— Jean-Jacques Rousseau
“Patience is bitter, but its fruit is sweet.“
So far at least, March has been yet another stellar month for risk assets, supported by robust investor sentiment and associated flows, notably from retail investors empowered by the proliferation of cheap trading platforms in recent years. In equities, most major regional indices have pushed to fresh all-time highs (largely thanks to expanding multiples) while, in fixed income, credit spreads have narrowed still further to reach razor-thin levels suggestive of a goldilocks ‘soft landing’ scenario for the global economy – at least at index level. But these valuations do seem somewhat out of step with a global backdrop characterised by clear pockets of weakness and much uncertainty. This weakness is most evident in China, where the still-sputtering economy is unlikely to recover quickly without a meaningful shot in the arm (i.e., government stimulus), and in Europe, where Germany is wallowing in recession, and the calamitous war in Ukraine continues to amplify downside risks for markets, growth, and humanity at large.
Nevertheless, investors have largely ignored these concerns; instead, they are transfixed by the potentially massive productivity gains of AI integration in the years ahead. For the past year, this AI frenzy has centred around Big Tech leviathans like NVIDIA, resulting in a significant and dangerous narrowing of US indices like the S&P 500 and NASDAQ 100 as investors pile in. But, increasingly, there is a sense that AI will lift many boats at once (and is not the only story); and the sectors that are out in front this month, despite rates having fallen, are more capital-intensive ‘old economy’ or ‘value’ sectors that are hardly the obvious place to look; namely, materials, energy, and industrials. This should serve as a reminder that diversification – across strategies, sectors, and styles – is an essential component of equity investing even if secular forces appear to support a bull case for one sector over others!
This should serve as a reminder that diversification – across strategies, sectors, and styles – is an essential component of equity investing.
More generally when we survey the equity outlook, we feel that investors have got ahead of themselves; and that the storming higher of equities this year is likely to be its own undoing as the impatient pace of gains proves unsustainable, at least in the short-term. A pull back is therefore likely in the coming weeks, in our view, and choppy trading may follow if rates do not embark on a more linear downward path. The Fed decided to do zilch at the last meeting of its rate setting committee, highlighting the still-unfinished nature of the fight against inflation, and markets are now pricing in just three cuts this year – down from a high of seven in mid-January! Any further data disappointments and investors may start to take note…
In mid-March, Bank of Japan (‘BoJ’) policymakers finally scrapped their most radical and controversial monetary policy invention yet, so-called Yield Curve Control (‘YCC’), and hiked policy rates – by 10bps, from -0.1% to 0.0-0.1% – for the first time in 17 years. In one fell swoop, therefore, they turned the page on years of unconventional ultra-accommodative monetary policy that, since 2016, included negative rates and YCC. YCC, which was tried only in Japan, saw the BoJ intervening in Japanese government bond markets to ensure that the 10Y yield, and other chosen points, stayed within specific ranges deemed sufficiently stimulative to achieve the policy’s goal; namely, a sustainable pick-up in inflation, to c.2%. The permitted ranges were made public, and their credibility required the BoJ to act very aggressively whenever the market tested their resolve (as it did several times since the pandemic). In the process, YCC thus led to massive inflation of the bank’s balance sheet – but, seemingly, not much else.
It was only in the wake of COVID-19 and the resulting supply chain shocks that inflation seemed to be more sustainably bedding in in Japan and the BoJ had nothing to do with that! Still, while other central banks fretted about the possibility of ‘wage-price-spirals’ developing as workers sought higher salaries to offset the costs associated with higher import prices, BoJ officials were rubbing their hands. Finally, this was an opportunity to end the deflationary mindset that had held back spending and investments in risky assets in the lost decades since Japan’s economy hit the skids in the 1990s; and it appears to be working. Headline inflation is currently running at 2.8% YoY and trade unions have just secured the largest pay increases for workers in big companies since 1992: 4%. This has shifted the macroeconomic picture and provided the policy space for the BoJ to adopt a more orthodox posture (or at least one that is a bit more aligned with other developed economies).
This has shifted the macroeconomic picture and provided the policy space for the BoJ to adopt a more orthodox posture.
Together with recent corporate governance and tax reforms, we believe that this change in the inflation picture is helping to create an attractive Japan equity opportunity, which is discussed in more detail in the ‘Asia’s Big Three’ note included in this edition of the Bedrock Newsletter. But, perhaps surprisingly, the rate hike and the abandonment of YCC did not lead to a yen rally. In fact, the yen has continued to slide and is now at its cheapest level against the dollar since 1990. But if Japan really has shifted into monetary tightening just as others move into loosening mode this would narrow the differentials between Japanese and other developed market rates and likely prove supportive for the Yen, as would direct government action to support the yen (mooted in recent days).
Gold (+6.5% MTD) has been a strong performer in March so far, benefiting from a more favourable rate environment and the uncertainty that prevails geopolitically and, outside the US, economically. We have been bullish the yellow metal for some time: for portfolio diversification purposes and thanks to myriad structural supply and demand factors that we believe collectively point to a higher gold price in the years ahead. These include strong demand from central banks and particularly from large banks in emerging markets that are keen to diversify their FX reserves away from USD and EUR; continued reductions in policy rates in the US, Europe, and emerging markets as inflation abates resulting in a lower opportunity cost associated with holding gold; growing demand from consumers in India and select other emerging market economies as their middle classes grow; and a deficit of new capital investment in the gold mining sector, reinforced by the pandemic, high rates, and a painful hangover from the prior era of overspending. Moreover, we believe that the clear support afforded to the gold price during the period of rising rates was a signal that, when rates started to fall, a strong bid would push up the price. Recent gains could thus be the start of a longer bull run – and we are well positioned for it.
Recent gains could thus be the start of a longer bull run.
If you have any questions about the themes discussed in this article, please do not hesitate to get in contact with us: info@bedrockgroup.ch
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