Forward Fumble…

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The recovery is coming, but it will not be smooth. The US lockdown on March 13, 2020, left offices, schools and other public places suddenly abandoned, like the Marie Celeste. Going back to “normal” will be different. Coming sooner than expected for some, and desperately anticipated by most, the move back into offices, schools, stores, sports will be an uncertain and bumpy process.

The uptick in unemployment claims last week was a reminder: the Coronavirus Recession remains a real and present danger to millions of Americans still without work. On the disease itself, we may be at an inflection point. Vaccinations are racing the variants. Renewed lockdowns in Europe suggest that Covid-19 is winning there — at least for now — with vaccine roll-out almost agonizingly slow. In the US, a sharp fall in new cases in January and February may now have bottomed out, with daily new infections still twice as high as they were during last summer’s lull. But vaccinations are proceeding apace in America, as in the UK. Hopes remain high that the race against the virus can be won in coming weeks. In addition, the remarkable, and the remarkably swift, legislative victory for President Biden’s $1.9 trillion fiscal package will flood the economy with liquidity, promising an earlier and stronger economic rebound. All this is good news of course. But could it present a challenge for businesses and individuals who have settled into remote work and, perhaps, looked to the prospect of a later return? And, many investors wonder, will all that fiscal stimulus be too much of a good thing — pushing up inflation and interest rates?
Observations and takeaways for investors:
1. Inflation worries: markets concerned, central banks — not so much

Last week was a big one for central banks. As we anticipated, the message from the Fed to the markets was — stop worrying, we are holding steady. Faster recovery and the likelihood of a pick-up in inflation worry bondholders. But the Fed remains unmoved.

The line from the Bank of Japan and the Bank of England was remarkably similar. Major central banks want growth and are in no hurry to remove stimulus even as they become more hopeful about economic recovery. For the Bank of Japan, which had announced a major review of policy three months earlier, the message of little change was more difficult to convey. But Governor Kuroda eventually spelled it out, stating “We will maintain our 2 percent inflation target, and will continue with our powerful easing patiently to achieve it at the earliest date possible.” Bank of England Governor Andrew Bailey echoed the sentiment of his American counterpart, noting that the “Committee does not intend to tighten monetary policy at least until there is clear evidence that significant progress is being made in eliminating spare capacity.”

In the US, the big fiscal stimulus makes the prospect of faster growth this year — and higher inflation — more real than in the other advanced countries. The Fed itself now sees more rapid GDP growth, raising its projections last week to 6.5 percent by the end of the year. At RockCreek, we think the risk is to the upside, closer to 7 percent, as long as the vaccine rollout continues as projected. Convincing markets that a sharp boost to growth is consistent with still contained interest rates. So far, Fed Chair Jerome Powell has managed to keep markets from tumbling uncontrollably. Equities slipped last week and volatility is high, but US stocks are still up for the year.

Bondholders are gloomier. For fixed income investors, a stronger recovery, more inflation and — at some point — a Fed hike would spell an end to the long boom in bonds enjoyed for years. Since January, longer-dated US treasuries have fallen by 14 percent, according to the Bloomberg-Barclays index of treasuries with a maturity of 10 years or more, as yields have climbed. The shorter duration index has also dropped, but by less.

Losses on fixed income have been higher in some other parts of the globe, notably on emerging market debt. A shorter duration proxy for emerging market fixed income is down a little over 5 percent this year. European government bonds have fared better given the mix of more aggressive central bank policy to control yields along the curve, and a bleaker economic outlook. The Bloomberg Barclays EuroAgg Treasury Total Return Index has returned -2.4 percent.

Neither Jerome Powell nor Janet Yellen, his predecessor at the Fed and current Treasury Secretary, are concerned about imminent inflation. They believe that some uptick in prices is inevitable as the global economy comes out of deep freeze. But they do not expect this uptick to become embedded. Moreover, a somewhat higher level of inflation — and eventually interest rates — is desirable as part of a shift in the macro policy mix from monetary to fiscal support. If price increases do start to accelerate, they say, central banks know better now how to anticipate and curb inflation than they did in the 1970s.

As Powell made clear again last week, the Fed is determined to continue to “deliver powerful support to the economy until the recovery is complete”. That includes containing inflation, of course. But it also means delivering “maximum employment” as a “broad-based and inclusive goal”. This Fed is mindful that the economic burden of the pandemic has fallen hardest on those least able to withstand it. As Powell also noted “we understand our actions affect communities, families and businesses across the country.” At the same time, the Fed would like to return to a more normal market environment. One sign has been the willingness to let the yield curve steepen without rushing to support the long-end. Another was the Fed’s decision last week, which banks did not like, to let lapse as scheduled at end-March the looser capital restrictions instituted at the start of the pandemic.

For some bond investors, policymakers’ refusal to respond to inflation worries now is a worry in itself. Will the Fed fall behind the curve and be forced into an unexpected and destabilizing tightening down the road? Interestingly, fear of inflation has now replaced Covid-19 as the main outside risk seen by global asset managers. But overall, they are in a cheerful mood, as the Bank of America Fund Manager survey shows. Not surprising, as stimulus demand feeds through to the economy. Services industries from travel to hospitality that were crushed in the pandemic are hoping for a summer boost — although many smaller businesses will likely never recover. Manufacturing is also reviving, with the Philadelphia Fed survey showing the best result for half a century.

Stronger economic projections and happier executives were not enough to keep equities up last week. The S&P 500 and NASDAQ each lost 0.8 percent last week and the Russell 2000 fell 2.8 percent in what was a choppy market environment, punctuated on Friday with quadruple witching — when stock index futures and options and single stock options and futures expired simultaneously. Approximately 17 billion shares were traded in the US on Friday, 20 percent above the 3-month average. Market indices were driven lower by weakness in financials where banks sold off on the news of a return to tighter capital restrictions. The energy sector also suffered a broad selloff coinciding with a drop in oil prices. Europe’s delays in getting its population vaccinated and rising infections in parts of the world led to worries that global demand could be lower than previously anticipated.

European markets also struggled to gain traction with the Stoxx Europe 600 flat for the week. Germany’s DAX rose 0.8 percent but France’s CAC 40 and the UK’s FTSE both declined by 0.8 percent. With many borrowing costs benchmarked to treasuries, higher yields in the US hung over international markets. Investors were encouraged by Japan’s plan to end its state of emergency for the Tokyo region on Sunday and Japan appeared to buck the general weakness across developed markets with the TOPIX gaining 3.1 percent for the week. However, much of that was technical in nature as the Bank of Japan announced it would be concentrating its ETF purchases specifically in ones that track the TOPIX. The Nikkei 225 meanwhile managed a smaller gain of 0.2 percent for the week.

2. Supply chains: from Just-in-Time to missing the boat

Another throwback to an inflationary past has come with a string of concerns about interrupted supply chains. Companies from Nike to Deere & Co. have pointed to supply chain problems for production in some cases and prices in others. Nike reported increased transit times of more than three weeks starting in December of 2020. Deere noted in its most recent earnings call that dynamics in its supply chain remain tight, and the firm expects an additional $500 million of input costs over the rest of 2021.

These rises in producer prices have so far not translated into higher prices for consumers as most companies search for ways to keep consumer prices relatively stable. The home builder DR Horton has experienced a 4 percent increase in price per square foot, but reduced the size of their new homes by 2 percent, holding the new home price increases faced by consumers to 2 percent. The just-in-time revolution was enabled by technology and popularized as globalization and ever-more specialized production helped global companies to shave costs. Covid-19 interrupted commerce, left ships sailing aimlessly without being able to dock for fear of disease, and upset production projections just as it upset the lives and plans of us all. The impact on trade has been worsened by government reaction to the pandemic. Governments who pledged to keep markets open after the Global Financial Crisis did almost the opposite this time around. Building resilience, re-shoring production and keeping out possible disease vectors have been watchwords.

3. Vaccine diplomacy (or not)

This mind-set has been evident in fumbled attempts, notably in Europe, to control vaccine production and distribution, to the extent of overriding contracts and threatening the Irish arrangements under Brexit. Italian Prime Minister Mario Draghi announced a ban on vaccine exports to Australia, where the virus is under control, as Italy has witnessed another surge in cases. There was some irony in the export ban on AstraZeneca vaccine produced in Italy. An unwarranted fear of this so-called British vaccine — it was developed at Oxford University and produced by AstraZeneca, an Anglo-Swedish pharma company — caused one after another European country to halt its use this month. After European regulators declared it to be safe — and not responsible for causing worrisome blood clots — most European countries, including Italy, have now restarted its use. As Italy goes into a new month-long lockdown, following France, and German officials warn of an exponential growth in new Covid-19 infections, what Europe needs is a surge in vaccinations. President Biden also talked about vaccine diplomacy by providing vaccines to Mexico. Emerging markets still getting courted by China and Russia with their local vaccines and plans are even later for these countries to get vaccinated into 2022 and beyond.

4. Governing is never smooth sailing: the world intervenes

The Biden Administration wants to focus on the virus and the domestic economy. Two months in, the rest of the world is intruding. In the famous quote attributed to post-war British Prime Minister Harold McMillan, it is “events, dear boy, events” that present leaders with their greatest challenges. There has been a spate of “events” in recent days. From a surge in migrants across the southern border to a horrific series of murders of young Asian women in Atlanta to a diplomatic spat with China at the start the first full sit-down in three years of the top diplomats on both sides, they crimped plans for a victory tour by President Biden and Vice President Harris.

The tension with China in Alaska set a sour tone for America’s most important foreign relationship. This matters for the US and global economy. It is telling that there were no economic officials at the Alaska meeting, nor any plans yet for restarting a financial and economic dialog between the US Treasury and Chinese counterparts. Much of the US political animus against China comes from its economic practices. This is being expressed in a hardening approach by national security and foreign policy officials, as the new Administration works through a major review of policy towards China.

The President likely shares the widespread feeling that American workers lost out as China entered the global economy and swamped the world with cheap exports. Of course, American consumers on average benefited from those less expensive goods. But slow growth and stagnant incomes hurt working families and devastated pockets of America, dependent on manufacturing goods that were no longer competitive. It makes economic sense for the US and China to find a way to address these issues — from intellectual property theft to unfair state subsidies to ill-treatment of American and other foreign investments.

Both nations have an interest in a stable and strong global economy and financial system. But the politics in both countries will make cooperation difficult. And other areas — notably climate change — may be more obvious for working together. Indeed, the one positive outcome of the Alaska talks was agreement to set up discussions on climate. President Xi believes deeply that “the East is rising and the West is declining” as he reiterated this month. Kevin Rudd, former Australian Prime Minister and China expert, argues that for China it makes sense to buy time until it has the technology, economic and military capabilities to match or exceed those of the US. For the US, the path may be less clear. Opportunities for investment and commerce abound in the world’s second largest economy. Resolving the issues related to intellectual property would help the terms of trade between these countries become more equal.

The news coming out of Alaska did not help Chinese markets reverse this month’s relative losses versus the rest of emerging markets. So far in March, Chinese equities are underperforming the rest of emerging markets by close to 4 percent in USD terms, a gap that takes getting used to, given the dominance of Chinese equities in recent years. It is easy to forget Chinese markets were not always so dominant versus the rest of EM (see graphic below). In the early 2000’s, it was the commodity-centric markets, such as Brazil, that dominated performance while post-GFC Chinese equities lagged relative to their peers for several years. The rise of Chinese equities coincides of course with the great emergence of its tech giants, a reality that is here to stay.

The scope and scale of value creation coming out of China (and neighbors in north Asia) puts them ahead of EM peers for decades to come. Put another way, neighboring Korea and Taiwan’s future growth is inextricably linked to their tech-centric ecosystem of national champions, whereas other emerging markets — like Brazil and South Africa — remain reliant on the vicissitudes of commodity markets, or as we saw overnight in Turkey, the political expediencies of an autocratic ruler determined to dictate monetary policy. Nevertheless, in the short term, with the geopolitical issues in China, we think Taiwan, Korea and north Asia, ex-China and, in particular, India stand to do well.
Despite the volatility in the north Asia markets, market participants continued to add capital to the region, in our view a sign that investors are looking to take advantage of attractive valuations in high-quality consumer, IT, and communication services related names in north Asia. Overall, EM equity fund inflows remained strong to record the 25th straight week of inflows (+$4.5 billion, from +$5.3 billion last week) — the largest ever streak in USD inflow terms. Asia ex-Japan led inflows with +$1.8 billion of new capital flowing into the region while commodity-centric Latin America (-$63 million from -$12 million) recorded outflows for the third consecutive week.
RockCreek Update
RockCreek Senior Advisor Jessica Einhorn presented her most recent work in behavioral economics last week to the team.

Last Tuesday, Afsaneh Beschloss appeared on Bloomberg Surveillance to discuss the Fed’s focus on inequality, vaccine distribution, and equities in the U.S. and Europe. Watch here.

RockCreek Managing Director, General Counsel and Chief Compliance Officer Sherri Rossoff will join other panelists at SBAI’s SPARK Launch for Small and Emerging Managers on Tuesday, March 30th to discuss the importance of standards and governance. Learn more here.

Team RockCreek

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