Thoughts through the cycle: W2 April ’21

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  • Scientists in the 1960s discovered that the end of the stone age saw a switch in the magnetic poles on earth from north to south. This occurrence, known as the Laschamp event, saw the earth’s magnetic field drop to just 6% of its normal level, exposing the earth to considerably higher levels of cosmic radiation, which devastated the climate and may explain the start of the ice age. To add a little spice to the story, a report published recently in the journal Science says it could happen again.
  • The last time this happened, the “Earth was left open to the fury of these cosmic winds. The ozone layer was destroyed, tropical electrical storms raged, unchecked solar winds generated spectacular auroras across much of the planet” (“Magnetic disaster that ‘wiped out Neanderthals’ is due a repeat”, The Times, 19/02/2021). As well as wiping out the Neanderthals, the climatic events saw the demise of the mega-beasts, huge mammals that had prospered in what is now Australia. Only animals smaller than the kangaroo were left.
  • While it may be stretching the analogy a bit far, a shift from a broadly disinflationary environment of the sort which we have seen for the past two decades to an inflationary one has the potential to reek similar levels of havoc in investors’ portfolios. One ought to consider for example how the negative correlation between bonds and equities has made the classic 60/40 portfolio such a success since 2000, but how the reversing of that polarity (to bonds being positively correlated to stocks) was a key characteristic of the inflationary 1970s. This was during a decade when bonds and equities both performed very badly in real terms, but more importantly where owning bonds didn’t buffer equities in a downturn, as has been the case more recently.
  • The graph below illustrates the bond/equity correlation issue more clearly. The red line shows the 5-year rolling correlation between the price of the 10-year US treasury bond and the S&P 500 Index. The golden age of the 60/40 portfolio can be seen from roughly 2000 onward. When equities lost money, the Fed cut rates and bond prices rose, offsetting the equity drawdown – happy days. The positive correlation between bonds and equities during the 1970s was far less forgiving, especially with respect to real investment returns.

Source: RWC Partners, 31st December 2021.

  • In terms of the bond market, the Fed’s official narrative, which is being tediously repeated by the various regional Fed presidents several times a week, is one of tolerating higher-than-target inflation in the short term in order to allow employment to return to pre-pandemic levels. FOMC chairman Jay Powell has made it clear that there will be no tapering of quantitative easing (QE) or rate hikes until the objectives are realised, not just expected.
  • At the last FOMC press conference in March, Mr Powell said that the Fed ‘dots’, a list of the individual FOMC board members’ current estimates of the timing of rate hikes, are at best a guide and subject to change. The current ‘dots’ show that a majority of board members see only one hike in 2023 as the first move.
  • Eurodollar futures, a key measure for discounting the future price of dollars on a global level, are pricing in one Fed rate hike in 2022, and another three hikes in 2023, even when Powell is saying no hiking until 2024 and the dots say maybe one hike in 2023. There is clearly a difference here between the market pricing of rate hikes and the Fed’s narrative.
  • The Eurodollar future is something to take seriously. While this is not papal infallibility at stake, Eurodollar futures are key forward indicators of the market price of the dollar, and the dollar is the key asset price from which other prices can be divined. For example, in mid-2018, the Eurodollar future was pricing in rate cuts in 2019 even as Jay Powell was reducing the Fed’s balance sheet and claiming that rate hikes were on autopilot. It effectively ‘knew’ more than him, if knowing is really the right expression here.
  • Perhaps what these Eurodollar futures are showing is that the Fed will have to hike sooner and more aggressively than its officials are indicating. This is likely because nominal growth exceeds expectations. With US real rates still negative, this could be seen as an excess of inflation. In the context of the Fed’s narrative conflicting with the futures market, the latter may be starting to suggest policy mistakes, both on the fiscal and monetary front, with the monetary mistakes following from the fiscal. If the US economy is really going to record 6.4% growth in 2021 as the Fed itself is predicting, does it really need another $2tn or more of infrastructure spending (along with chatter of further handouts of the Covid-19 relief variety)? Shouldn’t the Fed in fact be tightening monetary policy right now, rather than waiting for unemployment levels to drop further? Should the Fed be doing QE at all at this stage?
  • If the Eurodollar futures market is saying the Fed needs to hike, then bond yields will rise. Given the huge stock of government debt (129% of GDP at the end of 2020 and counting) the question is whether the Fed can in fact hike rates as much as is needed to tame any broader and more persistent changes in inflation expectations beyond the current 2% target in the medium term. If inflation pushes bond yields too high, then the US Government will struggle to pay its interest bill – this is another way of saying it risks insolvency. That just isn’t going to happen as a policy outcome.
  • This might mean we get yield-curve control (YCC), i.e. caps to yields rather than rate hikes. This really would be the polarity-changing moment for investors. The Fed would, for the first time in a while, be acting in the interests of the US Government, but not perhaps in the interests of investors more broadly. YCC would likely be highly inflationary as capping nominal yields in a period of inflation would mean that the only way for real yields to move would be lower, with inflation being the difference between the (capped) nominal yield and the (likely more negative) real yield. The Government would do fine as the real value of the US national debt would fall, but investors would lose out for the same reason since inflation is effectively a tax on private savings.
  • What can bond investors do? In a low rate environment, whether deflationary or one effected by yield-curve control, the two options are more risk (say buying investment grade or high yield bonds rather than treasuries) or more leverage (for example by trading curve steepeners or similar structures). While this is all good, the recent demise of the Archegos fund is a salutary reminder that higher risk and more leverage can be deadly if the market turns on you. Generally speaking, fixed income is not the place to be during a period of inflation – this is an investment truism, but an unhelpful one for 60/40 portfolio construction.
  • What about equities? Again, the mantra of value outperforming growth in a period of rising inflation is well known. The classic checklist involves basic resource companies, those with high levels of fixed assets, low capex spend, operational leverage and the ability to pass through costs to consumers. Good stock picking will go a long way to offset inflationary pressures. The problem though is with US equity market cap to GDP by some estimates as high as 190% (vs the previous dotcom peak of around 160%), there aren’t an awful lot of ‘value’ stocks around right now, certainly in an absolute sense. You can thank the ‘everything bubble’ for that.
  • What about the mega-beasts? The long period of favourable bond-to-equity negative correlation may be drawing to an end. With it one has to start looking more closely at some of the deeper drivers of equities as an asset class, not least the way in which overall US equity market capitalisation to GDP, a favoured value metric of Warren Buffett, has got so high.
  • A good starting point is to look at one of the long-term winners. An example is Costco (ticker COST.US). This is an excellent company. It is well run and has good worker-management relations. It has a 90% retention rate amongst its members, and the proportion of ‘executive’ members is rising. It has done extremely well during the lockdown period when so many US restaurants have been closed, but this has been a long-term stock market favourite due to consistently rising revenues and EBITDA. The mix of food retail and consumer staples makes it a stand-out in the sector.
  • The graph below shows the stock price performance over the last 15 years, during which the market capitalisation has grown from $25bn in 2006 to a current level of around $160bn.

Source: Bloomberg, 9th April 2021. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • One might think Costco is ideally suited to a period of inflation. It owns 80% of its properties, its balance sheet has hardly any intangible assets on it, and the company is largely debt-free. As a retail business with scale and operating leverage, it is in an ideal position to pass on costs.
  • Costco customers are however value conscious and during the recent Q2 2021 analyst earnings call, CEO Craig Jelinek said that Costco might not be a first mover in terms of passing on costs to customers. Cost inflation was a recurring topic on the call, and while Mr Jelinek said there were some localised areas of sharp price inflation such as bacon, the effects so far had been moderate. Areas such as prime meat had strong pricing power for Costco and gave them an advantage over other food retailers. He cited an issue of chicken prices from a decade ago where Costco kept the price at $4.99 even while inflation was pushing the real cost higher. Clearly passing on prices to consumers during a period of inflation is highly nuanced as margins are weighed against customer loyalty and the like.
  • The other issue for Costco is valuation, and this is where perhaps one needs to think more broadly about equity as an asset class and how the recent pleasant and favourable low inflation environment has allowed the mega-beasts to grow. Back in 2006 when Costco had a market cap of $25bn, it traded on an EV/EBITDA multiple of 11.8x and a P/E of 22.3x. With a current market cap of $160bn, it trades on a 12m forward EV/EBITDA of 21.5x and a 12m forward P/E of 36x.
  • This is how you get such a high overall US equity market cap to GDP. Costco is a great company by any measure, but it is considerably more expensive than it used to be. If an inflationary environment beckons, then one must start thinking whether some of the premium currently in equity prices might get questioned. It is quite possible that equities do well to start with, but the deleterious effect of inflation on earnings margins and post-inflation returns on equity have to be monitored very closely, especially with respect to real returns. In addition, rather than simply focusing on balancing equities with bonds, investors will likely need to broaden their horizons in terms of asset classes, most notably into commodities and real-asset investments. That is one area which did superbly well in terms of performance during the inflationary 1970s.

The information shown above is for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice.

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