as it may seem, except for specific contexts (see Chart #3). For example, European stocks are nearly flat on a twenty-year horizon. Global and US stocks ratios are nowhere near the levels they reached in previous bubbles, and with much more money around (this means that money also reaches earnings, thus supporting the above argument). Actually, if you clean out specific industries, like tech, valuations are pretty in range with historical averages.
The third idea is that tech stocks themselves may be living the kind of valuation that happens before a change in paradigm, in the very structure of the economic system. Many people call this a bubble also, and they might be right. But the fact is that, as the economic structure changes, this “winner” companies will profit in manners that we still don’t know. Think of the dotcom bubble in the early 2000s. Many tech companies disappeared, and many investors lost big amounts. But those that stayed with the winners (Apple, Amazon, Microsoft, etc) made up for huge profits.
For me, a bubble is a high valuation not supported by anything but an ever-growing expectation. Sooner or later such expectation hits reality. For example, we can foresee this kind of bubble in some contexts nowadays: the so called “green” stocks (see Chart #4) in the US, that rely only on the expectation of large government support for them, but their core business is much less profitable than others. This way, there seems to be an unreasonable expectation of this companies to turn magically more profitable. The reader may argue that the expectation of central banks delivering liquidity for ever is as unrealistic or even more; and they may be true. But the difference is that central banks are already delivering, so the fact that they may stop is a risk (see below), that not makes a bubble by itself. Admittedly, the well-known ratio total capitalization / GDP is very high and is one of the variables because of which many analysts agree on the concept of bubble. But such situation is explained easily again by money printing. Brand new cash reaches markets very quickly, but it takes longer to slip into GDP if ever.
Fixed income assets have long been thought of as a bubble also. Mainly because of its artificial overvaluation due to central bank’s intervention, particularly in Europe. But again, we’re in the same discussion: whether such high price exists for a reason other than pure self-fulfilling expectation. Now we can see some sovereign bonds edging up in yield, particularly in the US. This is the natural result of the ongoing process of reassessing expectations, mostly those related to inflation. Yield curve levels are still very low by historical standards, and the movement seems slow enough to stay under control. But nonetheless, it increases the chance of an uncontrolled burst (Does this mean that a bubble does exist in this asset class…?) caused by a policy or communication mistake (see section 3 about risks below).
Summing up, the discussion on whether there is a bubble seems only a semantic issue. The fact is that there are some factors driving valuations higher; that they look like they’re going to stay for some time, and that there are growing risks that may derail such trend, particularly in the fixed income space, although a full-fledged burst looks unlikely.
Risks that threat with a burst. Not only a discussion about inflation, but mostly
Regardless of the semantic discussion cited above, risks are for real, and it is well worth for us to pay attention to them, as they do can cause a burst. Three are the hottest topics in markets these days, that make up for the main risks: inflation, or the so called “reflation trade”; the pandemic’s economic effects and possible set back; and the way out of the mountain of debt. The three are related one to each other, but particularly the first and the third ones. However, in all cases, an eventual market collapse would probably be more related to a policy mistake than to an economic development itself.
The most important is inflation. Lately, everyone seems to be on the same side of the so called “reflation trade”, which is the bet for higher yield curves and riskier assets, on the expectation of higher inflation ahead. This, in turn, leads to a discussion about whether central banks will react to it, or how and when they will do so. And that is exactly where a serious policy mistake can take place. But inflation expectations deserve a full note on their own, as it is a very complex issue, often oversimplified by market practitioners. What we know for sure is:
- Inflation can mean many different things. CPI inflation is what makes central banks react, and so is the most talked about issue. But monetary (hyper)inflation is already ongoing, largely unnoticed.
- We are about to see a very significant increase in CPI inflation in Western countries, that will last until summer at least. This is due to temporary reasons, so should fade away as we approach year end. If It does not, we have a problem.
- The above expectation is swiftly sneaking into asset prices (see Chart #5). Even without surprises, this mere fact can change very deeply the investment landscape, should it continue for long.
- College manuals state that increasing monetary supply leads inevitably to higher inflation. That is true, but not necessary to “CPI inflation” in particular. As stated above, we may have (we are already having) other types of inflation. I insist this distinction is key to explain many of current developments.
- We cannot know for sure if, over the long term, we’ll have higher CPI inflation or not. However, evidence grows in favor of it. Particularly when governments and central bankers are interested in pushing CPIs higher (as if it were a controllable item), even with “helicopter” money.
So, given all the above, the so-called inflation trade carries several risks with it. First and foremost, everyone seems to be moving to the same side of such trade very quickly. This process is usually quite unstable, and no one can reasonably stay away or isolate from it. Second, the likelihood of a policy mistake grows higher when we are about to see higher CPIs, as well as its eventual impact when a trade is so crowded. Third, the trade is based on an expectation that may well prove false in a very short notice. In my opinion, this is the most likely risk. And fourth, some areas of the markets are being held back from its natural movement given this environment: in particular, euro sovereign bonds, which price does not reflect reality because of the ECB intervention (inflation prospects for the EZ are lower too, I admit it, but the correlation with other curves, namely the UST, is lost). If finally, we reach a CPI rate high enough in Europe, the ECB might find itself in a dead-end road, thus making investors in EZ bonds very uncomfortable. This is not likely within a reasonable horizon, but it’s worth to keep in mind.
The second hot topic is the pandemic itself. Investors assume that it is largely behind us already. The other side of the same view is that nothing will derail the positive economic prospects for this year (see Chart #2). Such expectation falls far on the optimistic side. Apart of the COVID 19, that stays as a risk, the evolution of economic activity in 2021 and 2022 relies heavily in several policy actions that may fail to deliver. In particular, European funds face several obstacles due to political reasons in each country.
But also, in the US the fiscal stimulus that is being pushed by the new administration fails to show a clear source of profitability. In other words, massive public expenditure should be directed towards actions yielding positive returns in aggregate. It is reasonable that some expenditure is devoted to just “support” some households or firms that suffer a temporary collapse of income. But if this turns permanent, potential growth falls very quickly as these funds are used inefficiently and discourages private activity. In Europe we have large experience on that. The risk is that US plans resemble dangerously this landscape, with the difference that, in this case, it will be financed with massive money printing. I’m not sure if this is good or bad. Anyway, it is just a risk. For the foreseeable horizon, monetary ammunition seems more than enough to trigger a several years long party. Just watch out the hangover.
However, macroeconomic data may pose a risk on the opposite side. If growth surprises to the upside, we’d be back to the discussion about inflation above. In that case it is possible that central banks were forced to change their stance to a tougher one relatively quickly. That would a U turn related to current expectations, so it would change dramatically asset pricing. In my opinion, this risk is at least as likely as activity disappointing.
The third hot topic is the excess of public debt. Oddly, at least in my experience, this issue is only being raised by final clients, but very few professional investors talk about it. The fact is public debt ratios are raising very fast, because of the multiple emergency measures during the pandemic. To some extent this is reasonable, as happens for example, in war times. The question is how to cope with such excess debt. At least, this is the question most often raised by clients. But in my opinion, there is another more important one, that must be addressed before: how to halt stimulus once the emergency is over, but agents have grown used to live with them. In both cases, but specially for the former, money printing is again key.
It is often said that public debt is diluted by inflation. To do that, monetary inflation is often enough. You do not need CPI inflation. With more money around debt is automatically worth less in money terms and the government can raise more taxes without raising tax rates (not VAT, since it is directly linked to retail prices, but income, savings and corporate taxes mainly). European debt, in addition, has the advantage of the ECB becoming the main creditor of EZ governments. Summing up, this does not seem an immediate risk, but for the fact that high debt ratios reduce growth potential.
Keep dancing as the music sounds. With massive money printing, an ongoing deep structural change in economic activity, and global demand moving fast towards rapidly growing countries (Asia), overweighting stocks is a must.
In the short-term watch for policy miscommunication, a setback in activity or a sharp jump in yield curves as the main risks. Over the longer term, higher inflation and a U turn in monetary policies.