Markets are going through a major change as they emerge from the Covid-19 crisis in a way that could increase risk for both equity and fixed income investors, according to Carmignac managing director Didier Saint-Georges. .jpg)
Rising interest rates have historically meant good news for equity markets as this usually indicates an improvement in economic recovery and activity.
But because of Covid-19 and the extreme financial measures required to get countries though the crisis, there has been a “regime shift in financial markets”, according to Saint-Georges (pictured).
“Financial markets have begun hyperventilating over the prospect that the recent uptick in long-term interest rates will continue, particularly in the United States,” he added.
Saint-Georges said that to understand how interest rates could impact markets today investors have to go back to the 2008 global financial crisis and the economic activity which was brought in. Then, central banks were forced to intervene on an unprecedented scale, implementing quantitative easing for the first time and catalysing a decade of ultra-loose monetary policy and historically low interest rates.
“Those low interest rates kept the stock market humming throughout the period. On the other hand, wages barely increased, economic growth was mediocre and prices practically stagnated,” Saint-Georges said.
This changed with the outbreak of Covid-19 when the consequential recession forced governments to sharply divert from their former “fiscal austerity mantra”, Saint-Georges said.
In the US, for example, extreme measures were taken to keep the economy afloat while businesses and consumer spending dropped. The latest instalment of this stimulus is president Joe Biden’s $1.9trn Pandemic Relief Bill, which will give individuals $1,400 directly.
Saint-Georges said: “We may well be experiencing what has been called a regime shift in financial markets. Going forward, the investment environment may start looking very different from the one we were familiar with for years.
“This could result in deep changes in the behaviour of companies and investors alike.”
In his monthly note, Saint-Georges added: “To put it differently, just when we were reaching the limits of how effective – and how socially acceptable – it was to rely on monetary policy alone to deal with a slump, fiscal policy was trotted out as the new frontier of economic policy.
“This regime shift initially triggered higher inflation expectations (since the latest fiscal measures will benefit consumers this time round), which have to a large extent cushioned the impact of rising bond yields on equity markets.
“But over the past few weeks, real long-term interest rates have also gone up because traders believe the Fed will eventually have to tighten policy. This state of affairs is obviously much less benign for equity markets, and by the end of February they started to show signs of stress and strain. It’s too early to tell whether the bond-market correction under way will ultimately force economists to dial back their sunny outlook for after 2021.
“But for now, the current regime shift in financial markets calls for a cautious approach to both fixed income and equities.”
A cautious approach – which Carmignac is implementing – is necessary because investors will soon have to contend with increased volatility. “A market regime that has held sway for several decades can’t be swept aside overnight,” Saint-Georges said.
Carmignac’s more cautious approach consisted of scaling back on risks across portfolios with hedges particularly on the Nasdaq index, as well as on long-term US yields.
“Next to our reopening names, we are therefore hanging onto our portfolio of high-quality growth names, whose predictable earnings growth and pricing power in the event of higher inflation will prove to be valuable assets under any and all market conditions,” he said.
On equity markets in particular, Saint-Georges highlighted the recent shift from growth to value as expectations about a post-Covid economic re-opening and increasing inflation builds.
“Such macroeconomic enthusiasm eventually prompted a correction in the most cyclical market sectors like consumer staples, utilities and technology, as investors began to worry about rising long-term interest rates, particularly in the US,” Saint-Georges said.
“With fewer factors sustaining equity markets in recent weeks, we took profits on the most highly valued names – notably in China – and put in place carefully targeted hedges on US stocks.”
He added that Carmignac plans to keep its approach cautious in the short term until valuations appear to reflect fundamentals more accurately “and a new interest-rate paradigm begins to take shape.”
One area of opportunity Saint-Georges highlighted was “the re-opening of the economy”.
Taking a variety of long and short positions would provide “a counterweight to our secular growth-oriented core holdings,” Saint-Georges said.
“For example, we will remain invested in Europe’s travel industry, alongside our exposure to luxury goods, as we feel they stand to gain from a pickup in consumer spending now that savings rates have reached historic highs.”
Fixed income markets have seen a recent rise in yields and real interest rates as well as a small decrease in inflation expectations. “That combination spells risk for the most interest-rate-sensitive assets,” Saint-Georges said.
In response the managing director said that Carmignac has continued to short its portfolios’ positions on US Treasuries, based on the US’ new round of fiscal stimulus and more efficient vaccine rollout.
By contrast Saint-Georges said that the firm is still avoiding most European sovereign bonds. But he added that see opportunities may appear down the line there “if the market correction continues”.
“Corporate credit markets have meanwhile held relatively steady. But a fair amount of caution is still required, as current spreads will provide very little protection against a sharp rise in interest rates. We have therefore reduced portfolio risk by exiting our main positions and establishing hedges.”
He added: “We are hewing to our highly selective positioning in emerging-market debt through targeted investments in countries like China and Romania. We have also put in place short positions in the economies most vulnerable to resurgent inflation. An example is Poland, whose central bank is likely to tighten monetary policy sooner than planned in order to keep a lid on inflation.
“In sum, while the swift, across-the-board global market correction under way may create tactical opportunities, an upcoming paradigm shift is keeping us on our toes,” Saint-Georges concluded.