Risk: On — Off — On?

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Economists are clear — the US economy is going to take off this year. Markets are less clear about how to react. Investors wonder what a booming US economy means for them. The VIX has dropped this year, ending last week at 18.9, but is still above its long-term median. Realized volatility in US equity markets ticked up slightly last week as the battle between growth and value played out in real time. Last week ended with somewhat higher inflation expectations, bond yields down and equities up. But equities and bonds are both seeing bad as well as good days, as competing narratives fall in and out of favor. Recovery is coming! Covid-19 is back in Europe! The Fed has to tighten! The Fed is not going to tighten! Blockage in the Suez Canal: rush to buy essentials! Boat afloat again!

Looking ahead, much depends on whether the fiscal boost now underway in the US ignites inflation as well as growth in the real economy. Supply chain pressures in the still very interconnected world, as illustrated by the Suez Canal fiasco as well as the prior shortage of microchips, will push up prices in the near term. Will massive government spending and loose money then trigger an inflationary spiral? There, economists do not agree. In fact, the one thing that many can agree on is that no one really knows. Predicting the impact of unprecedented policy action on top of a pandemic-induced recession that is itself unprecedented in modern times is fraught with uncertainty. But there are guide posts. The Federal Reserve and other central banks are trying to point them out, as well as use them to calibrate their own reactions.  

If the economic uncertainty was not enough, Covid-19 is still lurking. Already, a third wave in Europe is crimping prospects for recovery. The US, and the UK, have seen cases plateau, or even turn up again. We may be swift enough to vaccinate our way out of the pandemic this spring. But as long as there are billions still unprotected by a vaccine, the virus will have the opportunity to mutate and re-emerge. 
Observations and takeaways for investors:
1. Top-down or bottom-up: different ways to look at the odds of inflation.

Inflation worries are not unreasonable. As former Treasury Secretary Larry Summers pointed out, the fiscal boost to US demand coming this year is enormous. It is likely that even President Biden did not expect Congress to agree to the full $1.9 trillion relief package that he proposed. He and his advisers might have been ready to compromise on the overall size, especially in light of the $900 billion of stimulus passed just in December. But they did not get a serious offer from Republicans and, most importantly, no one could agree on which pieces of the American Rescue package should be bargained away. The element that gave some moderates and economists most heartburn was also the most popular politically — further stimulus checks of $1,400 for most Americans, supported by former President Trump among others. 

While this year’s fiscal stimulus could be viewed as too much of a good thing, from a macro point of view, a deeper dive suggests that inflation worries may be overdone. In a RockCreek Insights conversation with RockCreek Senior Advisory Board member Caroline Atkinson, Cathy Mann, former Chief Economist at the OECD and now Global Chief Economist at Citi, pointed to structural pressures that will continue to put the brakes on wages and prices in the period ahead. Mann pointed to the fact that the global economy — while rebounding from the depths of last year’s recession — is unlikely to recover to its pre-pandemic path until the end of 2024. Competition from overseas, as well as from further digitization of the economy, is likely to hold down companies’ pricing power and their willingness and ability to grant big wage increases. As the US expands ahead of the rest of the world, investors may well decide to put more of their money here. A resulting strong dollar will also tend to hold down prices. 

Two macro arguments also weigh against an inflationary spiral and there are two guides from the private sector that investors should watch carefully.  

The first top-down argument is that some of the additional government spending going out this year is likely to be used to repair balance sheets rather than go into the economy. This could include individuals catching up on unpaid rent and other bills, and boosting depleted savings, small businesses who stayed afloat by delaying payments that they can now make, or even state and local governments who now have more money putting some aside for rainy day funds rather than expanding spending. 

The second macro argument is a dynamic one. We know that there will be some price surge in the coming months. Higher energy and food prices will feed through to consumer prices. Supply side constraints have been evident in recent weeks. Bottlenecks are likely to push up costs as the global economy creaks back to life, often faster than companies had anticipated. That was true even before the massive Ever Given — more like a huge building than a ship — blocked the Suez canal, reminding us all of how much we rely on the nuts and bolts of trade. 

Chaos in the canal helped drive volatility in commodity markets last week. The Bloomberg Commodity Index rose or fell by more than 1 percent in four out of five trading sessions. The rolling 20-day annualized volatility of that index also climbed to its highest levels since May 2020. Even with the Ever Given now partially refloated, some ships are taking the long — and dangerous — route around Africa and others remain delayed, adding to price pressures across a range of goods. The commodity drawing most market attention — and uncertainty — is oil. The three month implied volatility of crude oil has risen to its highest levels since November. Raw materials prices more broadly rose by 3.9 percent in February, according to the ISM. This ninth consecutive increase brought the index to its highest reading since mid-2008, before the global financial crisis. 

But will an expected uptick in consumer prices in coming months lead to an inflationary spiral, with further rounds of price and wage increases? The Fed has indicated that it will be on the watch for such an acceleration. As Treasury Secretary Janet Yellen has said — policymakers have tools to push back on inflation. Investors and traders with long bond positions won’t like the Fed turning to such tools — cutting back quantitative easing (QE) and ultimately pushing up policy rates. Equities may not either. The central bank does not want to trigger financial instability. But as the Fed showed last year, when the key Treasury market seized up in the initial pandemic panic, it has tools to address that as well.

This brings us to the signals from markets and companies. If the market measures of breakevens climb above the Fed’s comfort zone, that would be an early sign of an unmooring of inflation expectations. So far, inflation expectations have been climbing, but not yet signaling concern. Breakeven inflation is highest at the two year mark where investors are pricing in CPI of 2.7 percent. It tails off gradually at first and then suddenly, falling to 2.6 percent at five years, then 2.4 and 2.3 percent at 10 and 30 years, respectively. These numbers are for the CPI, which tends to price higher than PCE, the Fed’s preferred measure of inflation. And they are likely within the Fed’s (new) comfort zone, at least for a period of time. 

Some investors still worry that the Fed may get behind the curve. They point to Fed Chair Powell’s insistence that inflation must be evident — and not just forecast — for the central bank to tighten. Could a sudden monetary tightening in the face of unexpected price moves then tip the economy back into recession? Remember, if the Fed does tighten sooner than it currently expects, the economy will still have the support from government spending to fend off recession. Company surveys provide another signal of likely inflation. Research shows that these yield good insights into pricing power and likely wage increases. The Fed’s latest beige book shows a mixed picture, with some retailers and manufacturers able to to pass through higher input prices, but many others reporting that their pricing power was still limited. 

Last week, bond investors saw a glass half-full. For the first time in two months (since the week ending January 22), Treasuries finished stronger on the week, with their best week of 2021. All maturities outside of 1-year saw yields decline with the 10- and 30-year yields declining 7bps and 8bps. Breakeven inflation rates were higher on the week as TIPS rallied more than their nominal counterparts. 10- and 30-year TIPS yields fell 10 bps and 12 bps, respectively, to take long-term implied rates of inflation (CPI) to 2.3 percent, as noted above. 

It wasn’t all smooth sailing for the bond market though as Treasuries finished well off their mid-week highs. An auction of $62 billion worth of 7-year notes on Thursday was met with tepid demand — the issue was awarded at 1.30 percent versus a 1.275 percent when-issued yield, which had ripple effects across the curve. It was an improvement on the February auction of the off-the-run maturity, but only just.

Other developed market sovereigns followed the US bond market’s lead and strengthened on the week, but it was a more mixed story in emerging markets where central bank policy is becoming less supportive — Russia and Brazil each raised rates the week before last — and idiosyncratic events have disrupted markets, such as the surprise dismissal of Turkey’s central bank head.

2. Rebound or recovery — it depends on where you live, who you are and what you do.

At last, the numbers of Americans losing their jobs and claiming unemployment benefits each week has dropped below its pre-pandemic peak. But at 684,000 in the latest week ending March 20, the flow is still high. This is why it is still fair to wonder if the economic growth expected for 2021 signals a rebound — from the steepest drop in GDP in decades (in three centuries in the UK) — or a recovery to the path that the global economy was on before the pandemic.  

One brighter possibility for jobs is that the very nature of this recession will also lead to a faster recovery in employment than standard models would imply. A new paper by Louise Sheiner and Gian Maria Milesi-Ferretti argues that the typical projections of jobs that will be created by a certain growth in GDP assume average productivity and average relationship between work and output. But we know that the services sectors hurt by pandemic lock-downs tend to have lower measured productivity. When demand rebounds, jobs may come back more quickly than expected. Against this, as many have pointed out, the continued advance of digital technology, including AI, and on-line provision of services will likely leave a changed jobs picture, post-pandemic. Higher productivity allows for higher living standards — provided the gains are shared. But governments and employers need to facilitate the training and support needed for workers in “old” jobs to shift to new, digitally enabled, employment.

As Women’s History Month draws to a close, there is a growing acknowledgment of the costs to women of the pandemic. “Part of the reason we want more women in academia and policy is because you get a different perspective,” said Pinelopi Goldberg, the Elihu Professor of Economics at Yale University during the RockCreek Insights discussion last week. “I think this became very clear. Last year, we talked relatively little about how COVID affected women, and I think it was mostly women who…pointed out that the effects are different between men and women.” 

The uneven impact of the recession goes beyond that within the US. There is some likelihood that the recovery, or rebound, will also feel very different in some countries and communities than in others. A divergent recovery, with the advanced countries in the lead rather than emerging markets, is a possibility. This would mark yet another difference from the 2008 global financial crisis, where emerging markets were not hit as hard and recovered more quickly.

One reason for the likely divergence between emerging and advanced economies is the uneven distribution of vaccines. So far, 95 percent of vaccinations have occurred in just 10 countries. The US is now facing a potential glut of vaccine supply, while in Europe shortages are leading to political tensions and divisions. And billions of people in emerging markets and low income countries are likely to have a long wait. “The number of vaccines at the moment are inadequate,” remarked RockCreek Founder and CEO Afsaneh Beschloss on IFC Insights Live last week. “You need the private sector, you need the public sector, and you need governments, and you need cooperation between the various multilaterals together to get that going,” she continued. 

In countries where many depend on the informal service economy for their livelihood, as well as countries dependent on tourism, the recovery in incomes and employment will also lag. The telework that has allowed many to stay employed in advanced countries is not as easy in most emerging countries. As Joyce Chang, Global Head of Research at JP Morgan, pointed out, only 12 percent of the populations in the poorest countries have jobs that can be done remotely.

Despite vaccine disarray in Europe, and renewed lockdowns in all but name in major countries on the continent, European equities continue to perform well. The STOXX Europe 600 is up 5.4 percent for March and 6.7 percent for the year so far. Japan’s TOPIX is up 6.4 percent month-to-date and 9.9 percent year-to-date despite its 1.4 percent slide this past week over concerns about the global economic recovery. Equity markets in both Europe and Japan have been outpacing the US this year, in contrast to 2020. The S&P 500 has gained 4.3 percent so far in March, bringing its year-to-date return to 5.8 percent. The lag in US equities reflects continued rotation globally away from growth to cyclicals, which make up a greater share of Europe’s and Japan’s economies. Digging into the S&P 500 at a sector level, information technology has been the worst performing sector for the month and near the bottom year-to-date. In March, the US market has instead been led by a combination of yield-oriented sectors like utilities, consumer staples, and real estate stocks and cyclical industrial, material and financial stocks.

3. Emerging Markets

In emerging markets, the divergence in performance between Chinese equities and the rest of emerging markets continues. As China has moved to tighten macro policy — taking the opposite tack from that of the US and Europe — we are also seeing divergence within North Asia, with Korea and Taiwanese equities significantly outperforming China. Most IT related exposures have corrected across North Asia as the sector faces the same headwinds — the prospect of higher interest rates — as global IT stocks. Divergence is again evident as different tech exposures are affected differently by today’s macro environment. China has more exposure to internet related businesses, which are particularly sensitive to changes in interest rates and are taking a breather after a stand-out year last year. In contrast, Korean and Taiwanese tech companies have a large amount of exposure to semiconductor-related businesses. We expect the strengthening global demand outlook to support further solid export growth in Taiwan and Korea, especially from the second quarter of 2021 onwards, which will feed through steadily to their respective domestic economies by supporting the labor market and household income. Lastly, the geopolitical factors at play between the US and China are also a damper on Chinese equities. Our portfolios have reduced exposure to China while maintaining an overweight stance in Taiwan and Korea.   

Of the major emerging markets, India stands out as one of the outperformers so far this year. The combination of fiscal stimulus and easy money — reaffirmed last week by the RBI’s plan for a sizable bond purchase program — has cleared the way for corporate earnings expansion. We expect Q4 earnings revisions to skew on the positive. The RBI has room to maintain rates low for longer than many EM peers as headline inflation has remained contained. Covid-19 is the possible Joker in the pack, with a rapid rise in infections now underway. However, with the Serum Institute, India is the biggest manufacturer of vaccines worldwide. Other countries don’t like it much, but the Prime Minister’s move to restrict vaccine exports and divert them to the domestic population should impact any short-term loss of investor confidence. Flows into the country were positive last week, maintaining a positive year-to-date streak. Our portfolios have been adding to opportunities in the financials, health sector and consumer discretionary space, sectors that should benefit from a growth rebound and relatively cheap cost of capital. 
RockCreek Update
This month, RockCreek launched its Women’s Voices Series. The inaugural episode spotlights Managing Director Sherri Rossoff in dialogue with RockCreek women, offering key insights into women in the workforce, pandemic triumphs and challenges and much more. Watch the full episode here and stay tuned for a special update this week as we share more episodes for women’s history month. 

RockCreek announced their commitment to the Net Zero Asset initiative. The initiative represents asset managers like RockCreek making new, enhanced commitments to support the goal of net zero greenhouse gas emissions by 2050 or sooner, in line with global efforts to limit warming to 1.5°C.  “There has never been a more critical moment than now for investors and asset managers to collaborate and signal the shift to net zero by insisting on transparency and bold action,” said Founder and CEO Afsaneh Beschloss. Read more here

The RockCreek book club met this week to discuss The Immortal Life of Henrietta Lacks by Rebecca Skloot. Next month we will be reading Coffeeland: One Man’s Dark Empire and the Making of Our Favorite Drug by Augustine Sedgewick. 

On behalf of the entire RockCreek team, we are wishing everyone a wonderful celebration of Spring equinox holidays. Chag sameach, happy Holi, happy Norouz and happy Easter to all who celebrate. 

Team RockCreek

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