Christopher Wood, Global Head of Equity Strategy for Jefferies in Hong Kong, talks about the most promising investments for the post-pandemic period – and the «Trillion Dollar Question» the Fed will have to answer.
When Christopher Wood speaks, investors around the world listen closely. The Global Head of Equity Strategy at Jefferies in Hong Kong and author of the legendary «Greed & Fear Report» keeps a close eye on the big picture of the global economy and financial markets.
For several months now, Wood has been successfully recommending the reflation trade to his clients, the alignment of the investment portfolio geared towards the post-pandemic economic recovery.
In an in-depth conversation with The Market NZZ, Wood talks about the all-important question of 2021 and shows where exciting opportunities are opening up for investors. He recommends equities and bonds Asia, cyclical stocks, gold – and Bitcoin.
Mr. Wood, in the past few months, financial markets have concluded that they can look through the pandemic and focus on the reflation trade, i.e. the reopening of the global economy. Are they right?
I’ve been propagating this view for a few months now. And yes, so far, it’s working. I have to say that the degree of the second pandemic wave is greater than what I was hoping three months ago. So I’m a bit surprised that markets have just looked through that. What really has been propelling the reflation trade forward were the positive vaccine news in November. Those announcements have kept it going.
Will that risk-on environment continue?
In the short term, what would kill this market is if there were any news that the vaccines don’t work against the new mutations of the virus. We haven’t had that yet, but that’s the main risk. But apart from that, my base case remains that markets will continue to look through the pandemic, provided that the vaccines rollout remains on course. For investors, this means you need to have a general bias towards cyclical stocks, because when this pandemic is over, the amount of pent-up demand will be massive.
What will happen then?
The most important thing for 2021, the trillion dollar question, will be this: How will the Fed react when we come out of the pandemic and the market is flashing strong cyclical recovery signals? Two obvious examples of such signals would be a further steepening of the yield curve and rising inflation expectations. Then the Fed will have to choose between two paths: One, they could say, «Oh, we have underestimated the strength of the rebound», and start to talk about withdrawing monetary stimulus. The code word there would be tapering. If the Fed indeed made a move in that direction, then equity markets will collapse. We’d see a short term car crash, an environment that would make the taper tantrum episode of 2013 look like a picnic.
And the other path the Fed could choose?
They could remain dovish and prevent long term bond yields from rising, even in the face of strong recovery signals.
Which of the two paths will they choose?
I'd say the latter. My base case is as follows: We’ll see the yield curve steepen, we’ll see the bond market selling off and long term Treasury yields rising. We’ll also see inflation expectations rising. I then expect the Fed to do two things: One, they will say that despite this cyclical rebound, because inflation has undershot for so many years, they promise to stay easier for longer. Remember that last year they gave themselves a formal licence to overshoot to achieve their 2% average inflation target. And the second thing they will do, if the bond market starts selling off, is move in and lock long term bond yields.
They’ll introduce a formal policy of yield curve control?
Yes, and they will justify that by saying they don’t want to jeopardize the economic recovery after the pandemic.
Ten year Treasury yields have been moving up to around 1.1% in the past few weeks. Are we close to the point of the Fed making this move?
First, I think the bond market is already partially pricing in some form of yield curve control around the ten year yield. So you should always look at the thirty year Treasury bond yield, as it has moved more than the ten year. The market assumes that the Fed will pick the ten year to fix. So at a certain point, if we really get a cyclical rebound, and if they really want to do this pegging, they should do it sooner rather than later. Obviously I personally don’t think that would be a good idea, but what I think is irrelevant.
To what level will the Fed let the ten year yield rise?
My guess is that they will move in at 1.2%. But that's a pure guess. The key point is if they want to do it, they will not want to wait too long. Now if they did that, it would be the first time the Fed introduced a policy of yield curve control in peacetime. The last time they did it was during World War Two. This would be a huge deal, don’t forget this is the government bond market of the world’s reserve currency. There are some economists out there talking about yield curve control in America as if it were a routine thing. It’s not a routine thing at all. It would be extraordinary.
Why will the Fed feel the need to do it?
Again, they will say they are afraid that rising interest rates will jeopardize the recovery of the US economy after the pandemic. But markets will conclude that the main reason they are doing this, the reason they can’t tell us publicly, is that the system can’t deal with higher rates. That’s the political reality. The US, the G7 economies, can’t afford higher interest rates.
What will the consequences be for financial markets if the Fed introduced a policy of yield curve control?
First, it would be dollar bearish, and by extension it will be a further positive for equities in Emerging Asia, which I think will outperform in the coming years anyway. Second, if you are a fixed income manager, there is no point owning Treasury bonds anymore. You will want to gear your bond portfolio towards Asia as well. Last March, I launched a sovereign bond portfolio for global fixed income managers, and I’ve told every client owning G7 government bonds, including Swiss bonds, to sell them and to invest in Asian government bonds. In that portfolio, I currently have a 60% weight in Chinese ten year sovereigns, 20% in Indian and 20% in Indonesian government bonds.
Why such a large weight in Chinese government bonds?
As a bond investor, you want to own Chinese bonds because the People’s Bank of China, of all the major central banks, is now by far the most orthodox in their monetary policy. Overall, Asian emerging economies still run an orthodox monetary policy and are not on a course of currency debasement. If the Fed should do yield curve control, this will make the Renminbi and the Chinese bond market a much more important reference point for global financial markets than it is today.
Do you see the dollar in an extended, structural bear market?
It’s looking like that, yes. In the short term we might have a bounce, and we’ll have to double-test that when we get the next big risk-off move in markets. But the combination of the fiscal deficit increasing and broad money aggregates – M2 in America – surging, looks dollar bearish to me.
Do you see a return of structural inflationary pressure?
For one, we’ll have a significant base effect kicking in around April, so inflation readings will be high. I think that when our economies reopen, inflation could surprise on the upside, beyond the base effect, because of all the bottlenecks in the system. Also, in a real reopening, the oil price and commodities should be rising further, so inflation should move up. In the longer term, the question on inflation will be answered by how the Fed will react to the cyclical recovery: Again, if they remain dovish, if they let inflati0n overshoot, as I expect them to do, combined with this huge broad money growth we have seen, then I think this will be the end of a multi-decade disinflationary era. This is a big difference between today and the Financial Crisis of 2008: Back then, monetary policy just managed to increase narrow money supply. But today, it’s the broad money aggregates that have exploded.
Hence your view that fixed income managers should get out of G7 government bonds?
Yes. In G7 sovereign bonds, the upside is minimal, and there is a massive downside risk. In terms of currencies, the Renminbi on the other hand looks like the most straightforward long bull story. In a world where the PBoC remains orthodox and the G7 central banks doing their extreme policies, it’s kind of logical that the Renminbi should strengthen.
Apart from Asian bonds, what should an investor buy to prepare for this scenario?
First, I like Emerging Asian equities. Last year, the best three were China, Korea and Taiwan. They have had the whole technology super cycle going for them. They’re all still good, and you can continue to own them. India is a market that you should buy on any pullback. South East Asian markets are all good, my least favourite there right now is Thailand, because of their political issues and their tourism lockdown. If I had to pick one Asian Emerging Market outside China, Korea and Taiwan, I’d recommend India.
Chinese authorities have lately been on a clampdown campaign against tech giants like Alibaba. How do you assess that risk?
Regulatory curbs are overhanging the sector, and we could be looking at a period of underperformance for the Chinese tech sector. But in the big picture, I don’t believe Beijing will want to kill Alibaba or any of its giant tech companies. That would not make any sense. They just don’t want them to crush every small business in China. The case of Ant Group actually made sense to me. Chinese regulators don’t want these fintech platforms to destabilize the conventional banking system. Ant Group had no skin in the game in its consumer lending business, they only had 2% equity at stake. Chinese regulators have a track record of addressing things before they blow up. Which, in a way, is the opposite of Western regulators.
With your base case, I suppose you must be bullish for commodities?
Yes, in a world that goes back to normal, you can have one hell of a cyclical move in the energy sector. I don’t see why oil demand should not return rather quickly to 2019 levels.
Energy stocks have seen a big jump since late October. Do they have more room to run?
Absolutely. I was bullish on energy stocks this time last year, because they had already gone out of the ring. But then, with the hit of the pandemic, they sold off. So energy stocks may have had a big bounce in the last three months, but it was from a dramatically low level. The issue with oil stocks of course is whether fund managers can still buy them, given the push for ESG investing.
What’s your view more broadly in terms of sectors?
In a global cyclical recovery, you want to own stocks related to energy, automotive, industrials and materials.
How about financials?
Banks stocks are a winner in an environment of a steepening yield curve, hence they rallied heavily. The case for banks is tricky, though. They will trade well until the Fed starts with yield curve control. But then they will take a hit. I must stress of course that I might be wrong and that the Fed will not choose the path of yield curve control. So if the Fed would just let the yield curve steepen, without interfering, banks will do very well. In general, I prefer banks in Asia. You don’t have to worry about yield curve control in India or Indonesia.
What about the winning sector of the past decade, US technology stocks?
If the Fed locks bond yields at a reasonably low level, this would support growth stocks, because it will send the message that rates will remain low for longer. Yet I think the era of their vast outperformance is over. My base case until proven otherwise is that the outperformance of the FAANG stocks against the S&P 500 has peaked. Clearly, the tech sector was a winner of the pandemic, which has brought forward five years of earnings growth into six months. It’s hard to replicate that. Plus, on a five year view, we are going to have material regulatory action against these companies, especially against Google and Facebook.
You’ve been bullish on Japan for quite a while. Is that still the case?
Absolutely. Both Japan and Europe should do well in a cyclical recovery, but so far Japan is doing much better than Europe. Japanese equities are cheap, and the trends in terms of improving shareholder returns are going in the right direction. There is one key technical problem in Japan, which is that domestic institutional investors still don’t appear to be reallocating to their own stock market yet. They are still sitting in Japanese Government Bonds, which is bizarre, given that the Topix has been outperforming JGBs for several years now.
What’s holding them back?
I don’t know. I just see that they don’t appear to have reallocated to Japanese equities yet. The good news is that the Japanese market managed to go up last year, even though foreigners were net sellers in the first three quarters. Foreigners only became net buyers again in the fourth quarter. There will be a point when domestic institutionals will reallocate back into the Japanese stock market. And that could set up a huge move.
Why is Europe not performing better?
Banks are a big part of the European stock market, and the negative interest rate environment is just very bad for European banks. What would send Europe flying would be some signal by the ECB that negative rates are over and yield curves could steepen again. On the bright side, the Recovery Fund has positive implications for Southern Europe, because it has led people to believe that we are heading in a direction of fiscal integration. In Europe, I would favor Southern Europe, because they are the beneficiaries of the Recovery Fund. I’m actually quite bullish on Greece. But to be clear: If you forced me to choose between Japan and Europe, I’ll definitely own Japan.
With the assumption that we will see yield curve control by the Fed: That must be bullish for gold?
Yes. Yield curve control will be very bullish for gold, because the Fed would send a clear message that they are going to suppress real rates. The dollar gold price moves inversely to real dollar rates. The issue for gold right now is that we have a new competitor as a store of value, and that competitor is getting more and more profile: Bitcoin. I don’t see gold and Bitcoin as mutually exclusive, but the practical reality is that baby boomers are comfortable with gold, while the Millennials are more comfortable with Bitcoin. The other practical reality of course is that Bitcoin has massively outperformed gold last year.
Will that continue?
The key point is that Bitcoin has become investable from an institutional standpoint. In the last year, the likes of Fidelity have established custody relationships. Before you had bona fide custody arrangements, institutional ownership of Bitcoin was not possible. The extraordinary thing in late summer was this Nasdaq-listed company, Microstrategy, putting Bitcoin on its balance sheet and the SEC and the auditors approving it. That was a game changer. With that move, Bitcoin became accepted.
So what should an investor do? Own gold or Bitcoin?
Just own them both. Bitcoin has been somewhat stress tested now, it has seen a major bear market. So, just like the pandemic has accelerated the earnings growth for tech stocks, it has also created this policy response, particularly in the US, which has reinforced the store of value of Bitcoin. Don’t forget that in market cap terms, Bitcoin is vastly smaller than gold. There is about $13 tn worth of gold above ground, while the market cap of Bitcoin is only a little more than $600bn. Institutional ownership of Bitcoin has just begun. The fact that some prominent hedge fund managers have bought was interesting, but the thing that really caught my attention was Mass Mutual, a conservative Boston life insurer, that bought Bitcoin for $100mn. Also, we now have Bitcoin trackers. The more this happens, the more Bitcoin becomes investable. Thus, my recommendation is rather simple: Buy some Bitcoin, and buy more if it goes down. And don’t get freaked out by the volatility.
And at the same time, you’d own gold?
Yes. The gold price should be considerably higher than what it is. If I had to choose between gold and gold mining stocks, I would opt for mining stocks. They remain very cheap relative to gold, they are good value. The miners generate very high cashflows, and unlike the last cycle, this time around they have remained disciplined. They haven’t gone on crazy expansion projects, they are controlling costs, and they have been paying out rising dividends. So I would definitely buy them.