Stock Market: Covid and rising oil prices big headwinds for India: Chris Wood
When the year started, the general view was that interest rates will remain low, bond yields will remain low, inflation will not come back and central banks will not change policy stance but you had said that US bond yields will head towards 2% very soon. What a fantastic call! What is driving this growth that has surprised everyone? Or is this inflation scare?
It is a combination of the two. Last quarter, stock markets globally saw a big rotation out of high PE growth stocks to cyclical value names like bank and energy stocks and this was a very natural consequence as markets were increasingly confident about the vaccine rollouts, particularly in America where growth was expected to come back roaring.
We saw a growth forecast surge as consensus economists competed to upgrade their growth forecasts but along with the rise in the bond yields, on rising inflation expectations and so far the Fed has remained very sanguine in the face of rising inflation expectations. My view remains what it was at the start of the year. We should expect more yield curve steepening, we should expect more of a rally in cyclical stocks and we should expect more of a selloff in the bond market. The key issue for markets in 2021 is how the Fed responds to what I believe is going to be the biggest inflation scare since the early 1980s.
Why do you think the US Fed is not worried that if interest rates go higher, they will have to service the debt at a high level of interest?
That is true but last September, the Fed announced that following a strategic review, going forward it would informally give itself room to overshoot its 2% inflation target first and foremost. Second it formally dispensed with the so called Phillips Curve and the trade off between unemployment and inflation. So while the Fed is willing to overshoot the 2% target, it has been deliberately vague about how much it can overshoot and for how long.
What I have been telling investors is that in recent months it has become critical to watch market driven inflation expectations. In my view, a key level will be reached when the market driven inflation expectations is 2.5% because at that level, there will be more pressure on Fed Chairman Powell to be more specific about how much he is willing to overshoot 2% and for how long. We are likely to give above 2% inflation in the next two months because of the year on year base effect because we have seen the collapse a year ago. But going forward, the Fed’s view is inflation will come off. But in my view, there is a huge potential for inflation to surprise on the upside if we really come out of this pandemic and the US economy is fully opened because I am expecting massive pent up demand to be triggered on a real reopening of the US economy.
The basic way to value any stock is to look at future cash flows. Yields having gone higher means that even if you are in a growth sector, the future valuations will get compressed and this will impact cash flows. Why is that basic principle of valuations not getting recognised by the markets?
It is because of a big outperformance of cyclical stocks and even growth stocks. It is misleading to look at the overall index. What you can see is that the FAANG stocks peaked as a percentage of S&P capital last summer. If I show you a chart you can see that value stocks have significantly outperformed growth stocks. So what has happened is that the markets brought it out from those few FANG names and bank and energy stocks had very significant rallies. But to me, even 2% on the 10-year does not kill the stock market. What matters is the Fed’s policy response. I am of the view that if we see a further sharp rise in bond yields and a rise in inflation expectations, the doves on the Fed in those circumstances would want to impose what is called yield curve control, where they fix bond yields rather similar to what has been happening in Japan since 2016. It is also similar to what they have in the Eurozone. They are targeting nominal bond yields but they are not formally admitting it by buying all these various Eurozone government bonds.
Now what would be the argument to do yield curve control in America? The doves would say we want to lock in bond yields to stop higher bond yields undermining the post pandemic recovery and thereby undermining us reaching the 2% inflation target. But if they do such a policy, it would not be admitted in public that is to keep bond yields from rising because with the huge surge in the US fiscal deficit in the last couple of years, higher bond yields will make that deficit unaffordable. I think projections of the US fiscal deficit this year would be around 15% to lock in bond yields in America.
“While the Fed is willing to overshoot the 2% target, it has been deliberately vague about how much it can overshoot and for how long.”
Commodity prices — be it steel or copper, coco or sugar — have been rising. But for the first time the US government has said that we would be spending $2 trillion to boost America’s crumbling infrastructure. That will mean more demand for steel, cement and commodities. Is the bull run in commodities here to stay?
We could be. You should maintain positions in commodity stocks. I would own both energy stocks. From an Indian standpoint, people need to understand that oil prices can rise more on full reopening of the global economy and that the obvious commodity is copper where there is a supply constraint. So I have a positive view on commodities.
What is your view on the US FAANG stocks considering that that is where the concentration is? Do you see that reversing and if that reverses, what happens?
That has been going on in the last few months. Last summer, I said that FAANG stocks would peak as a percentage of S&P in market cap. That remains correct as of today. I believe these high PE growth stocks will remain under pressure. Another risk to the FAANG area is simply growing regulation. It does not necessarily mean that they have to collapse but if they lock in bond yields in America, that will make the market think that rates can be lower for longer and that would be good for these stocks. But on the other hand, if they lock in bond yields in the US, it would be very US dollar bearish and that would be good for the commodity complex.
In my view, you should continue towards cyclical stocks. They can continue to outperform in the short term on the reopening trade. The long-term issue of whether inflation comes back will depend on how the Fed responds. If the Fed turns orthodox, shrinking the balance sheet by raising rates, the deflationary trend can resume. But if the Fed remains very unorthodox in response to evidence that inflation is coming back or if Fed does yield curve control by formally suppressing bond yields and introducing a regime of financial repression, then the conclusion will be that we are moving towards a regime change and we are going back to a more inflationary world because we have been in a disinflationary world in America since the early 1980s.
In your latest note you have mentioned rising Covid cases in India. What would be the implications of that? India in a sense got a premium positioning because of the way Covid numbers reduced earlier this year and late last year. Do you see that changing now?
I am afraid, yes. To me, what is remarkable is that India outperformed last quarter in an Asia and emerging market context to spike growing evidence in the last month or very sharp rebound in Covid cases. I have been heavily overweight India in my Asian portfolio but I have reduced the overweight in my greed and fear published yesterday. It is obviously a growing short-term risk in the market because the cases have picked up a lot. The steep rate of rise suggests that maybe the new variant in India like in Europe is more infectious. But my base case is that India does not have another national lockdown.
It is slightly unfortunate but exactly a year ago we were looking at the same news in terms of the number of Covid cases in India and financial markets panicked. You have always said that markets do not react to the same situation twice. But do you see a little bit of reversal happening in Indian markets?
No. I believe the market is taking great comfort from the rapid vaccine rollout in America. The market is making one major assumption as am I that these vaccines have basic efficacy. If I and the market are both wrong, then we are going to get another collapse. Probably in India, the vaccine rollout is much less advanced than in the US. Now the risk is that the vaccine does not have efficacy against the new variations.
What I have been told by people who know much more about this than I do is that this new messenger technology which has been used in vaccines from Moderna and Pfizer. The vaccine is very easily tweaked for every new variance. That is a key point. But it means that the developed world is going to roll out this vaccine much more quickly than the developing world. That is a positive for countries such as the US and the UK that are leading in the vaccine rollout.
Post Budget, the Indian government has clearly sent a message that they would be focussing on growth by increasing spending and are committed to reducing government ownership in some of the non-strategic sectors. Could that be the differentiating factor for India?
No I think the Indian budget was of historic dimension and the key point was not the big surge in the fiscal deficit; the key point is that this is a pro-growth budget because the spending is almost all capex and so this is a growth friendly budget. There was no real increase in transfer payments. So it is very focussed on the long-term growth potential and the key issue is the execution of that infrastructure spending. But to me it is a very positive Budget and the stock market clearly responded very positively to it.
If you are so bullish, why have you downgraded your outlook on India?
Well I have reduced my overweight very simply because the Covid cases are going up again. It looks inevitable that this big cyclical recovery we have seen in recent months has peaked out for the moment.
In the past, you have liked retail facing banks. Is it time to look at corporate banks because if cyclicals do well, that means the bend of the economy again will start moving back towards corporate banks?
No, if you are an Indian domestic investor, you will still need to own some stocks which are beneficiary of higher commodity prices, particularly oil prices because rising oil prices, apart from Covid, is the other big macro negative headwind for India. The reason why the oil price can really rise a lot even from current high levels is the lack of investment in the energy sphere because of anti-fossil fuel sentiment.
So we have a very strange situation where oil companies are being encouraged not to invest in oil but the world still consumes oil. That means the oil prices are going to go up and the other issue is that shale oil production is declining for geological reasons as they have already exploited it. I think oil price has the potential to go up to $100 per barrel again once the economies reopen fully. But I think it is a headwind for India. I would hedge that risk in an Indian equity portfolio.
When we spoke last year, you were bullish on both gold and Bitcoin. Now gold is at a multi-year low and Bitcoin is at an all-time high. Why do you think both the assets are moving in a different direction?
I am still long gold but I should have more Bitcoin relative to gold. I could have made that allocation on Bitcoin in my long-term portfolio for pension funds in mid of December. I should have done that earlier. The reason I didn’t do it earlier is because it was not really possible last year for institutions to own Bitcoin in an institutional complaint manner. But now you could get proper custodianship and digital assets which means that institutions can now invest in Bitcoin.
I put the Bitcoin weighting in December, clearly it is a lot higher than that but I think Bitcoin will still go up a lot more. In fact I am expecting Bitcoin to have another bout of strong gains in the coming quarter. The problem for gold is that Bitcoin represents an alternative store of value which is traditionally the role of gold. There is also a demographic issue for gold because it seems that millennials are much more interested in buying Bitcoin than buying gold. In the long ,run I do not believe the two assets are mutually exclusive, I think you can own both. But so long as bond yields are rising, gold can remain under pressure.
Do you think after five-six years the asset allocation for everybody would include some crypto?
I see this becoming a growing trend. But the most interesting development last year Nasdaq listed MicroStrategy put Bitcoin on its balance sheet. This company moved all the cash from its balance sheet into Bitcoin and this was approved by its auditors and more importantly by the SEC. I think there are potential other corporates to make that move.
If somebody is in his 20s and he walks up to you and seeks advice on how to get rich, how would you respond?
I think they should be learning about the crypto block chain world. I believe it is clearly going to become more and more important and from a 10-15 year view, it probably represents a bit of an existential risk to the established financial order.
Source link
