Independent market strategist Gerard Minack expects the end of secular stagnation. The rotation into last cycle’s laggards will continue, while the former leaders will be facing headwinds.
Gerard Minack has been analysing, forecasting and advising on financial markets for almost 35 years. It is fair to say that he has experienced many ups and downs in the markets. Having been a «secular stagnationist» for years, he now expects a period of reflation for the global economy, as fiscal policy is taking over the baton from monetary policy.
The former global cross-asset strategist of US investment bank Morgan Stanley and author of the legendary «Downunder Daily» keeps a close eye on the big picture of the global economy and financial markets. In 2013 he retired from Morgan Stanley and started Sydney-based Minack Advisors which provides research for institutional investors around the world.
In an in-depth conversation with The Market NZZ, Gerard Minack talks about the shift in fiscal policy and what it means for investors. He recommends asset allocators to avoid bonds as much as possible, sees opportunities in European and Japanese equities and favors value over growth stocks. He talks about the difficulties asset allocators are confronted with and whether bitcoin or gold should be part of an investors’ portfolio.
Mr. Minack, recently, we have witnessed market behavior that has echoes of the dotcom-bubble, such as increased speculation by retail investors, a flood of IPO, the SPAC-frenzy and extreme price increases for electric vehicle companies. Are we in a bubble?
We’re not in the same league as the dotcom bubble, which was absolutely world’s best practice. Just to compare valuations, which is the obvious way to measure whether you’re in a bubble: on a cycle-adjusted price/earnings-basis, I now put the Nasdaq at a multiple of around 45 to 50. In the late nineties it was at 100. So, if you think things are crazy now, if we really were to replicate the late nineties, this is a market that could double. That doesn’t mean markets are cheap though.
No major problem, then?
I certainly think markets are vulnerable, whether you want to describe it as a bubble or not. The macro cycle after the global financial crisis was one where growth was relatively scarce and the premium on anything that could grow earnings just went up and up and up. If you look at the US, the big six tech stocks, the FAANG plus Microsoft, effectively contributed to almost all of the S&P 500’s earnings growth over the last five or six years. The remaining 494 stocks in the S&P have had almost no earnings growth. I absolutely understand why investors have piled into the growth stocks. Did that concentration of buying power push those stocks to expensive levels? Yes. Are there at the margin true areas of craziness? Yes. You can either go to bitcoin or you can go to the SPAC phenomenon or you can go to some electric vehicle companies. These are examples where they pushed valuations to ludicrous levels. But the core of the story is now vulnerable as we get a broader economic expansion. If the valuation premium arose because these companies had the rare ability to grow earnings and the ability to grow earnings no longer becomes rare, the premium will come down.
In other words, we are on the cusp of a big sector rotation?
Absolutely, the big theme of this year and potentially the next two to three years is not going to be the strength or weakness of equity returns as an asset class, it’s going to be the rotation one level down. Going forward, equities once again may give you okay, or I’d suspect probably only mediocre returns, but the real story is going to be the rotation into last cycle’s laggards and the headwinds facing last cycle’s leaders.
Which are these laggards?
My highest conviction is in what I characterize as the «high-beta goods producers». Everywhere you look, demand for consumer durables, including autos, is strong. Business investment expectations seem solid. Everyone has been stuck at home for a year, everyone wants to put up an extra bedroom, so housing indicators everywhere are very strong. So, I think the high-beta goods producers, the home builders, car makers, miners, materials and energy companies all look good.
Do you expect a new growth cycle?
If – and this is the $ 64’000-question – if we see fiscal policy take over as the primary manager of the economic cycle, with central banks just in a supportive role, then this could be an extended high-growth cycle where economies are run much hotter than they have been for arguably 15 years. And in that environment you want to invest in companies with the ability to expand earnings fast when sales go up. And that’s going to encompass those high-beta goods producers, but in that setting the rotation is going to broaden out and it’s going to pick up a lot of the value stocks I mentioned. You can talk about financials, the broader industrials doing well, because they are the ones with operational leverage. They are the sectors that look cheap and in some sense they are among the most hated segments of the market. So, positioning, valuation and the economic cycle point to a sector rotation, particularly if we get this shift to fiscal dominance.
We have already witnessed a rebound in these sectors. Hence you expect the rotation to have legs?
Correct. I think the expansion is absolutely assured this year. The vaccine rollout seems to be going okay, notwithstanding the recent news about AstraZeneca’s potential issues. The fiscal stimulus remains strong. Households in a number of countries have built up a lot of dry powder last year, as they simply couldn’t spend all the checks sent by the government. And all the economic indicators such as business investment look absolutely rock solid. Through the summer in the Northern hemisphere you will see a spending boom. How far that runs into next year and beyond is the big question.
Is it not too late for investors to jump in?
The way I am looking at markets, I separate what I call the «great reflation» from the «minor reflation». The minor reflation is just based on 18 months of strong growth and an outperformance by the high beta goods producers. That would be comparable to the time period that started in the beginning of 2016, which was a great period for miners, commodity prices, commodity currencies and emerging markets equities. It all then petered out, but it was a tradable rally you could participate in.
What would the great reflation look like?
The great reflation will take place if we shift to a sustained fiscal dominance, in which case the upswing could run on for several years. But that requires fiscal stimulus on an ongoing basis to counteract the headwinds from secular stagnation. But if we get that, that’s a huge deal.
That would be the end of the bond bull market.
Correct. I’ve been a secular stagnationist for many years. Japan has been my guiding light for twenty years. But a shift to fiscal policy can provide an effective antidote to secular stagnation. Done with sufficient vigor, it could bring the curtain down on the secular stagnation era. That would have obvious ramifications for bonds.
For this to work, governments need the help from central banks.
Yes, but the active ingredient in my view is the fiscal spending. In the aftermath of the global financial crisis, when we had massive QE programs, we saw fiscal austerity. The net impact of that was weak growth. Now we have the reverse. We’ve got fiscal easing – yes, central banks are backstopping it. But if central banks were not there, if they weren’t doing QE, yes then you might get a lift at long yields but we’d still be banking on better growth given how much money is put into the system. Obviously, the combination of the two ensures that the market can’t really protest at the government’s policies in most developed economies. Effectively, what we are seeing is helicopter money.
The Fed is monetizing the deficit?
Over the last twelve months, the US budget deficit increased by almost $ 2.5 tn. and the Fed has purchased almost, but not quite, $ 2.5 tn of treasuries. I mean, that is helicopter money. To be fair, Jerome Powell is not directly dumping bags of cash in Janet Yellen’s lap, the whole transaction is being laundered by a brief period of private sector ownership but that’s just to get around some accountancy issues. For an economist, that’s helicopter money.
Couldn’t this strategy lead an upheaval in markets as investors dump bonds?
That’s an obvious risk on a two, three year view, but the larger risk is the reverse. Japan repeatedly prematurely tightened fiscal policy and killed promising expansions. They just didn’t seem to learn. And you’ve got people like the chancellor in the UK who are already worrying about deficits and debt and the need for tightening policy. For me the risk that policy makers chicken out and flip the switch back to austerity too fast is larger than the risk of excessive easing.
Is there a risk that people lose their faith in the currency?
Ultimately, if we do see excessive easing, we could indeed end up with unacceptably high inflation. Whether we get a complete loss of faith in the currency is a much bigger stretch. I doubt that very much. Unacceptably high inflation is a plausible outcome on a four, five year view.
With the regime shift from deflation to inflation, what shall an investor do on an asset allocation level?
There are real problems with the bond market. First: at current yields, you are locking in terrible returns. That’s in contrast to the last thirty years when US long bonds have delivered almost the same returns as global equities, but with lower volatility. Second, the risk outlook has changed, because, as duration has stretched while yields have fallen, bonds produce a lot more volatility. So, you’ve got poorer returns and more volatility. But it gets worse.
Because one of the things bonds offered over the past two decades was a powerful inverse correlation with equities. That was manna from heaven for asset allocators. It meant that bonds were a terrific insurance policy. But now combine the two: the inverse correlation and the fantastic returns: here was an insurance policy that actually paid you. However, if we move to a period of higher inflation we are likely to see positive bond-equity-correlation. So, think about the positive attributes of bonds over the last three decades: high returns, lower volatility than equities and an inverse correlation to equities. Going forward, potentially, you lose all three. There is nothing to like about bonds at the moment. I would recommend as low an allocation to bonds an asset allocator can tolerate.
What’s an alternative?
If you want safety, cash is king. Obviously, cash costs in a lot of countries, but it is still a safe asset. If you want to insure your equity portfolio, we’re now in an era where insurance is no longer free. It costs, just like it costs to insure my car. Another point: This long three-decades declines in interest rates hugely facilitated an increase in leverage in the financial markets. So many smart investment banking strategies were simply dressed up examples of employing leverage to enhance returns. Now, being a levered investor at times was painful, but with rates trending down, for every year of pain there were several years of pleasure. If we see rates trend up, that pain-to-pleasure ratio is going to shift. Going forward, rising rates are going to be a headwind for returns. There is no way I can think of a vanilla strategy that’s going to replicate the investment returns of the last three or four decades over the next ten, twenty years.
In other words, investors have to lower our expectations?
Yes, look at US equities, which are the most expensive major equity market in the world at a cycle-adjusted price/earnings-ratio of 30. That does not necessarily say anything about returns in the next twelve months. But for a ten year period you have to expect low single-digit or more likely than not even negative real returns. That’s what history says. And the US accounts for half of global equities. That’s a big deal for asset allocators.
So we have zero returns on bonds and meagre returns on equities – that does not sound very appealing.
No, a balanced portfolio that invests 60% in equities and 40% in bonds looks a dreadful place to be in the US. The return outlook is different elsewhere, valuations aren’t nearly as onerous in the equity space, but of course, in the bonds space in many places it’s even worse. Yes, you can buy a Japanese or a German long-term bond and lock in a nominal loss if you want. It all gets back to this: it’s been a fabulous three, four decades for investors when capital won at the expense of labor, but now the political pendulum is clearly swinging back. Last time I looked, there wasn’t an eleventh commandment that says investors shall always get good returns.
So bonds aren’t the antifragile asset anymore. Is there any replacement, maybe gold or bitcoin, that will play a bigger role in investors’ portfolios in the future?
I don’t think gold, let alone bitcoin, has ever demonstrated the reliable inverse correlations that you want in a portfolio. I would hold some gold just as an insurance against tail risks, I wouldn’t hold bitcoin. I don’t think it’s an investable thing, but clearly, over the last couple of years I have been completely wrong. It just seems to me the risk/reward is not attractive at all.
Why not, it’s always going up?
Yes, that’s right. I bet they said that about Pets.com as well, but perhaps Pets.com had more substance. It’s either a currency or a store of wealth, it’s unlikely to be both. And if something is as volatile as bitcoin, I can’t possibly see how it can become a currency. If Elon Musk is going to sell me a Tesla, I don’t want the price to be in bitcoin and fluctuate wildly up and down in dollars in the course of a cycle. Bitcoin may be a speculative tool, I still think it’s a greater fool theory and one of the great ponzi schemes.
What about gold?
Gold, on the other hand, has a much longer history and does have some intrinsic value. So I’d be much more willing to be long gold than to be long bitcoin. But protection against tail risk is not the same as having an asset that gives you a reasonably safe return and also having other desirable properties. Bonds delivered extra returns when the rest of your portfolio was going down. And as I said, I don’t know quite of anything that could replace this asset class.
Where do you see opportunities?
I like Japan, I think there’s a structural story there. The country will benefit from the kind of cyclical world that I am expecting. In addition, I don’t think many people are invested there. In Japan, there is just a tremendous amount of apathy. So, positioning is low, Japanese equities are cheap, it’s got a structural story and it’s got a market that has a greater sensitivity to the global cycle than any other equity market in the world. Japan ticks a lot of boxes for me.
Then there’s Europe, which is easily the most hated equity market. Even the Europeans hate Europe. And if we really see European policy makers embrace the prospect of ongoing fiscal stimulus, in particular with mutualized debt and it’s clear the ECB will do whatever it takes, to support the bond market, then that’s a game changer for Europe also. Given everybody hates Europe, there is no presumption amongst anybody that it is going to outperform, whereas if the cycle is right, it absolutely could.
Given your scenario, should investors increase their allocation to emerging markets?
History would suggest so. EM equities look cheap and have operational leverage. My preference to play the cycle is Japan and Europe over EM. My single biggest problem with emerging markets is China, which dominates the MSCI Emerging Markets Index.
What is the problem with China?
Two things make China special in my mind. The first is, it’s the only major emerging market economy that has got the hallmarks of secular stagnation. The cliché is true, China is in a race to get rich before it gets old and I am not sure it’s going to win the race. It’s got a chronic oversaving problem and coupled with that is persistently investing too much or is exporting its investments, which is part of the reason it set up the belt-and-road-initiative. It’s levered, which is a real macro headwind for China. They will be surprised how quickly China’s trend growth rate will slow over the next five to ten years.
And the second issue?
The second issue is the politics. China is creating a lot of enemies. Pushing back on China is one of the few areas of bi-partisanship in Washington and that creates real risks when we see parts of the global industries be forced to choose whether they participate in US-centric industrial supply chains or Chinese-centric supply chains. Countries in Asia will probably go with China but what we have seen repeatedly with China, and Australia is experiencing at the Moment, is China using its economic heft as a political tool and that exposes risks. And I don’t think there will be quite the same willingness to hitch up with China as has been historically with the US or Europe. China is a very tech-heavy market and the politics there are also fraught. Even in Washington everybody hates Big Tech, everybody hates Facebook and a regulatory backlash could come there as well. So history says emerging markets should do well in a stronger cycle and I can’t deny that. However, I think there are safer ways to play it.