Monday Digest

Posted 22 February 2021

Overview: reflation is the word of the week (possibly year) 
Twelve months ago, stock markets hit their pre-pandemic high, before plunging towards the most extreme global market crash ever known, as the world accepted COVID-19 presented a threat of unprecedented dimensions. Learnings from the global financial crisis of 2008/2009, and the impaired growth dynamics that followed, led to the extraordinarily timely and decisive policy actions undertaken in March and April of last year. Just one year on, another significant change in investment dynamics lies ahead, what market commentators are summarising as the ‘return of the reflation trade’. Last week, the FTSE 100 jumped more than 2.5% in a day, thanks to progress made by firms highly dependent on cyclical economic forces in the global economy, like energy, resources and banks.  

In this context, ‘reflation’ simply means a reversal of deflation, signalling a change in the direction of travel in bond yields. Markets are beginning to expect the recovery in demand will be strong enough to push up general price levels of goods and services, with the resulting risk of this turning into structural inflation proving sufficient for bond holders to demand higher yields. A normalisation of bond yields is no bad thing, although if yields rise quicker than corporate profits rebound this could smother the recovery. More importantly for investors, equities are no longer ‘the only show in town’. The reflation theme could also spell trouble for those low capital-intensive growth and tech stocks that spent most of 2020 benefitting from falling yields. Those darlings may now face headwinds that can only be overcome by offsetting earnings growth. 

Should the post-pandemic recovery succeed, and we see economic growth rather than stagflation prevail, investors should continue to see decent returns from rising corporate earnings that effectively neutralise the headwind effect of rising yields. Bond investors may therefore still not have much to look forward to, but investors with diversified portfolios should once again be best positioned for the changing fortunes in global capital markets. Just as we tilted portfolios last year – keeping them equity overweight and favouring a slight growth bias – we have been shifting our portfolios in favour of the cyclical recovery theme since September. With central banks determined to counter rising yield pressures to prevent a slow recovery that would stifle the impact of its policy response, we think it is still too early to take the next step – namely tilting towards value stocks which are most likely to benefit from higher yields over growth. However, if higher economic growth persists beyond the initial rebound, and becomes firmly entrenched, a more pronounced rotation is clearly on the cards. 

Fear battles complacency over rising debt levels 
Historic and unprecedented policy intervention makes politicians – and the public – understandably nervous. As a result, the question of how to pay for the coronavirus response, and the twin spectres of debt and deficit continue to loom over every economic conversation. The underlying assumption is that these immense debt loads will soon need to be paid for somehow – either by higher taxes, austerity or, worse, sovereign debt crises. First, we should remind ourselves that economists and policy experts agree that a world with lockdowns and deficit spending leads to better long-term economic outcomes than one with lockdowns and no deficit spending. For now, the global recession is an artificial one forced by government-imposed closures. But without furlough schemes and emergency loans supporting incomes, the unemployment and default rates would skyrocket, depressing aggregate demand and landing us in a ‘classical’ recession – and a vicious one at that. 

Second, while growing government debt piles will force some kind of adjustment at some point in the future, it is not true that only tax rises or austerity can tackle debt in the long run. Public finances are a delicate equation, comprising tax receipts (and outlays), borrowing costs, and long-term growth prospects. A growing economy means higher tax receipts at the same tax rates, just as a declining economy automatically leads to lower receipts. As long as the cost of new borrowing is below expected nominal long-term rates of GDP growth, the money governments take in should outpace the money they hand over to bondholders. Even the International Monetary Fund – previously the world’s pre-eminent budget hawk – recommends developed nations borrow their way through this crisis, as the alternative would lead to even higher debt and lower growth over the long term. 

In the current climate, reverting to any form of austerity does not appear like the smart option, given this reduces the demand side which all other policy measures are trying to stimulate while the virus-induced economic wounds are still so visibly apparent. While we all hope for higher nominal GDP growth, in the meantime there is the option to keep the pressure off governments by suppressing borrowing costs with the help of central banks. In other words, we may well be in for another extended round of ‘financial repression’ (last seen post-2008) from the world’s central banks, with huge asset purchases crushing bond yields and forcing the ‘risk free’ rate of return down. In that environment, inflation-protected assets like equities can do very well. 

Why Italy’s Super Mario is once again the man of the hour  
Can the man described by Paul Krugman as “the greatest central banker of modern times”, lift Italy out of its current slump? Investors seem to think so. Since Mario Draghi’s recent appointment to Italy’s top job, Italian bonds rallied sharply (and yields fell), as markets became optimistic about the former central banker’s turnaround management skills. Such is the prestige of the former president of the European Central Bank (ECB), Bloomberg reported he “took less than a week to turn the political system on its head and boost the country’s standing in financial markets”. The boost is sorely needed. Italy has been one of the worst affected countries during the pandemic, with one of the highest death tolls and multiple damaging lockdowns, but the country’s problems go well beyond the virus. The Eurozone’s third largest economy has struggled with low productivity and growth for over a decade. Its sizable government debt pile continues to grow, and its banking sector is burdened with swathes of non-performing loans – preventing it from engaging in productive lending.  

Italy also has one of the highest debt-to-GDP ratios in the Eurozone, with government debt totalling almost 160% of its economy. In the past, Brussels has pressured Italian leaders to enact cost-cutting reforms and trim public spending. But spending is not the main problem. Indeed, until the pandemic hit, Italy has had a consistent history of running a primary budget surplus. The reason for Italy’s large national debt is not so much the money it is handing out, but the potential tax receipts it can take in. Without a strong impetus for growth, Italians are trapped under debt built up in the past – on both the private and public side. The banking system is another formidable problem. Not only are Italy’s banks ailing under the weight of historic non-performing loans, but their fragmentation also makes it difficult for small and medium-sized businesses to access adequate financing. All in all, these factors make it extremely difficult for Italian businesses to grow. 

This is the task Draghi faces – a country and continent in crisis in need of deep structural reform. Fortunately, those are circumstances the former ECB president will be familiar with. His priority will be to utilise the money available from the European Union’s recovery fund, which he has wasted no time in addressing. Crucially, Draghi understands debt management is about more than just cost-cutting, highlighting that, with bond yields as low as they are, “it is not interest rates that determine the sustainability of public debt, it is the growth rate of a country”. Hardly a new argument, but Draghi has the reputation and the opportunity to enact reforms and boost growth more than his predecessors could manage. Italy is currently benefitting from immense support from the ECB, but that support will eventually run out – threatening to cause a jump in Italian bond yields. Now is the window for reform, while bond yields are pinned down and EU budget rules temporarily suspended. Markets, at least, seem confident that he can rise to the challenge. If anyone can, Super Mario can. 

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