The Great Rotation
The last time the banks were leading the world index higher was back in July 2006, they subsequently lagged by 4% per year ever since. Despite huge underperformance, there have been three bold rallies. The first came in 2009, straight after the credit crisis, and the other two around the time of the 2013 taper tantrum, and in 2016, when Trump was elected. What do these periods have in common? They all saw bond yields rise.
Back in 2006, the US long bond yield was over 5%, whereas today it is under 1.5%. 14 years of underperformance is a remarkable losing streak and is a direct consequence of low rates. But it is not just the banks that have lagged the world; Japan, Europe, UK, Asia, and the emerging markets have all been left behind since the aftermath of the credit crisis. It has been a decade of US dominance.
US equities currently account for around 56% of the global total. The FAANGs alone have an 11% weight, which exceeds any other country. The whole of Western Europe represents 16.7% and Japan 7.3%. The last time we saw such US dominance was in the late 1990s, when tech was booming, and the dollar was strong; not dissimilar to what is happening today. It was only once the dollar started to fall in 2001, that everything changed. From then until the credit crisis, US equities and tech became the laggards, while Asia and the emerging markets led the way. European and UK equities didn’t do too badly either, meaning the asset allocators’ most important decision was to be underweight the USA.
It all comes back to the dollar and interest rates. At the 2000 peak, US rates were ahead of the rest of the developed world. Then Greenspan cut them from 6.5% to 1% over the next three years. The result was a slide in the dollar, which resulted in capital flows from the US to the rest of the world. Then in 2004, the Fed started hiking again. It took time for the dollar to strengthen, but once it did in 2008, global asset prices collapsed. We have seen this repeated, to a lesser degree, in 2015, and late 2018. Whenever the Fed have imposed tight monetary policy, the result has been a crash in asset prices.
The late 2018 selloff caused the Fed to end their monetary tightening, and even to reverse course. Then came COVID, and rates were slashed to zero. If that wasn’t enough, they restarted the printing presses and are now spending like Franklin D Roosevelt did in the 1930s. The dollar responds to policy goals, but on some occasions, there has been a time lag. Until recently, the dollar remained stubbornly strong, but that has started to ease as it has just made a post COVID low.
A weaker dollar is like a tax cut for the rest of the world. It makes it easier for the emerging markets to repay their dollar debts. It puts upward pressure on weak currencies, which then enjoy capital flows. That leads to economic activity, which boosts commodity demand and causes equities to rise. A stronger economy also sees rates rise and a boom in real estate follows. Higher property prices clean up the bank balance sheets, and a steeper yield curve entices them to lend.
When the dollar is rising, the US is the beneficiary. Money flows to the USA, and that puts downward pressure on the rest of the world. The value versus growth divide also fits this thesis, because the last great growth cycle was in the 1990s, another era of US dominance. It used to be that most market watchers believed value always beat growth in the end, because of dividends. Over the long-term, it is probably still true, it just hasn’t been so during recent periods of US dominance. As the dollar falls, value will enjoy a resurgence, which could last for a decade or more.
Practically all fund managers will tell you they are value investors, for no one will openly admit that they like to overpay for assets. I would emphasize that value investing is not just the price you pay, but the regions and sectors you choose. By value, I would include a broad mix of energy, commodities, banks, industrials, UK, Europe, Japan, and above all, emerging markets. These are areas which are currently cheap but won’t be by the top of the next bull market, when valued will offer poor value.
But this seismic shift needs a weaker dollar to fuel it, and there is the risk that it doesn’t happen. But then you look at the outlook for the US budget deficit, which will remain structurally high for years to come. Like QE, which was supposed to be temporary, the recent spending programs will become permanent, so long as the bond market allows. This means monetary policy will remain accommodative, because the US needs to create 20 million jobs, which it won’t do with tighter policy. Even with the best efforts, that will take time, leaving a substantial deficit in the process. The casualty will surely be the dollar.
Perennial US and tech outperformance have become a consensus view. This has led to large allocations to the FAANGs and US equities in general. On the other side, allocations to the value areas are low. The iShares Emerging Markets ETF (EEM) has seen 56% of its shares redeemed since the 2013 peak, while the tech funds have surged. When large amounts of money are concentrated into certain areas of the market, things can unwind rapidly once the fundamentals turn.
While we have been forced to work from home, COVID has been a boon for technology. It has accelerated the existing trends of tech dominance and the demise of the high street. But as the lockdown eases, investors will come to realise that growth rates will slow, and the tech premium will ease. On the other hand, diminished industries will regain pricing power as a result of reduced capacity. Fewer shops and restaurants will make more money than they did before. But it’s not just a few shops and restaurants that will challenge US tech dominance (and US market leadership), it is the rest of the world, reinvigorated by a weaker dollar.
Charlie Morris, Atlantic House – Head of Multi Asset
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