The Wellington Blog — A diverse marketplace of ideas, where our investment professionals share and challenge each other’s views. They decide independently how to draw on those ideas to sharpen their investment decisions, unconstrained by any single “house view.”
Whiffs of the long-awaited “taper talk” around US monetary policy are finally in the air. The Federal Open Market Committee’s (FOMC’s) June 2021 statement and press conference indicated that the FOMC has discussed when it ought to start tapering its large-scale asset purchases amid the ongoing economic rebound and mounting inflationary pressures.
The FOMC upgraded its US growth and inflation forecasts, yet kept its unemployment rate forecast unchanged, as labor supply shortages in an environment of strong consumption are leading to higher inflation than the FOMC previously anticipated. The increasing inflationary risks also resulted in the median FOMC participant now expecting to hike interest rates twice during…
The “plum rains” of Taiwan’s monsoon season, or Meiyu, have started to fall, bringing a modicum of relief to the island’s worst drought conditions in over 50 years and enabling manufacturers and technology investors to exhale — at least temporarily. While the weather forecast in Taiwan would not normally make financial headlines, the island’s exposure to climate risk, current severe water shortage, and reliance of its large semiconductor industry on water have the global business and investment community on alert.
Global semiconductor hub
Taiwan produces 50% of the world’s semiconductors and 92% of the high-end transistors used in advanced technology applications like autonomous driving and high-performance computing. Any disruption in local manufacturing could short circuit the global technology supply chain. The overarching risk to semiconductor fabrication in Taiwan is lack of water. Semi fabrication requires enormous amounts of water: the typical chip factory consumes between two and four million gallons of water per day; larger companies use even more. Without sufficient water to power and cool chip fabrication, production…
As I consider various potential sources of market volatility over the coming months, the one I believe poses the biggest threat to today’s constructive backdrop for risk assets is so-called “bad inflation.” The costs of intermediate goods and inputs to production are climbing at their fastest pace in decades, which presents a likely headwind to corporate profit margins. Additionally, commodity prices are all rising in unison, be it coffee, corn, lumber, sugar, wheat, or gasoline, further straining corporate and consumer budgets.
Where the Fed may be wrong
The US Federal Reserve (Fed) has repeatedly stated its intention to “look through” the inflationary surge we’re seeing today, which it views as transitory. The Fed seems to assume that supply will quickly come back online as the economy reopens and recovers, allowing pricing pressures to abate. I hold a different view. I suspect that productive capacity for commodities in particular will not bounce back as swiftly as the Fed is forecasting. To be clear, I believe much of today’s bad inflation is being driven, either directly or indirectly, by these rising commodity prices and will therefore prove “stickier” and more stubborn than the Fed expects.
A paradigm shift in the making
As I see it, the public companies that have been rewarded the most over the past decade have behaved more or less like rent-seeking monopolies. Many investors covet steady, predictable cash flows to which they can apply a low discount rate. Conversely, some of the best…
The job gains cited in the May 2021 non-farm payrolls release fell well short of what the market had hoped. A fluke? Maybe, but this disappointing jobs report suggests to me that US inflation dynamics are beginning to shift from “demand-pull” to “cost-push” inflation.
The perils of cost-push inflation
Demand-pull inflation is the upward pressure on prices that occurs when aggregate demand outpaces aggregate supply. Cost-push inflation, by contrast, is caused by increased costs for raw materials, wages, and other inputs to production. The latter type of inflation tends to be much more harmful to an economy, as it forces companies to choose from among three distinct (and all undesirable) options:
- Seek to cut their capital costs elsewhere to preserve profit margins
- Invest in productivity-boosting solutions to reduce their labor costs
- Pass their increased costs on to consumers in the form of higher prices
The most probable scenario, in my judgment, is…
I think one of the biggest catalysts behind the general rise of the US dollar (USD) over the last 10 years or so has been the marked improvement we have seen in the US energy trade balance.
The so-called “shale revolution” has benefited the US economy in myriad ways, from enhanced productivity to higher levels of employment and increased tax revenues. However, the degree to which it has helped to moderate the underlying deterioration in the US current-account deficit has gone largely underappreciated. That, in turn, has been a tailwind for the USD for most of the past decade. I’m just not sure how much longer…
The US stock market appears dramatically different to me now than it did just 12 months ago. Equity issuance by US-listed firms has gone up since then, while cash returned to shareholders has gone down. Based on net cash flow, I believe the market is starting to look overvalued and even bears some resemblance to the tech-stock bubble of 1999 – 2000, with stocks offering little reward potential but plenty of risk. As of this writing, I would suggest that US equity investors consider overweighting defensive, cash-producing stocks.
Is it 2000 all over again?
For 10 years following the 2008 global financial crisis, the US equity market was more or less a “cash cow,” reliably returning cash to shareholders via dividends and share repurchases. Broadly speaking, the market’s annual cash yield was around 3%, with a dividend yield of 2% and net repurchases of 1%. That changed in recent months, with net cash flow turning…
The November 2020 election of US President Biden and a Democrat-led Congress rekindled many health care investors’ fears of sweeping drug-price reform that could be an albatross around the neck of the pharmaceutical industry. So far in 2021, there has been some legislative movement by Congressional Democrats to address drug pricing, but little more than lip service in terms of support from the Biden administration. For now anyway, it seems that other pressing matters — battling the COVID-19 pandemic, supporting the US economy, and improving the nation’s infrastructure — have kept the administration from pushing for drug-cost legislation.
Of course, that could change going forward. Or perhaps not. In the meantime, the market does not like the ongoing uncertainty around the fate of US drug prices, which has recently pressured many pharmaceutical stocks and may continue to do so (not unlike the struggles of HMO and health care services stocks when Obamacare was in progress). Here’s my latest take on the risk facing the industry in the form of three possible scenarios to consider, including the…
A climate-driven capital cycle is underway, and we believe companies must invest in low-carbon solutions to protect and grow the value of their assets and strengthen competitive positions. In our view, companies that prioritize environmental stewardship and establish clear climate strategies can be first movers and market leaders that profit from the low-carbon transition and deliver value for investors.
Identifying — and encouraging — climate leadership
We want all portfolio companies to achieve net-zero greenhouse gas (GHG) emissions by 2050 and set science-based targets to accomplish this. We look for companies that view climate planning as a strategic priority. We seek businesses adapting to changing regulations and positioning themselves to capitalize on evolving governmental incentives and consumer preferences. During our engagements, we ask boards and management teams to embrace low-carbon practices and align business plans with the Paris Agreement to cap global temperature rise to 1.5°C. We seek leadership on supplier practices and sustainable product innovation as a way to reduce indirect emissions. Our proxy voting policies are aimed at…
In my recent blog post, I outlined why I believe large-scale public payment processors will maintain compelling long-term growth rates even as fintech disruptors take market share. I think that share will largely come at the expense of banks instead. Banks are still the largest players in the payments market, and their 50% – 60% market share is the easiest target for these fintech companies. In addition, in my view, many banks have weak product offerings and a lack of strategic focus in this space that results in a large amount of payments volume sitting in the weakest hands in the industry. This transition may also benefit scale processors if banks look to partner with them to maintain share. We are seeing this begin to play out in Europe, but I expect the trend to continue, if not accelerate, across most geographies.
Despite this long-term growth potential, some investors have wondered why these scale processors’ performance has recently lagged that of cyclical recovery stocks. The main reason is that these stocks have never acted as a cyclical element of portfolio construction in the past and therefore aren’t viewed that way by the market.
These scale processors are now being compared to peers that have had drastically different experiences in the pandemic due to distinct business models. The stocks that have underperformed have generally been impacted by…
For fixed income investors, varying the amount of credit risk in your portfolio can exert a major influence on the portfolio’s realized alpha. Indeed, historical data shows that this single factor can have a larger impact than decisions around what bond sectors or individual issuers to invest in. Accordingly, it’s worth spending some time thinking about precisely how much credit risk to take and when. My latest research in this area focuses on the role that valuation can play in adjusting credit risk over an economic cycle.
Methodology at a glance
I looked at the strategic timing of buying and selling credit exposure (in the form of corporate bonds, using cash or US Treasuries as a funding source) with low turnover, and using market valuation as the sole buy/sell signal. There are, of course, other predictive drivers of credit returns, such as…
With so much money flowing into new markets like renewables and cleantech, we will see some companies succeed and perhaps become the next Tesla. We will also see some companies fail spectacularly. In other words, there will be a great deal of dispersion. We have seen hundreds of special purpose acquisition companies (SPACs) raised in the last few years, with many focusing on cleantech and other forms of energy and transportation disruption. Most of them assume a J curve in their revenues and profits, and I think it’s reasonable to expect that they won’t all achieve their projections. However, given limited sell-side coverage, identifying those that will make it and those that will not could prove to be lucrative.
The importance of time horizon for traditional and renewable energy sectors
In thinking about energy investment opportunities, I believe having a differentiated time horizon is essential — that is, focusing on the long term when others are focused on the short term, and vice versa. When things go bad in the energy sector, it’s difficult for investors to imagine how things can go back to normal. During the COVID crisis, for example, many were ready to write off the oil market, believing that prices were permanently impaired and treating the equities and debt of the companies accordingly. But as we saw…
“We suggest that a budget constraint be replaced by an inflation constraint.”
— Three MMT economists in a 2019 letter to the Financial Times
MMT in a nutshell
Modern Monetary Theory (MMT) is often dismissed as a fringe concept regarding unlimited government spending, but it’s a bit more nuanced than that. Basically, MMT holds that a nation’s budget doesn’t (or shouldn’t) really constrain spending because the government can always print more money if needed. Thus, it’s the “real” economy — the production, purchase, and flow of goods and services — that truly matters.
Taking it a step further, the government can theoretically spend as much as it wants to until said spending begins to create excess demand, thereby generating inflation, at which point the government should…
In my February 2021 blog post, Anchors aweigh at the short end?, co-authored with my colleague Caroline Casavant, we shared our outlook for short-end interest rates and short-duration credit assets, along with an idea on how to diversify liquidity sources through exposure to short-hedged non-USD government bills.
By way of follow-up here, here’s an actionable implementation strategy for investors to consider: “Tier” cash-management buckets and select investment components for each tier to enhance yield on excess cash balances.
An actionable strategy
Given today’s historically low interest rates, many clients wish to boost the yield on their operating cash, but without compromising the important role of cash as a source of portfolio liquidity. We believe the answer may lie in “tiering” one’s cash investments to ensure…
The challenges of the past year have highlighted the potential for environmental, social, and governance (ESG) factors to become even more relevant to the investments we make on our clients’ behalf and have underscored the increasing importance of stewardship by fiduciaries and active investors. In 2020, an unprecedented number of our corporate engagements included ESG topics, a trend we think will continue in 2021 and beyond. In particular, we expect many conversations to address executive compensation and climate change, along with diversity, equity, and inclusion (DEI).
Based on the most recent available data, March 2021 was the first month ever in which Chinese imports exceeded US imports (Figure 1). China was already the world’s largest trader overall (imports plus exports), but this latest development now also makes it the largest source of both global demand (imports) and global supply (exports). This is a notable milestone and perhaps another step toward China eventually surpassing the US as the world’s biggest economy (which, as I observed in my February 2021 blog post, could occur as early as 2028).
The strong import number, together with a weaker-than-expected export number and the potential for further export weakness as the world normalizes, could put some near-term pressure on…
Every quarter, the Wisdom of Wellington team surveys around 100 of our Wellington colleagues across different investment disciplines and locations to get their views on what we see as the key macro questions of the day. The results can pinpoint where the firm’s views differ from the consensus and can also reveal important shifts in our collective thinking.
In January’s survey, we asked which risks the market was most complacent about. This quarter, we followed up by asking respondents to rank which upside risks the market should be focusing on (Figure 1). The number two upside risk was the potential release of pent-up savings amassed during the pandemic, which has already been the subject of widespread comment. But the top-ranked upside risk — of a structural boom in capital expenditure (capex) — has attracted far less comment. Many of our macro thinkers believe that the market is underestimating the potential for a lasting increase in capex fueled by investment in green initiatives and infrastructure…
The US Federal Reserve’s (Fed’s) message on inflation is clear: Higher domestic inflation is likely in the period ahead, but it should be “temporary” in nature. This begs several questions, among them: What exactly does “temporary” mean? Which price increases, if any, could be longer lasting? And if higher inflation proves to be “stickier” than anticipated, how should investors position their portfolios?
The Fed’s latest forecast is for the Consumer Price Index (CPI) to rise to 2.6% this year (which it already hit in March), before settling back down to just over 2% in 2022 and 2023. Likewise, market expectations (as observed in recent “breakeven” inflation rates) are for US inflation to pick up in the near term and then come down longer term. Yet I am hearing from some of my analyst colleagues that many areas of the economy are facing stubborn supply shortages and upward price pressures, including freight, semiconductors, housing, raw materials, and labor.
Thus, in my view, the risk is that higher inflation may have a longer-than-expected “tail” before…
As discussed in my latest white paper, An allocator’s agenda for a reflating world, I’m concerned that many asset allocators seem to remain stubbornly positioned for a world of falling bond yields, declining inflation, and low economic growth. In my view, this is largely due to what I call a persistent “status-quo bias,” rather than much in the way of active positioning for the realities of today’s evolving global landscape.
As a result, I believe many clients have portfolio positioning that is ill-equipped to successfully navigate the potentially reflationary period ahead. The remedy? While I certainly don’t recommend a wholesale shift to all “reflationary” assets, I think one important item on every allocator’s “to-do” list should be…
The recent flurry of US sanctions leveled against Russia has aggravated frictions between the two nations and cast a long shadow of doubt on the Russian equity market.
Russian President Vladmir Putin more or less forced US President Biden’s hand when he deployed an EU-estimated 150,000 troops to the Ukrainian border. However, pressure had already been mounting for the US to get tougher on Russia following the country’s unprecedented SolarWinds hacking operation and its largely unsuccessful attempts to interfere in the 2020 US presidential election.
The “new normal” for US-Russia relations
Based on these troubling incidents, it seems we have entered a “new normal” in US-Russia relations and should expect risk premiums in Russia’s equity market to…
The forex (FX) 1 market volatility experienced amid the COVID-19 crisis in 2020 has not entirely dissipated through the first four months of 2021. An improving economic backdrop, along with recent rises in US inflation expectations and interest rates, have somewhat altered global currency dynamics. Here are the latest views from members of our global fixed income platform.
At a high level
As of this writing, we continue to see the most attractive global currency opportunities in non-dollar crosses. 2 Supply bottlenecks worldwide and pent-up consumer demand will likely support developed market (DM) trade and commodity-linked DM currencies, while continued US economic outperformance and concurrent higher US yields could pressure select high-beta currencies in the…
The Wellington Global Cycle Index1 points to an upturn in global economic activity but, in my view, even that positive prognosis is underestimating the bounce that’s ahead. Over the next six months, I predict that growth numbers almost everywhere will be exceptionally strong.
Where we differ from consensus
Almost all analysts now have the same broad roadmap for 2021 as we have — strong growth, with a gradual rise in inflation through the second half of 2021. All list the same set of risks: upside risks are attached to a full household-savings unwind and another round of fiscal support, while downside risks are attached to public health. All assume US growth leadership. What is striking is how there is actually very little discussion of inflation.
As economies reopen, it will be difficult for the market to distinguish between…
Over the past few years, easy monetary policy worldwide hasn’t been enough to fully revive global economic growth. It has, however, helped to catalyze a strong equity rally, concentrated in a fairly small number of stocks — many of them technology and e-commerce businesses — that have been able to consistently “outgrow” the sluggish global economy. This rally has been aided by the advent of growth-focused ETFs, index funds, and smart beta products, along with (more recently) the US day-trading phenomenon that has accelerated amid COVID-19.
But we think the world is starting to change. Driven by unprecedented levels of monetary and fiscal stimulus in response to COVID-19, the economic growth outlook is improving. Commodity and interest-rate markets are grappling with…
With front-end US interest rates flirting with the zero mark recently, the question of how to manage cash investments in a world of ultralow or even negative yields has been top of mind these days. So I’d like to share my latest thoughts, from an investment treasurer’s standpoint, on how investors with cash positions might navigate this challenging landscape.
Nothing special about ultralow or negative rates
The decline in yields over the past year or so has had a meaningful impact on the search for incremental alpha, particularly in the cash and short-duration space. Many institutional clients need or want to put languishing cash balances to work in an effort to…
Since January 2021, many investors have come around to the view that the US appears poised for a strong rebound in economic growth, driven by fiscal stimulus, vaccine administration, and economic reopenings. Meanwhile, bottlenecks in global supply chains have made it more challenging to meet increased demand for goods and services, causing input costs to rise across a number of industries.
Taken together, these developments have led to mounting inflation expectations and upward movements in interest rates. Year to date through 12 April 2021, the 10-year US Treasury yield has risen 75 basis points (bps) to 1.67%. The spread between the fed funds rate and the US 10-year Treasury note, a general proxy for yield-curve steepness, is also up meaningfully.
I believe the risk of further rises in inflation expectations and interest rates is not yet fully priced into markets. There are steps fixed income investors can take now to manage this growing risk to their portfolios. One way to do so may be via allocations to higher-income, shorter-duration assets such as floating-rate loans (FRLs).
The “duration rotation” is underway
In today’s low-yield world, a steepening yield curve can have a material negative impact on…
At Wellington, we have long believed that strong environmental, social, and governance (ESG) ratings and characteristics can generate value for shareholders and improve a company’s long-term investment performance. We believe this applies broadly across market sectors and have established frameworks — what we call “research playbooks” — for evaluating companies within each sector based on various ESG criteria that we deem to be of material importance.
Here we look at the health care sector, to be followed by other market sectors in future blog posts by our ESG team.
Key ESG issues for the health care sector
ESG is of course just one input into our investment team’s multi-pronged fundamental analysis of…