“We’ve basically dug ourselves into a huge hole. And we’re hoping to fill that hole by printing loads of money… We’re just taking the 2008 reaction and pumping it up with steroids.” — Louis-Vincent Gave, CEO, Gavekal
The reopening of business activities within the wake of the COVID-19 pandemic, the bloated balance sheets of central banks, the resurgence of inflation and the competitive dynamics between the United States and China provide the idea for an enriching dialogue by which Rob ArnottFounder and Chairman of Research Affiliates; Joyce ChangChairman of Global Research at JPMorgan; and Louis-Vincent GaveCEO of Gavekal.
Four central themes emerged.
1. The Policy response to COVID-19
The effectiveness of lockdowns varies world wide, but business closures have led to lost production and employment opportunities almost in every single place, panelists noted.
“There’s a narrative that it’s a trade-off between saving money and saving lives, but it’s never been either/or,” Arnott said. “Deaths are family and personal tragedies. The same goes for the destruction of careers, hopes and dreams.”
The scale of the monetary and monetary policy response to the economic crisis is unprecedented: debt-financed government spending and ultra-loose monetary policy pumped the markets with abundant liquidity.
In monetary policy, some of the vital developments, based on Chang, is the central banks’ shift from an anticipatory, prospect-based, response technique to a results-oriented one. Interest rates will only rise when inflation and unemployment targets have been reached.
“They learned from the last crisis. They didn’t want to pull back on the stimulus measures too soon,” she said. “But if you wait to see what happens next, there’s just a real danger of timing it right.”
This increases the likelihood that monetary tightening will come too late within the economic cycle to maintain inflation under control. In addition, Chang said, the shortening of the economic cycle, as reflected within the strong recovery in economic activity, further increases the chance of mistiming monetary policy.
“This is not a normal business cycle,” she said. “A year ago, we were all talking about what the recovery was going to look like: Is it a ‘V,’ is it a ‘W,’ is it a ‘U’? It kind of looks like a ‘U.’ It was the fastest downturn and also one of the fastest recoveries.”
Gave elaborated on the inflation risk, declaring that the pandemic has led to massive disruptions in supply chains and a less connected world.
“We are not experiencing a deflationary shock, but an inflationary shock,” he said. “We are seeing the world closing in on itself. Instead of an acceleration of globalization, we are seeing a world that is falling apart.”
During the 2008 financial crisis, Gave recalled, monetary policy stimulus was aimed toward promoting growth in any respect costs and thus stopping deflation. In contrast, the present monetary policy impulse is of a much stronger magnitude and, combined with supply dynamics, may lead to significantly higher inflation in the long run.
On the state of fiscal policy and the results of high public debt, Arnott noted that excessive debt slows gross growth and that excessive spending may lead to human capital being diverted from the private sector to certain government programs.
“There are many more job openings than people looking,” he said. “It’s true that unemployment is still higher than it was before COVID, but it’s gone up because we’re paying people more not to work than to work. If that went away, we’d have full employment now.”
Arnott also warned that there can be devastating consequences if the US government gathered debt without plans to repay it.
“If we borrow with the intention of paying back, we either pay back or we default,” he said. “If we borrow with the intention of never paying back, this reckless behavior will eventually be curbed by a domestic and global loss of confidence in the currency and in the healthy functioning of the U.S. economy.”
2. Divergence between the US and China
“It’s a strange situation when the biggest guy in the room is stepping on the gas like never before. And the second guy is stepping on the brakes.” — Louis-Vincent Gave
The fiscal expansion that the United States is currently embarking on is on a scale that has few parallels in recent history.
“Last year, the U.S. national debt per American increased by $13,000,” Gave said. “In 2008, it was about $3,500 per American. So that’s more than four times what it was in 2008.”
At the identical time, China is already tightening its monetary and monetary policies. The normalization of Chinese policy reflects the situation the country found itself in throughout the economic crisis triggered by COVID-19.
“They were the first in and they’re the first out,” Chang said. “They’re in a position where they can start to take some more proactive steps that I think the market wants to see now.”
The political divergences between the world’s two largest economies will end in capital flowing east as China integrates into financial markets. Despite tensions between the 2 superpowers, these inflows, supported by measures to liberalise financial access and ownership structures, should provide a tailwind for China’s markets and economy.
With yields of around 3.5 percent, the Chinese bond market could actually see inflows of $160 billion, Chang predicted.
The net effect can be a continued appreciation of the renminbi against the US dollar and thus a shift in purchasing power from Western to Chinese consumers.
3. Inflation and asset prices
“Stimulating the economy through monetary measures is like lowering the water pressure in the neighborhood by opening the fire hydrants. Those who have buckets near the hydrants get plenty of water, the neighborhood doesn’t.” — Rob Arnott
Central bank policies have exacerbated inequality by inflating the worth of monetary assets, thereby rewarding those that own them and gain the chance to take part in financial markets.
In general, global inflation is anticipated to be three percent this yr, compared with one percent last yr, and the reflation trend will proceed within the medium term, Chang said.
“We are in different conditions than we were in 2008,” she said. “And I think asset price reflation could continue for a while, because right now we have excess savings and consumer debt is at a 40-year low.”
There is concern that an actual discussion about debt sustainability is not going to happen until the market is not any longer willing to finance further debt, but given rising asset prices, this could possibly be some time yet.
The problem of asset price inflation raises concerns about potential bubblesAccording to Arnott’s definition, the essence of a bubble is unrealistic growth expectations.
“You would have to use implausible growth assumptions to get a risk premium for an asset at its current price,” he explained. “A typical example is Tesla.”
To justify its current share price, Tesla would must grow 50 percent annually over the subsequent decade, Arnott explained. That’s 55-fold growth, far exceeding Amazon’s 11-fold expansion over the past decade.
“If [Tesla] is growing at 50% annually and ending the decade with profit margins as high as the highest profit margins of any major automaker in the last decade, just over 10%, which would be discounted to today’s value of about $430 a share,” he said. “Okay, that’s below current prices. So it’s a bubble.”
But Arnott went further in his bubble definition and identified a second essential characteristic.
“That’s because the marginal buyer doesn’t care about the underlying fundamentals and valuation models,” he said. “So that’s true with GameStop. The message there is, ‘Don’t pay attention to the fundamentals. This is a short squeeze.'”
Other stocks which can be experiencing bubble formation and where fundamentals appear kind of irrelevant to the marginal buyer include certain FAANG stocks and a few Chinese technology stocks.
4. Investment opportunities
“Emerging markets are one of the areas where things are not so overvalued right now. They lack the financial space to implement and sustain such measures.” — Joyce Chang
The underperformance of Value stocks versus growth stocks is some of the striking features of the stock markets over the past decade.
“The gap between growth and value is wider than ever, or at least it was wider than ever last September,” Arnott said.
The price-to-book spread between growth stocks and value stocks peaked at 10 to 1 at the peak of the tech bubble, but was as little as 13 to 1 in September 2020. The current spread is back to about 10 to 1, suggesting that value stocks have outperformed growth stocks by about 3,000 basis points (bps) over the period since September 2020.
“This run on values will continue for a long time,” he said.
As for fixed income, Gave gave a dismal forecast.
“US Treasury bonds no longer serve the role you expect them to in your portfolio,” he said. “They no longer hedge your equity risk.”
How will we know Diversification advantages decline? There were three separate periods last yr when the U.S. stock market fell 5% or more, Gave explained. And every time, U.S. Treasury bonds also declined.
So what’s the choice? Emerging markets and Chinese government bonds for fixed income portfolio allocation.
“U.S. Treasuries will no longer be the antifragile building block of your portfolio,” Gave said.
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