A question facing most investors today is the outlook for equities, and more broadly market risk. This ties into the outlook for the COVID-19 recovery, inflation and various technical parameters (such as flows, positioning, volatility and bond-equity correlation). Recently,we have seen a number of strategists calling for a market correction or indicating equities are in a bubble. In the last few days, we have witnessed turmoil related to trading activity in small highly shorted stocks. Our outlooks for asset allocation as well as equities remain firmly positive.There are 3 main reasons for these outlooks: 1) equity positioning is low in a long-term historical context, and we expect it to increase; 2)we expect the COVID-19 pandemic to rapidly subside at the back of vaccines and population immunity (already started to happen); and 3) we expect monetary and fiscal support to remain in place, driving consumption, global trade and demand for goods, and supporting higher inflation. In that light, any market pullback, such as on driven by repositioning by a segment of the long-short community (and related to stocks of insignificant size), is a buying opportunity, in our view. Below we explain our views and highlight some longer-term risks and how to hedge them.
Positioning across risky asset classes, and in particular in equities and commodities, in a long-term historical context is low. Our analysis shows that equity positioning is in the 30th percentile relative to the past 15years, both for systematic and discretionary managers. There as on forth is is simple: market expectations of volatility and tail risk are still very high (e.g.,as indicated by VIX,variance convexity,etc.), and historically that has been the main impediment for institutional buying of equities. Figure1, below, shows the equity beta of global hedge funds as well as our model for equity exposure (percentile) of systematic investors–they are largely following (inverse) volatility, and currently there are no signs of exuberance in institutional equity positioning. Here,we also want to discuss the question that we often get: “how come data from prime broker xyz shows that exposure is high?” The reason is often combination of these factors: prime data tend to have a short history of 1-3years (and in the context of the global pandemic and trade war/manufacturing recession of past 3 years, indeed net positioning is above average). However, 2021 should be a transformative year of COVID recovery, and looking at a 1-3 year history is not sufficient. Also, many data sets from prime brokerage do not include index hedges and derivatives products used for hedging, and thus may overstate net portfolio exposure. The key variable for positioning is the level of volatility. We expect the VIX to decline into the mid-to-high teens and positioning, accordingly, to increase from the ~30th to~60th historical percentile. In fact, realized volatility has already declined significantly (S&P 500 realized volatility ~10 vs VIX ~25 is a near-record spread). Given the low levels of inflation over the past decade, global trade war, and recent pandemic, the exposure of investors to equities and inflation protecting assets such as commodities is also very low (as compared to pre-GFC era).
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COVID: We expect the global COVID pandemic to decline rapidly in the coming weeks. In fact, the pace of decline in new cases over the last 2 weeks is the highest on record both in the US and globally. What is driving this? We believe it is the impact of a large number of cases over the past few months (which we estimate from fatalities and IFR–see here) and the beginning of large-scale vaccination programs. For instance, in the US, the current vaccination pace is >1M per day, and new vaccines (J&J) are expected to be announced shortly. Given the estimation of natural immunity (cumulative cases), current pace of vaccination, as well as other considerations (e.g. the impact of warmer weather, variation in susceptibility here), we expect the pandemic to effectively end in Q2. In addition to the individual impact of the above drivers, there is also a positive feedback loop between them, which we think will lead to a rapid decline in hospitalizations and enable a fast reopening of economies this spring. Implications are significant for growth expectations, outperformance of equities over bonds, the outperformance of value and cyclical assets over growth and defensive assets, and a new commodity bull market.
In addition to the above, Central Banks should remain accommodative given the elevated unemployment levels and over a decade of low inflation running below their targets. Fiscal support for individuals and businesses hurt by the pandemic will also likely continue and be a significant driver. The monetary and fiscal backdrop of2021,along with the strong recovery from COVID-19 and relatively low positioning in risky assets, should be positive for stocks and commodities and negative for bonds. We believe Inflation will be an investment theme, reinforcing bonds to equities flows, and a continuation of the rally in value stocks and commodities, and steepening of the yield curve. Short-term turmoil, such as the one this week, are opportunities to rotate from bonds to equities. While our view is positive, we do acknowledge that some market segments are most likely in a bubble. This is a result of excessive speculation (including but not limited to retail investing) as well as perceived benefits for these segments from the COVID-19pandemic and related political trends. Let’s first define some parameters of what could be considered a bubble. Taking historical examples of the Nikkei in 1989, Nasdaq in 2000 or commodities in 2008, and several other bubbles in broad asset classes that appear to be quite similar–assets tend to quadruple (~300% return) in a period of ~3 years. If one looks at the performance of the S&P 500 over the last ~3years, it is up a bit over 30%, and it would not fit the profile of a broad asset bubble. This is especially true given the amount of fiscal and monetary easing in that time period and given that many value and cyclical stocks are actually down over the past3 years. That said–we seesome market segments that fit the bill of a speculative bubble: for instance Electric Vehicle stocks, which increased ~10 fold, or Solar Energy stocks, which increased ~5 fold in a year. This price action occurred inexplicably at the onset of the COVID-19pandemic (Figure 2). To hedge this risk, one can short the market segments that fit the profile of a bubble and go long value and cyclical stocks that are expected to benefit from the COVID recovery and reopening.
Related to the topic of COVID, bubbles, and market impact of policies, we highlight a potential macro-economic risk scenario that could materialize over the next 1-2years. To be clear, this is not our forecast, but just one risk scenario to consider. We will call this COVID-green risk, and it is a scenario of large energy and commodity crises that could happen as a result of underinvesting in traditional energy infrastructure in the aftermath of the COVID-19recovery, characterized by stronger growth and inflationary pressures. Despite bubble-like capital allocations to green energy technologies (illustrated above), the solar and wind shares of primary energy consumption in the USareonly~1% and 2.6%, respectively. As we don consider wood/biofuels burning to be a sustainable source of energy supply growth, in a scenario of stronger post-COVID growth and inflationary pressures, energy needs could result in significant supply-demand frictions. Given the low level of new investing in traditional energy, and inability to quickly change the popular investment, ideological and geopolitical paradigms, it is possible that a full-blown energy crisis of the western world could materialize with potential to destabilize financial markets, economies and more broadly societies.
That strikes me as mostly sensible with the exception that the bubble is clearly large in technology and it rather looks like it’s about to blow.
Some charts from Goldman are supportive to the JPM argument:
However, I highlight again that the commodity super-cycle material is over-egged as China slows later this year and particularly in 2022.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
