By HENRY H. MCVEY Mar 03, 2021
Another Voice Update: Value Creation Through Reflation
With a new stimulus package on its way as well as an accelerating number of the global populace receiving vaccines, we decided to drill down further into key topics we explored at the start of the year in our 2021 Outlook: Another Voice. To review, our base was that faster nominal GDP growth would force investors to shift more assets into beaten down areas of the market that may have lagged ahead of and during the onset of the pandemic. Said differently, we were encouraging investors to ‘make a new beginning’ in terms of portfolio construction towards more hard assets and more cyclical exposure. In this follow-on piece, we detail in depth why we have increased conviction about our Another Voice macro overlay. In fact, to borrow again from T.S. Eliot, it will be a time when “...only those who will risk going too far can possibly find out how far one can go.” To be sure, upward inflationary pressures and rising rates are transitory risks to consider, but structural deflationary forces, including technology and demographics, should ultimately outweigh the increase in money supply and supply chain tightness that we are seeing in the goods segment of the market. So, when we pull all the macro pieces together, we see a constructive environment, particularly for collateral-based cash flows, where we get reflation without runaway inflation, as this synchronized global economic recovery continues to unfold.
...and only those who will risk going too far can possibly find out how far one can go.
T.S. Eliot poet, literary critic, dramatist, and editor
When we penned our macro outlook, , in December 2020, we challenged investors to ‘make a new beginning’ with their portfolios. Specifically, our macro models were all pointing towards a broadening of markets that required portfolio managers to make a major shift away from defensive growth portfolios towards more cyclical ones that could outperform in a faster than expected nominal GDP environment.
In this latest Insights note, we are – once again with the help of T.S. Eliot – encouraging investors to lean in further to our Another Voice framework. Indeed, as Eliot puts forward, “...and only those who will risk going too far can possibly find out how far one can go.”
To this end, we have updated our latest thinking on our macro framework around two areas, both of which are key underpinnings to our 2021 Outlook. Our thoughts are as follows:
- With another sizeable stimulus package coming and vaccinations on the rise, we are now even more constructive on our Another Voice framework for 2021 and beyond. Initial results support our view on global portfolio construction, as the Russell 2000 and the Emerging Markets are handily outperforming the S&P 500 in 2021 (Exhibit 1). A similar performance story holds true in Credit. Further stimulus by the U.S. government, which could include both more direct deposits to consumers and a sizeable infrastructure plan, should only reinforce our view that market breadth will continue to improve, as investors take further advantage of wide dispersions within and across asset classes.
- Reflation without runaway inflation. We are boosting our 2021 U.S. Real GDP growth forecast to 6.5% from 5.0% and lifting our 2022 U.S. Real GDP growth estimate to 4.0% from 3.0%. We are also boosting our U.S. nominal 10-Year interest rate forecast for 2021 to 1.5% from 1.25%, while our U.S. nominal 10-Year 2022 forecast goes to 2.0% from 1.5%. Importantly, our longer-term macro framework still suggests that the uptick in inflation we are forecasting for this year and next is both transitory and largely in-line with past recoveries. Without question, being right on the direction and level of interest rates is incredibly important at this point in the cycle. However, from our vantage point, structural deflationary forces, including technology and demographics, still outweigh the increase in money supply and supply chain tightness that we are seeing in the goods segment of the market. When we pull all the macro pieces together, we see a constructive environment for risk assets where we get reflation without runaway inflation. To be sure, long duration debt and growth companies with higher P/E ratios will be more vulnerable, but that is not where allocations from our Another Voice framework are leading us.
Looking at the big picture, we remain constructive on many risk assets across much of the global capital markets, particularly those investments that dovetail with our Another Voice framework. Without question, there will be setbacks along the way, including concerns about growth, stimulus, rates, and geopolitics. However, our primary message is that we are entering a new economic cycle, not stuck in an old one. The breadth and speed of the global economic growth we expect will soon make its way into the markets. As such, a new ‘voice’ will be required to succeed. Indeed, investors will need a different investment playbook to thrive in a world of faster than expected nominal GDP growth. To this end, we continue to favor the following mega themes that we laid out at the beginning of the year:
- We are bullish on collateral-based cash flows. Asset-Based Finance, Infrastructure, and many parts of Real Estate should perform well in the faster nominal GDP environment we are envisioning. This call remains a table pounder for us, particularly given the unusual backdrop of rising cyclical inflation, more stimulus, and higher commodity prices.
- Given record low rates and the campaign against austerity, investors should back fiscal beneficiaries, particularly as it relates to ESG. Climate change and the transition to cleaner energy, which we think could be a three trillion per year global investment, are clear areas of focus for many investors. We also continue to prioritize opportunities that benefit from COVID-related structural tailwinds across areas like education/work-force development, waste management, and industrial technology. Finally, given rising geopolitical tensions as well as the devastating weather events in Texas, we see infrastructure ‘resiliency’ as an influential investment theme, particularly as it relates to supply chains and power distribution.
- The rise of the global millennial is upon us. In the United States, the 68 million millennials are now at an age where they are buying houses, spending on their families, and shifting their consumer preferences. Moreover, in Asia there are now more than 800 million millennials; their shifting preferences at a time of huge technological change will have significant implications for all aspects of the global economy. If we are right, then our ‘nesting’ theme has more room to run.
- Though COVID-19 will certainly accelerate the trend, we think local bias preferences by both governments and corporations were already leading to shifts in the global supply chain. Our strong belief remains to invest behind this transformation. Reshoring of property, plant, and equipment will be an attractive investment area, though the rise of local technology and services champions could be an even more fertile area for investment capital, we believe.
- We think that more volatility and more dispersion lie ahead. Not surprisingly, we favor flexible mandates such as Opportunistic Liquid Credit, particularly managers who can toggle between High Yield and Loans and Structured Credit, as well as Real Estate Credit funds, including those that can move up and down the capital structure. Funds that also benefit from market dislocations and can deliver capital solutions should do well in the environment that we envision.
- Despite our desire to ride the cyclical wave in the economic growth we are forecasting, we do not believe that Growth investing behind secular winners should abate. Our distinct preference is less for Venture Capital and more towards Growth ideas in areas such as Healthcare, Technology, and Consumer. The reality is that Technology is no longer a distinct sector; rather, it is now woven through every industry in which we invest, a backdrop that creates an attractive environment to back long-term champions of innovation. However, unlike the last 2009-2019 economic cycle, valuation will now matter more on a go-forward basis.
Why are we so adamant about embracing our macro themes? Because our strong view is that investors will need a structured roadmap to outperform in a world where both nominal and real returns are going to be much more modest than in the past. Also, there are now already some excesses in the system that need to be considered – and potentially avoided. In particular, easy financial conditions during the second half of 2020 have led to a potentially unsustainable boom in new issuance activity (Exhibit 25).
Overall, though, we think that the environment for 2021 is a compelling one for the investment strategies we are pursuing. The illiquidity premium is likely to expand further, dispersions are wide within the liquid markets, and we expect more stimulus, including both consumer and infrastructure packages. So, we enter the spring of 2021 confident that – given the shifts we are seeing across our macro models – now is the time to ‘risk going too far’ in terms of repositioning one’s portfolios towards our Another Voice framework.
In the following section we respond to two of the most pressing macro questions that we have been discussing of late with our global deal teams and thoughtful clients.
#1: Do you still have high conviction about your Another Voice thesis?
It was almost thirty years ago, in the fall of 1991, that I started in the financial services industry. As I reflect back on the journey, it certainly has been rewarding, albeit with lots of mistakes made along the way. Importantly, though, I have also used those mistakes to learn, and one of my most profound learnings is that the sizing of positions – not always having the best idea – can often be the deciding factor in investment outcomes. What I have learned is that when you are wrong, often your best course of action is to cut your losses and move on. But, when you have the wind at your back, it often makes sense to increase the size of your position until the market catches up to you. As legendary investor Stan Druckenmiller (also a Richmond, Virginia native) said, “I like putting all my eggs in one basket and watching the basket very carefully.”
At this point in 2021, Druckenmiller’s aphorism fits neatly into our framework. ‘Risk going too far’ is not only Eliot’s advice but our advice too. Said differently, we do not think it is too late to lean in to our thesis about a surge in global nominal GDP leading to reflation without troubling inflation – at least in the near term. As part of this backdrop, we see a broadening of the market beyond big capitalization tech stocks. I am not a chartist, but I would argue that the Russell 2000 and the MSCI Emerging Markets indexes are just coming out of bear markets that started back in 2018. A similar story holds true in the commodity complex. If we had to mark a day that their bear markets ended, it would be the day Pfizer’s vaccine received emergency use authorization from the U.S. Food and Drug Administration on December 11, 2020.
We Believe That a Changing of the Guard Is Occurring Across Global Equity Markets
Importantly, the ‘Catch-Up’ Trade Is Only Now Just Beginning to Unfold
Implicit in our outlook is that the vaccines will make a positive impact on spending behaviors, even with the diseases mutating into new forms. As such, we think that we are now transitioning from the ‘square root’ part of the recovery we outlined in our July 2020 Insights note towards a faster than expected rebound in corporate profits and economic growth that could extend well into 2023 and beyond. Against this backdrop, we believe that this recovery will be quite different than the one that followed the Global Financial Crisis (GFC). This viewpoint is critical, as most investors tend to compare the prior downturn and subsequent recovery to forecast where we are headed. That would be a mistake this time around, in our opinion.
There are four points of differentiation, we believe, that make this recovery path different. They are as follows:
Point #1: Central banks acted with greater intensity and there was less bank de-leveraging during the pandemic Investors often forget that, although central bankers embarked upon quantitative easing (QE) fairly quickly in November 2008, they did so with much less conviction and intensity. Some work by my colleague Brian Leung highlights that during the GFC, G4 (U.S., Euro Area, the U.K., and Japan) central bank balance sheets increased by $2.4 trillion (or seven percentage points as percentage of GDP); by comparison, balance sheet expansion has been three times bigger in response to COVID, increasing by $8.5 trillion (or 21 percentage points as percentage of GDP). Today, G4 balance sheets stand at about $24 trillion compared to around $15.5 trillion at the start of 2020.
The GFC Response, While Considered Unprecedented at the Time, Pales in Comparison to Today
The Excesses of the Global Financial Crisis Were Not Present at the Start of COVID-19…
…As Many Changes Post GFC Centered Around Debt Ratios
Incredibly, the U.S. Federal Reserve bought more bonds under Jay Powell’s leadership in the six weeks after the pandemic hit the U.S. than it did during the prior 10 years under both Bernanke and Yellen combined. Another point of differentiation is in regards to bank leverage. In 2008 the ratio of assets-to-equity at banks was inordinately levered from fueling a period of extreme excess. In the run up to the GFC, the median bank leverage ratio was 32-to-1; however, bank leverage at the onset of COVID was a much healthier 11-to-1. Rate cuts have also happened much more aggressively post pandemic, as during the GFC it took eight months for the weighted average developed market economy policy rate to reach a trough, while it took just one month to cut rates to the low of zero percent during COVID. During the GFC, developed market central banks’ policy rates reached 0.6% in May 2009, down from 3.2% in September 2008. While developed market central banks completed 70% of the rate cuts during the initial three months, the remaining 30% were spread out over the subsequent five months. In 2020, the policy response was much more quick and decisive as it took just one month for developed market central banks to cut the average policy rate to the low of zero percent in March 2020 from 0.75% in February 2020.
The Policy Response in 2020 Was Incredibly Decisive. It Was Much Less So During the GFC
It’s also important to consider fiscal stimulus as well. The global fiscal response to the pandemic has been approximately three times greater than the support provided during the GFC. The type of stimulus provided is also very different. Back then, tax cuts and public investments accounted for the lion’s share of the assistance, whereas this time it has been about direct support for the private sector in the form of cash payments, unemployment insurance and job retention programs as well as business loans and grants.
The Global Response to COVID Has Been Three Times Larger Than the Support Provided During the Global Financial Crisis…
…Back Then Tax Cuts and Public Investments Accounted for the Lion’s Share of the Total. This Time It Has Been Much More About Direct Payments to the Consumer
Point #2: China will likely lead the world in global growth again, but this time with much less debt accumulation In 2008 China’s government, fearing a major, sustained collapse in the U.S. consumer, overstimulated its economy to bolster the world economy. While it worked in the short-term, China spent much of the decade trying to rein in its debt load, which ultimately dented productivity. One can see the impact of these challenges in China in Exhibits 9 and 10, respectively.
China Is Not Overstimulating This Recovery Cycle Because It Knows the Consequences
A Major Hangover From China’s Prior Debt Binge Has Been a Major Fall-Off in Productivity
This cycle, however, China has barely spent to reignite its economy. One can see the significant delta in approach in Exhibits 11 and 12, which shows how much the U.S. has had to use its central bank balance sheet to improve financial conditions relative to China. A similar story holds true on the fiscal side. Indeed, according to my colleagues Rebecca Ramsey and Frances Lim, fiscal spending in the U.S. since the pandemic started is now approaching five trillion dollars, dwarfing the one trillion dollars that the Chinese government has spent to reignite growth following the onset of the pandemic.
The U.S. Is More Aggressively Utilizing Monetary Policy in Response to the Pandemic…
…Whereas China Did So During the GFC
Point #3: Direct Deposits Unlike during the Global Financial Crisis, governments have been much more aggressive around the fiscal impulse required to re-accelerate the economy. According to some work by my colleague Dave McNellis, the average U.S. household had an expansion of disposable personal income of 4.6% in 2020, despite the U.S. experiencing a recession that was five times as bad as the average recession. Moreover, we forecast disposable income will grow by almost five percent further in 2021. Driving this unusual outcome is direct deposits issued by the government. As one can see in Exhibit 13, consumers have been able to increase their disposable incomes during the pandemic with the assistance of government transfers, despite high unemployment.
Government Transfers (i.e., Stimulus) Have Buoyed Disposable Incomes, Despite High Unemployment
The Recovery in Jobs Post-COVID Is Handily Outpacing the Recovery Path Post-GFC
So, the net result is quite positive. First, savings is ballooning because of this increase in disposable income. In fact, we now estimate that consumers will have banked about $2.5 trillion in extra savings by year end, equivalent to fully 17% of pre-pandemic annual consumption spending. Second, unemployment is coming down much faster than in prior cycles, which should further lend support to our thesis that this recovery will be more robust relative to the prior recovery in 2009.
Our bottom line: While we are still troubled by the unemployment trends with low income and minority workers, the middle and high income consumers in the United States appear poised to significantly bolster their spending habits heading into 2022. They have saved, paid down debt, and improved their cost of capital on what debt remains. Moreover, there is pent-up demand that we think could lead to something akin to a ‘Roaring 20s’ if our base unfolds as expected.
Point #4: Austerity and rate increases have given way to more dovish frameworks like AIT Unlike the aftermath of the Global Financial Crisis, there will be no debates about austerity post pandemic. There will be no rogue bankers or traders taken to task for their association with COVID-19 – only human tragedies, and as such, politicians will feel emboldened to spend more than normal when and where they can find any agreement. Consistent with our viewpoint, we note that Vitor Gaspar, the head of fiscal policy at the IMF, recently acknowledged that the austerity plan implemented during the European sovereign crisis was a mistake. He then went on to encourage more spending, giving assurances that “The [public debt] ratio in our projections stabilizes and even declines slightly towards the end of our projections which shows that COVID-19 is a one-off jump up in debt and with low interest rates, the debt dynamics stabilize.”
The Strategy to Reflate Is Based on Holding Nominal Interest Rates Below Nominal GDP
Meanwhile, on the monetary side, the Fed has become amongst the most dovish of the central banks by introducing a totally new framework that should hold rates low for a much longer time. As we discussed in October 2020’s , average inflation targeting (AIT) is likely the biggest shift in U.S. monetary policy since the introduction of quantitative easing at the end of the Global Financial Crisis. As a refresher, this shift by the Fed will allow inflation to run above the target of two percent (to make up for periods when inflation is below the target) for some time before hiking interest rates. Indeed, we are of the opinion that the lion’s share of central bank committee members now believe inflation is so structurally low that the committee’s shift reflects their view that “a robust job market can be sustained without causing an outbreak of inflation.” This statement is important because it reveals two things. First, it suggests that, despite the Fed’s dual mandate, it appears to be intensifying its focus on employment relative to price stability. In fact, Powell recently stated that, “This change (in the inflation mandate) reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities.” Second, when it comes to future inflation trends amidst further downward pressure on wages, he certainly sees a negative skew.
Our Earnings Growth Leading Indicator (EGLI) Suggests a Massive Rebound in Growth in 2021
President Biden in the United States is also charting a course that is heavily reliant on fiscal initiatives, many of which we expect to bolster growth. Against this backdrop, we are using this update to further bolster our GDP forecast. Our 2021e U.S. Real GDP goes to 6.5% from the 5.0%, while 2022e goes to 4.0% from 3.0%. Consensus has been ticking higher, but is still at a relatively modest 4.9% for this year. If our forecasts are directionally correct, 2021 will be the best year for U.S. growth since 1984. There have been three key developments since our last GDP update in early December that influence our thinking. They are as follows:
- Democrats took control of the Senate, raising the outlook for stimulus: We now see a ‘Phase 5’ bill coming in at around $1.5-1.9 trillion. Prior to the Senate turnover, our expectations for additional stimulus were much more constrained (around $200-500 billion), focusing mostly on extending unemployment protections. This new larger bill, however, means that we now expect further disposable income growth of almost five percent this year, following the substantial gains in 2020 (Exhibit 13), supporting an even more robust economic recovery.
- The pandemic has slowed, supporting mobility and spending: Back in December, we thought the pandemic surge could create an economic air pocket in 1Q21. What has happened instead is that new case growth has slowed since mid-January, the vaccine rollout has accelerated, and mobility data have started to improve (Exhibit 19).
- Regardless of the aforementioned improvements, the Fed has remained dovish, spurring financial conditions: Central bank policy remains highly accommodative, credit spreads have been grinding tighter, and the housing market is ebullient. Importantly, our quantitative GDP indicator continues to hook higher, and actually points to almost five percent growth this year, before even accounting for the fundamental tailwinds of stimulus and pandemic recovery.
Positive Real Estate Pricing Is the Most Influential Input in Our EGLI
A Sizable Build-Up of Household Savings Can Help Underpin a Multi-Year Recovery, We Believe
Mobility Data Is Starting to Improve, Coincident With Impressive Declines in New Cases
In terms of investible implications, we are focused on the rising stock of savings, the falling unemployment rate, and the ongoing inventory cycle.
- Excess savings: We estimate consumers will have banked about $2.5 trillion in extra savings by year end, equivalent to 17% of pre-pandemic annual consumption spending (Exhibit 18). Not all of those dollars will get spent at once, but we do think they will support a multi-year expansion. Much of the extra savings have built up at the high end (Exhibit 21), as lockdowns have curtailed upper-income spending on travel and leisure. Excess savings should help catalyze big-ticket discretionary spending amid re-opening.
- Falling unemployment: The pandemic has suppressed labor force participation, contributing to a rapid decline in the official unemployment rate, which we think could fall to 4.5% by December (Exhibit 22). However, we think it will take time for displaced workers to come back, in our view, which means that in many markets jobs may be harder to fill - and wages better supported - than one might otherwise expect. This is part of our ‘early cycle reflation’ hypothesis, in which core inflation recovers and 10-year yields converge back towards the low-2% range relatively early in the cycle.
- Inventory cycle: In many markets, demand is snapping back faster than producers anticipated and/or faster than they are able to resume production. We see this as a broad phenomenon across raw commodities, semiconductors, retail goods, and housing. The heated inventory cycle also supports our ‘early cycle reflation’ hypothesis.
Pandemic Relief Has Supported Disposable Incomes Most at the Low End…
…But High-Income Households Have Actually Banked the Bulk of Excess Savings
We Forecast Official Unemployment to Fall to 4.5% by Year-End, as Labor Participation Rates Remain Depressed
The U.S. Economy Was Relatively Late-cycle by December 2019. However, the Pandemic/Recession Has Reset Most of the Indicators We Track Back Towards Early-cycle
Against this backdrop, we think macro investors and global asset allocators should be leaning into the following five themes:
- Corporate carve-outs: If there ever was a time to buy complexity and sell simplicity, now would be that time. In our humble opinion, the best way to pursue this strategy in size is via large corporate carve-outs that require operational improvement. The good news is that one of the fall-outs from the pandemic is that an increasing number of CEOs are refocusing their businesses on core initiatives, which means the supply of available non-core entities for sale is on the rise. Throw in some additional pressure from the activist community, and the market backdrop for this macro investment theme feels quite constructive to us.
- Leverage wide dispersions with a more cyclical bias: Given our constructive view on nominal GDP, we also believe that now is the time to add some cyclical growth to the portfolio, particularly if one can find a ‘price maker’ (i.e., the ability to pass through cost). There are several forces at work. First, we think that we are in the early phases of a global capital spending recovery cycle, and the need for heightened supply chain resiliency will only accelerate this trend. Second, we estimate the current transition towards more environmentally friendly platforms could total three trillion annually over the next five years. Finally, with such wide dispersions, we think the potential for active management has rarely been more compelling.
- However, maintain some secular winners in the portfolio: While there is clearly a more distinct cyclical bias inherent in our portfolio for 2021, innovation is still highly relevant in the world we are envisioning. Indeed, given all the seismic changes that have taken place in Healthcare, Security, Software, and Consumer sectors, we still want to be long a slew of disruptors in our portfolio. The reality is that there are just fewer companies that can sustainably grow eight percent or more. As such, we see outsized gains for these companies over the next five to seven years.
- Lean into shifting consumer preferences: We are bullish global consumption, particularly service related areas that could snap back faster than expected. As mentioned earlier, we think that the nature of this recovery will lead to a faster improvement in the unemployment rates versus the 2008 downturn. Indeed, while this recession was five times the historical average in terms of severity, duration was just 25% of the historical average, and disposable income has actually increased during this recession. Key themes on which to focus, we believe, include nesting, personal safety/resiliency, domestic travel/leisure, and e-commerce.
- Avoid long duration government bonds: As we indicated in our 2021 outlook, we think that we are at an inflection point for traditional asset allocation. In particular, we think that government bonds can no longer fulfill their destiny as an income producer and a diversifier. This insight is not to be taken lightly, as government bonds have delivered performance on par with global equities during the last decade, though with much less volatility and better downside protection.
In terms of what could derail our thesis, we believe the single biggest risk is that something unsettles the bond market. Were that to occur, valuations could prove quite challenging, as we show in Exhibit 24. What could do that? Most likely it would be a potential misstep by the Federal Reserve, or one of its global peers around tapering in the second half of this year. Another risk could be if inflation increased faster than we expect. As we discuss below, we don’t see either the Fed or inflation ruining our Another Voice thesis in the near-term. Regardless, as we mentioned above, we would be underweight government bonds. Finally, financial conditions appear attractive – too attractive? Indeed, as we show in Exhibit 25, the new issue market seems to be at extreme levels.
The Market Looks Expensive on All Metrics Except Interest Rate Adjusted Metrics. Importantly Though, Interest Rates Do Matter
The New Issue Market Seems to Be at Extreme Levels
Overall, though, our bottom line is that we think investors should double down on our Another Voice framework. In fact, as our T.S. Eliot quote suggests, we would ‘risk going too far’ in terms of adopting our macro themes and approach relative to booking some of the substantial gains that have occurred so far in 2021. In our humble opinion, these changes towards faster nominal GDP are more secular than cyclical in nature. If we are right, then the success of our Another Voice thesis should be measured in quarters or years, not days or months.
#2: Are we at risk of high inflation due to Fed policy and fiscal stimulus?
…to me, a wise and humane policy is occasionally to let inflation rise even when inflation is running above target. Janet Yellen, former Federal Reserve Chair and current Secretary of the U.S. Treasury
If there was ever a time to talk about inflation, now is that time. We have record money supply growth, a dovish Fed, and a new Secretary of Treasury who may be even more dovish than the current Fed chair. Not surprisingly, at almost every client meeting in which I participate, the conversation turns to inflation and some variation of the question of whether the Fed and its central bank peers have it all wrong. Specifically, a growing number of investors are increasingly concerned that central bankers are re-committing their dovish stance just as growth is re-accelerating around the globe. Interestingly, this prioritization of market risks is quite different than just a few months ago (around the election) when we conducted our survey of Ultra High Net Worth investors. At that time, the focus was squarely on geopolitics, i.e., U.S.-China trade tensions, not inflation. Fast forward to today, and inflation risk is clearly the issue most heavily weighing on investors’ psyches.
Why is this happening? Beyond new leadership in Washington, inflation concerns are rising to the forefront today because inventory shortages are rolling through multiple supply chains. Demand — while in many instances still weaker than pre-pandemic levels — has snapped back faster than producers anticipated, and/or faster than they are able to resume production. This tension, in turn, is squeezing purchased goods prices considerably higher in many instances. At the same time, consumers in aggregate find themselves holding considerable excess savings, with more support on the way via further stimulus. In addition, wage growth has, to date, remained surprisingly resilient, due at least in part to ongoing support to the lowest wage tiers via widespread minimum wage increases at the state level.
Purchasing Managers Are Seeing Widespread Pricing Increases…
…As Supply Chains Restock from Historically Tight Inventory Levels in Many Instances
Inventory Constraints Are Also an Issue for Industrial Inputs Like Steel, as Demand Outperforms Production Plans That Were Set Earlier in the Pandemic
Semiconductor Inventories Have Tightened, With Few Areas Easing
While the headlines sound somewhat alarming, the current backdrop of a heated inventory cycle unfolding amidst abundant consumer dry powder is actually a fairly typical early-cycle pattern. In both 2003-04 and 2010-11, for example, inflation surged early in the economic recoveries, driven by inventory cycles and consumer resilience. Interestingly, Treasury markets historically have overestimated the persistence of early-cycle inflation, as 10-year yields and breakeven inflation expectations peaked in the early years of the last two recoveries.
Inflation Readings Often Look Most Elevated in the Early Phases of Expansions…
When we pull all the facts together, our bottom line is that, while we do not necessarily expect nominal rates to spike to cycle-peak levels in the near term, we do think inflation concerns will remain at the forefront of investor attention. What’s different this time is the unprecedented level of Fed QE and – maybe more importantly – extended rates guidance. So, while we do think inflation breakevens could hit near cyclical peaks in coming quarters, we believe real yields will stay low relative to history, helping to suppress nominal rates too.
Central to our thinking is that, as shown in Exhibits 33 and 34, the flow-through effect of input cost increases and disposable income surges into core consumer inflation tends to be rather limited. Importantly, consumer goods make up less than one-quarter of the overall core consumer inflation basket. We believe goods inflation is the primary transmission mechanism through which input cost spikes and inventory squeezes are translated into core consumer inflation.
…Which Also Tend to Push Up Treasury Yields Early in the Cycle
Investors Initially Over-Extrapolate the Persistence of Early-Cycle Inflation
Historically, Significant Spikes in Input Costs and Disposable Income…
Moreover, the pandemic continues to dent pricing power in a few key categories holding outsized CPI weights, including apartment rentals, health care, and education (Exhibit 35). These categories have not recovered in the initial economic bounce, and in fact have come under increasing pressure in recent months (Exhibit 36). We think capacity and regulatory overhangs likely will restrain any major resurgence of pricing power in these categories in coming months, thereby dampening the rebound in core inflation.
…Have Been Associated With Only Limited Increases in Core Consumer Inflation
A Few Critical Sectors Drive the Bulk of Core CPI…
...And Are Experiencing Rather Weak Trends
There are also secular forces to consider. Indeed, despite the cyclical inflation we are forecasting, we maintain a high degree of long-term conviction that structural forces around demographics and technology are set to continue exerting long-term downward pressures on aggregate prices. As such, we are not concerned that inflation gets out of control this cycle. Ongoing moderation in large services-based inflation categories such as rents, healthcare, and education are also moderating forces. Remember services account for roughly 60% of inflation inputs.
There Is a Strong Historical Relationship Between Demographics and Inflation
Technology’s Effect on Prices by Industry Has Been Significant in Recent Years
If we are wrong in our long-term outlook, we think it will be because growth in money supply actually leads to a sustained increase in the money multiplier. Under that condition there would likely be too much money chasing too many goods and services. However, as Exhibit 40 shows, the money multiplier is actually contracting, not expanding. Moreover, my colleague David McNellis highlighted for me some interesting work by UBS, an investment bank, there has been essentially zero relationship between inflation and money supply growth. Importantly, the inflationary impulse from an M2 surge is usually offset by the deflationary impulse from the economic weakness that the M2 surge is intended to offset. One can see this in Exhibit 41.
The U.S. Money Supply Is Booming, But…
…the U.S. Money Multiplier Is Not. We Expect It to Remain Sluggish in the Near-Term
Since the Mid-1980s There Has Been Essentially Zero Relationship Between Inflation and Money Supply Growth
Given the huge surge in sovereign debt that we are seeing to pay for pandemic relief, we also looked into whether outsized government debt loads result in higher inflation. What we found is that there are actually no good examples of debt-related inflation surges outside of wartime conditions. Cynics could argue that governments like the United States and Europe have approached the current pandemic with wartime-style stimulus and spending. However, we do not believe that is an apt analogy based upon our research. Postwar inflations are typically ‘back door’ defaults by governments that are offloading war-related debts via currency depreciation. Often it is the losing side that does this, and/or a successor government that repudiates the policies of the prior government. A critical aspect to remember is that a country that seeks to inflate away debt will face highly constricted access to capital markets, and therefore will likely need to run a balanced budget. Debts from war are one-time in nature, so it is more straightforward for a country to balance the budget after wartime expenses go away. For a country like the U.S. today, which is running persistent deficits due to demographic and entitlement issues, balancing the budget is much more complex. In fact, the debt is mounting because voters do not want to balance the budget. So, in our view, history suggests that the surge in pandemic-related debt will not in itself generate higher inflation (Exhibit 42).
Outsized Government Debt Loads Are Associated With Low, Not High, Subsequent Inflation (Unless the Debt Is War-Related). In Fact, There Are No Good Examples of Developed Countries Inflating Their Way Out of Debt Outside of Wartime
Putting all the pieces together, we are making modest increases to our near-term outlooks for inflation and 10-year yields, but no changes to our longer-term forecasts for inflation. Specifically, our CPI forecast goes to 2.4% from 1.9% for 2021e and to 2.0% from 1.8% for 2022e. Consistent with this view, our 10-year targets go to 1.5% from 1.25% for 2021e and to 2.0% from 1.5% for 2022e. Finally, there are no changes to our outlook for the Fed, which we continue to think will keep the funds rate pinned at zero through 2023.
Year-Over-Year Inflation Readings Will Surge in April-August Due to Easy Comparisons, but Then Decelerate, We Believe
Our New Targets Assume That Inflation Breakevens Continue Rising While Real Rates Remain Low…
Our Bottom Line: Reflation Without Structural Inflation With the Democrats now fully in control, and the stimulus outlook rising, we forecast that a yield curve steepening may play out faster than market participants are currently anticipating. One can see this in Exhibit 45. Importantly, though, the lion’s share of the yield increases we now anticipate will play out via higher inflation breakevens, not higher real rates, as we show in Exhibit 44.
This backdrop is actually a constructive dynamic for markets, we believe, particularly given we do not see a structural outbreak of inflation in 2022 and beyond (Exhibit 43). In terms of specific investment considerations, it reinforces our overweight to Global Public Equities, particularly those with some cyclical bias, relative to Sovereign Debt. It also supports our view that owning collateral-based cash flows including Asset-Based Finance, Real Estate, Real Estate Credit, and Infrastructure all make a lot of sense. As a ‘soft’ hedge, it also supports owning more Financials, which benefit from a steeper yield curve and lower provisioning amidst faster growth, from a sector perspective. We too favor owning more floating rate instruments, including Loans, across Fixed Income portfolios. EM currencies too make sense.
…and That the Back End of the Yield Curve Continues Steepening, Which Is Typical at This Early Stage of the Cycle
We Believe That the 10-Year Yield Will Trade Around 150 Basis Points Below Nominal GDP, In-Line With the Post-GFC Trend
The measure of intelligence is the ability to change. Albert Einstein
Unlike in some of our pre-pandemic Insights notes, we have leveraged more of a question and answer format since March 2020 to better address specific queries that are coming up in deal team and/or investor conversations. To this end, we want to make sure that our readers have a clear understanding of our overall macro conclusions. They are as follows:
- We think that we are in the early stages of an economic recovery that will look quite different from that which occurred starting in 2009.
- We think that nominal growth will run above trend for the foreseeable future, driven by a stronger than expected consumer and a rebound in non-tech related capital expenditures.
- While we expect cyclical inflation, we remain in the camp that a secular increase in inflation is not upon us.
- Consistent with this view, we expect real rates to generally stay low, (though we do expect them to move up in absolute terms), which drives our view that nominal rates too will not get unglued. As such, the value of the illiquidity premium should increase in this type of environment.
- From a portfolio construction perspective, we advocate for more of a cyclical bias that favors pricing power and is connected to global growth and hard assets. Financials, Loans, and higher quality Emerging Markets should all benefit. All forms of collateral-based cash flows should be owned in size. By comparison, government bonds should be underweighted in global portfolios, particularly in the United States.
Importantly, these aforementioned ‘tactical’ suggestions all support our larger conclusion that portfolio managers, even the most bottom-up oriented ones, must now change their approach. Specifically, what worked last recovery – and gained momentum throughout the decade – will not lead to the same outsized returns this cycle. Given how tilted most portfolios are towards the ‘old’ regime, we think that our Another Voice framework may emerge as a differentiated prerequisite for success in the macroeconomic backdrop that we now envision.
In terms of our concerns arising from global growth being too hot, we think that the biggest risk is actually what we laid out at the beginning of this piece. It is that investors don’t lean in enough to what our macro models are saying about future growth and return prospects. We do not typically make these type of table pounding statements, but the early indications across the global capital markets in 2021 suggest that we are at the early stages of a secular change in portfolio construction that warrants attention from all globally-oriented asset allocators and macro traders.
Our ‘Another Voice’ Framework for Asset Allocation Will Likely Be Required to Avoid Diminishing Future Returns
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