Inching toward Neutral
What a difference a year makes!! Massive government programs have greatly mitigated the social and financial consequences of the pandemic-induced economic contraction. At the same time, wide-ranging scientific innovation has developed and produced 90%+ effective vaccines paving the way for robust economic activity in the second half of 2021. All of this good news has not been missed by investors. Equity markets worldwide have vaulted higher. The MSCI World Index, representing global large and mid-cap developed market equities, has gained 36% in Canadian dollar terms over the past twelve months.
It was just this time last year that we wrote about the unprecedented value that we then saw in equities. Equity yield premiums over the risk-free rate were at historic highs. In the year that has since passed, equity yield premiums have narrowed substantially. This has occurred not just as a result of the impressive appreciation in equities as cited above but also from a significant increase in the risk-free rate. US 10 Year Treasury yields have risen from a low of approximately 60 basis points in March of last year to 1.7% today. Much of this increase has happened in the last eight weeks. What this means is that the slam-dunk value, we then saw in equities afforded by the COVID crisis, has been realized. We now find ourselves preoccupied with the old normal (at least as it relates to investing) which is forward corporate earnings and the general level of interest rates.
While it is difficult to accurately gauge exactly how much good news is reflected in current equity prices, it seems certain that public sentiment will continue to improve as vaccinations increase and social restrictions are lifted. Under these circumstances, economic activity and corporate earnings could easily exceed current expectations. This scenario is positive for equities and neutral, at best, for fixed income. This is the scenario for which we currently have portfolios positioned – overweight equities (underweight fixed income) with an emphasis on value and economically cyclical oriented international equities.
Much focus from the pundits has been given to inflation during the recent runup in interest rates. Will all the monetary and fiscal stimulus, married with pent-up consumer demand, result in a bout of inflation? We agree with Federal Reserve Chairman Powell’s view that it is too early to get overly concerned about inflationary influences. Clearly there will be some cyclical “demand pull” on prices but secular inflation requires “cost push” in wages. We just don’t see that on the horizon. While vaccination rates are rising quickly, we are a long way from herd immunity and normal economic activity, suggesting that temporary setbacks are to be expected. We expect US 10 Year Treasuries to trade in the 1.5% to 2% range over the next nine to twelve months.
As things currently stand, we will rely on the process of rebalancing to manage portfolio risk. However, further equity market rallies without a clear indication of “new good news” will prompt us to move to a more neutral stance (reducing equity allocations and raising cash) over the next few months.