Roger [00:00:00] Some of the recent data releases have highlighted how inflation is preventing reflation or true growth from taking place. Investors, therefore, see inflation as the biggest threat to financial markets, but in reality, it's the direction of yields and the US dollar that remain the most persistent risk. Inflation may cause yields to surge, but if they continue to remain relatively stable, despite inflation that is rising sharply, then risk assets can remain on a firm footing. In this week's Big Conversation, we look at the risks posed by the US dollar and yields and whether they should be of concern to policymakers.
[00:00:36] In the last few days, we've seen data from Chinese imports in dollar terms show a rise of over 50 percent year on year, up from 43 percent last month. This was in line with expectations, but it was driven by price rather than volume. The main culprit was the rise in commodity prices, which have been a central component of many recent rises in inflation prints. Chinese exports fell more than expected because of issues with global supply chains and a drop off in demand caused by high input costs. German industrial production data showed a 1 percent decline month on month versus expectations for a 0.4 percent rise. This is not a significant miss, given extreme comparisons that continue to distort many global data series. But the unexpected decline also reflects the problems with supply chains and higher input costs. Inflation is impacting demand before real growth or reflation has had a chance to properly establish itself. Outside of government support, there's still very little organic growth in the system, with commercial lending and borrowing still struggling to take off. Therefore, inflationary pressures are damaging growth prospects. Chinese authorities recognize this. They've been verbally intervening in the commodity markets, leading to significant gyrations in some of the leading commodities, such as iron ore. They've also started to intervene in the currency markets by increasing their reserve ratio requirements and initiating reverse repo operations to lend excess dollars. The problem for importers of raw materials and for China in particular, who are still the world leaders in commodity consumption, is that the move higher in commodities on the back of a weaker US dollar, has more than offset the strength in local currency versus the US dollar. It would actually help Chinese policymakers if the dollar rose and reversed the strength in commodity prices. At the same time, a weaker Yuan would help Chinese exports. The problem for China is that they won't have much impact if they're acting alone. The euro has been strengthening versus the dollar. This has been taking place despite the ECB expanding its balance sheet at a faster pace than the US Federal Reserve. The euro should have been on the back foot because of this dilution effect, but instead it has strengthened, presumably because anything that helps to build confidence in the eurozone will be rewarded with a stronger currency. Longer-dated real yield differentials are also not at play. Both the US and German 10-year real yields, when deflated by spot CPI are around minus 2.5 percent. If Chinese policymakers can engineer a weaker Yuan. It will be only part of the story if ECB policies continue to undermine the dollar. But nonetheless, global policymakers are starting to take note. We've already seen ECB members showing concern that too much euro strength could undermine their export-led economy and their attempts to create inflation. Though once again, we can see that input prices are far outweighing currency concerns on the inflation front. The DXY, the dollar index, is precariously positioned with the consensus expectation that it drifts lower. That would keep a bid under commodities, and if it falls gradually, adjustments can be made. The dollar has on a few occasions attempted to break out. The big level is around ninety-two point five. And if that was broken, then we should expect to see a relatively rapid rally back into the middle of the last six-year range. The point here is that the reflation trade continues to show extreme sensitivity to dollar strength, especially the relative performance of emerging market assets. With only a small rebound in the dollar index, we saw the ratio of the S&P 500 versus the broad-based emerging markets head back towards the recent highs, having previously seen the S&P perform better than expected in the face of weakness in the U.S. dollar. When the dollar has dropped back, emerging market equities have not made up the lost ground. Therefore, even a small rise in the dollar poses a significant threat to a global market that's all in on the reflation and inflation narrative. The good thing is that if the stronger US dollar does cause a pullback in that narrative, then it would help bond yields fall and that should be supportive of risk assets, even if it means a rotation back to tech from cyclicals. Yields remain the other major threat to risk assets. Hopefully, both the US dollar and yields are self-correcting. What that means is that higher yields would undermine risk assets and that would quickly see yields reverse lower again. A stronger dollar would also see yields decline if it undermined that reflation trade. There's probably slightly more risk that the move higher in the dollar would have greater longevity, because it would force those countries and international corporates who've increased their dollar denominated debt to scramble for more dollars. But are there risks that yields could surge? Well, we've certainly seen many air pockets for risk assets in the past. Crucially though, the bond market is far more open to manipulation by the authorities if yields do start to move too quickly. And another question is, what is the level of tolerance for the markets and policymakers? At the end of 2018, bond yields were allowed to rise to 3.2 percent at which point the market rolled over. Arguably back then it was the policy misstep of a rate hike in December that year which took the equity market over the edge. They're unlikely to repeat that mistake, but that doesn't mean they know where the clearing level for bond yields is. So far, the market has tolerated U.S. 10-year yields at 1.7 percent, and although real yields did initially squeeze higher, they have now drifted back lower. If we take those yields minus spot inflation, they are at multi-year lows. It's the speed of the move in nominal yields and the impact on real yields that therefore matter rather than inflation per se. High levels of inflation could eventually spook the bond market. But if US core CPI does hit a four-handle, there should be no surprises, given the current expectation for significantly higher used car prices. And yet so far, bond yields have hardly budged. If anything, 10-year yields looked like they will roll-over. Maybe this is simply the inference that the Fed will opt for yield curve control. But we can also see the 10-year swaps are also looking like they might roll-over. Swap spreads are influenced by bond yields, but if the market gets wind of real inflation, then swaps can move higher, even if there is a cap on 10-year government bond yields. And we've also seen that collateral issues continue to keep the front end of the government curve subdued. Yields on the US two-year note have been in a well-defined trend channel. Whilst yields on the three-month note have been dipping marginally in and out of negative territory. The reverse repo balances have also made new highs, reflecting the lack of collateral and the build up of cash that commercial banks no longer want to process because of the lack of opportunities that are partly tied to those collateral issues. We can see how subdued these front-end yields are when we compare them to a similar Eurodollar contract. Their implied yields here have also recently fallen, but they remain elevated relative to the bond market. Perhaps this begs the question, can bond yields therefore ever be a threat? Obviously they can, because policymakers have a habit of reacting to events rather than proactively preventing them. Taking 2018 again, yields were grinding higher and not causing too much of a problem for the global economy that was benefiting from a synchronized global growth spurt. But eventually, those high yields took their toll. A market of grindingly high yields will be manageable, but they will eventually reach a tipping point. So what are the types of hedges that investors have been employing? Most of the impacts of high yields or a higher dollar will first show up in asset rotations before they morph into anything broader based. Both high yields and a higher dollar will impact emerging markets, which is one of the reasons they've been struggling despite a reflation narrative which is usually supportive of EM assets. Therefore, if inflation is indeed the driver of the next leg higher in yields, we should look at the laggards within the inflation spectrum. Crude oil has historically been one of the key drivers of both inflation and inflation expectations. Although there are a huge number of regulatory headwinds for the crude oil sector, underinvestment means that higher oil prices may be inevitable even though OPEC has the ability to reopen the taps. The ratio of both the U.S. or the European oil and gas sectors versus the local markets are still close to their lows and they've seen huge underperformance versus the mining sector. It seems highly unlikely that inflation will take a significant leg higher without the involvement of oil and energy stocks. These remain the laggards of the reflation story.
[00:08:34] Within the currency space, we should keep an eye on the Korean won and the Australian dollar for clues as to whether the dollar is going to meaningfully break higher. Both of these are heavily influenced by the direction of the yuan, and it seems clear that Chinese policymakers would like their currency to drift lower. The Korean won is close to a major trend support level, while the Australian dollar has been losing momentum around the high 70s versus the US dollar. These should act as early warning systems, though dollar call options versus the euro may be an appropriate long-term hedge because a sudden and disorderly search higher in the dollar would inflict the most damage on portfolios. As for the fixed income markets, high yields would be damaging to risk assets, but lower yields might be the response to a risk-off environment. Puts on bond ETFs like the TLT might be the best hedge though institutional investors may look to pick up volatility in the fixed income space. The MOVE index is toward the bottom end of the range, and any event that caused a surge or collapse in yields from current levels would likely be accompanied by higher volatility. Very few people will be interested in protection on the equity market, even though we are close to the all-time highs, and with some significant divergence on the RSI. In a week's time, we have the quarterly options expiry, which has probably been helping some of the option fueled surges in meme stocks such as AMC. But with the VIX at 16, whilst 10 day realized volatility is under 6, index options don't offer great value. That said, some of the biggest moves in equities often start when realized or historical volatility has compressed near the all-time highs. But there's nothing that currently suggests a reversal that we don't already know about. Neither the dollar nor yields look particularly threatening at the moment, but both remain significant potential catalysts that should be hedged. And one of the main things that has helped the performance of equities this year has been significant inflows into equity funds. The headline figures certainly look impressive, but as Tom Roseen, Head of Research Services at Refinitiv Lipper points out, there has been a significant amount of diversification behind those headlines.
Roger [00:10:41] Fund flows year to date have been fairly spectacular, but Tom notes that these flows have not been exclusively towards equities. In fact, there have been some relatively cautious destinations as well.
Tom [00:10:50] We've seen about seven hundred and seventy-nine billion dollars going to the fund business, that includes both the conventional funds as well as ETFs. But while we're taking a little deeper dive into that, we see that a lot of the money is actually still going in a very conservative asset classes rather than the 'go go' funds that we thought probably would be there, considering we've had an eleven-point five percent return year to date. So what we've seen is taxable bonds take in about two hundred and forty-one billion dollars. We see muni bond funds have taken about forty- four point seven, and money market funds have attracted two hundred and ninety-six billion dollars, while equity funds have taken in one hundred ninety-seven point seven. Good numbers, but a little bit lopsided. We would have thought that people would have probably gravitated towards equities more diligently than they have the, let's call it the safe haven plays.
Roger [00:11:40] Over the last decade, flows into equities have been fairly stop start affairs, with many years actually registering outflows. Therefore 2021 does look relatively impressive on that metric.
Tom [00:11:49] The numbers are looking pretty strong for equity funds. When we take a look at this, one hundred ninety-seven point seven dollars billion net new money coming in all the way through June 2nd 2021 is certainly something to write about. We haven't seen those type of inflows since 2014. So, but the story is a little bit different if we're taking a look at this, because it hasn't just been all equities, as we would have thought of, and in fact, if we take a look at the breakout of how this has been had, we see that there's a big story, a tale of two cities, if you will, between ETFs, equity ETFs, and conventional funds.
Roger [00:12:31] For equities in particular, the flows have been split by manager type between active and passive mandates as well as a large split by style.
Tom [00:12:38] First of all, we've seen massive outflows continue for the conventional funds. And when I say massive, ninety-eight billion outflows, if you will, year to date. But on the ETF side, on this equity universe, we've seen two hundred and ninety-five point eight billion dollars. So when I gave kind of the high number, one hundred and ninety-seven point seven dollars billion, very strong return, eleven point zero five, it has not equated to fund flows into conventional funds, but primarily into ETFs, and how this is broken out, if we take kind of a greater focus on this, we see that investors are actually changing, they're doing rotation. We've been talking about rotation for quite some time. And what I mean by rotation is we all know that the stay-at-home stocks and the tech stocks, the FAANG stocks were very popular last year and even into the first part of 2021. But what we have seen, is investors taking money and putting it into areas that have underperformed. So to your point, international we've seen international equities taking about seventy-seven point six billion dollars. Easy for me to say here, on the ETF side, but they've actually handed back about thirty-five point seven on the conventional fund side. So total we've seen above forty-one point nine dollars billion go into equity, but on the international market side. That trend actually continued into other unpopular asset classes. Small-cap funds, which were out of favor in the entirety of 2020, have now been a main attractor of investors assets, about thirty-eight billion dollars coming into that group, not quite as lopsided here, we see ETFs took in about twenty-five billion, we see conventional funds take in about thirteen billion, so the numbers look good there. But another trend we have seen is that rotation into, we call it 'sector other' in that kind of the macro group sense, but commodity funds. We all know that commodity prices have been skyrocketing, really going up quite a bit, and we see that sector other funds have attracted about twenty-one point six on the ETF side, about nine point five billion on the conventional fund side. So certainly doing that. But one of the stories that I do want to point out is, I told people we've seen money go into large-cap funds, about eleven point eight billion dollars billion have gone into large-cap funds, but here is where the story changes. One hundred, eighty-seven billion of those inflows actually came from ETFs, while seventy-five point three billion have been outflows from large-cap funds from the conventional fund business. So this has been quite the story and a story we've been talking about for some time.
Roger [00:15:12] The reasons for these splits appear to be in part motivated by the generational need to diversify and reduce risk ahead of retirement, despite the positive momentum in equities.
Tom [00:15:22] With large-cap funds, we have people that have been putting money to work for years upon years, let's call it for the last twenty, thirty years, and have been told on a core and satellite basis to put their money into large-cap funds. So I don't think this, this quote that I told you, people are redeeming from large-cap funds, I think they found two things. First of all, there is the ETF advantage, there is low-cost providers and the like, but secondly, there are people that are going towards their retirement years, it's all of a sudden woke up and said, "I've got 80 percent of my assets and large-cap funds" and their advisers are telling him two things. You need to diversify, and not only do you need to diversify, but you need to go into other asset classes. So it's not just like buy another large caps, but you need to buy the bond funds, you need to have international in your portfolio, you need to have reach. You need to have other asset classes that are basically diversified in non-correlated or at least lower correlated.
Roger [00:16:16] The generational needs as well as the current growth opportunities are therefore splitting flows towards both defensive mandates as well as more aggressive equity opportunities.
Tom [00:16:24] We're actually seeing a bit of a change in, on the side of moving towards the equity market, moving more towards the aggressiveness. Now, that said, we are still seeing money into money market funds, flows into money market funds are counter indicator, right? People just don't know where the market's going. But it's ironic that we're seeing these fund flows go into, remember the Fed has been talking about, yes, we're going to keep easy money, no we're going to cut back on our asset purchases. But we all know that inflation is starting to look like it's rearing its ugly head. But people are still pounding money into that taxable bond fund category. I think that's a carryover, I think that's automatic monthly investments. But we are seeing this change into outer rotations, into a different rotation, into more risk seeking assets, small-cap commodities, those that show kind of a continuation of expansion of the economy. So, so this is a good story. We are seeing this. It looks like it has some legs, even though the market's starting to kind of ease off a bit.
Roger [00:17:25] Overall, the positive flows look set to continue through the year and should remain supportive. While the last year has highlighted the rise of the millennial investor, these fund flows are also a reminder that baby boomer flows are more conservative in nature. If growth expectations subside, the net effect on flows could be the shift away from equities by retirees.
