Partner, River Valley Asset Management

River Valley Asset Management

Partner

Singapore-based boutique asset management firm

River Valley Asset Management is a Singapore-based boutique asset management firm. Our team at RVAM strongly believes in being a trusted steward of our clients' wealth across generations.

Each of our fund managers has years of rich portfolio management experience over multiple market cycles at world-class investment houses. We bring our clients the combined strength of our investment team to manage their financial portfolios and to provide bespoke guidance on all aspects of their financial health.

We offer multi-asset class expert investment advice to accredited investors who are family offices, high net worth individuals and institutional investors to preserve and grow our clients' wealth.

The fund management team of the company includes Homiyar Vasania, Anand Ramachandran and Jamshed Desai.

Cross Asset Strategy

  
	
		
			
				
	
		
			A year ago, if someone had made a prognosis that a majority of humankind would still be under some form of lockdown today, it would have been difficult to imagine markets trading at current levels. But then we have gone through many unusual times over the recent past. Our lives continue to be turned upside down while markets continue to be on steroids, defying bulls and bears in equal measure. Lockdown beneficiaries continue to do well, as do reopening trades.  Something has to give but nobody wants to take the punch bowl away, least of all the central banks who continue to believe in their role of the ultimate grandmaster who has to deliver certainty in an uncertain world.
Six months ago, with vaccine approvals on the horizon, many of us especially in Asia were breathing a sigh of relief. We were expecting travel to open up in the near future, liberating us from the cloistered life many of us have been forced to lead, sitting in front of screens with endless video calls, switching between work to personal to social all within the settings of the same four walls. With Asia having handled the pandemic better than many developed countries of the West, the expectation of a quicker road back to normal was not just a genuine desire for many but also supported by facts on the ground. Perhaps that was hubris or complacency, but with fresh COVID-19 outbreaks driving lockdowns across Asia, international travel increasingly seems like that fleeting hope which is so near yet so far away. Strict quarantine measures with impossible expectations of near-zero COVID-19 cases increasingly present a Hobson’s choice of pandemic control. This virus seems like it will be endemic and the key question now is when Asian societies and governments will accept this paradigm and learn to live with the virus with immunity slowly building up with vaccinations.
The Rising Graphs Of Asia 
April broke the hubris in Asia with a stratospheric rise of cases in India driven by the new Delta variant of the coronavirus, which turned out to be highly contagious and leaked to other parts of Asia, driving authorities to roll in lockdowns. What has not helped Asia is the slow pace of vaccinations which leave most countries in the region vulnerable to spikes from emergence of further new variants. Going into the second half of the year, the developed countries of the West which have shown tremendous vaccination progress are likely to open up their economies, which is likely to further widen the global divide between rich and poor as the developing world lags in vaccinations.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			Unfortunately, past success in containing the virus and a lack of urgency in ordering “untested” vaccines has resulted in Asia falling behind in the vaccination race. Lockdowns forced by spikes from new variants are finally driving Asia to show a sense of urgency, though only Singapore seems ready for relaxation by the end of the year, based on its rates of vaccination (as seen in graph above). While most of Europe and the U.S. are seeing current vaccination rates running at 40-60% of the population, the majority of Asia is languishing in the 5-20% range. The economic costs of prolonged lockdowns could be something that markets may finally start worrying about as Asia goes about its slow grind up the vaccination curve.
The chart below depicts lockdown intensity across two time frames. While the West, which was operating under strict restrictions in March 2021, is slowly relaxing going into June, Asia has moved the other way, from moderate levels of lockdown to stricter regimes now.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			Unintended Side-Effects
The mutations of the virus are not only escaping established control protocols but creating new challenges as human beings try to battle their effects. In India, an extremely rare fungal infection called mucormycosis is on the rise among recovering and recovered-but-vulnerable COVID-19 patients. Colloquially referred to as “black fungus” due to its dark pigmentation, this potentially fatal infection starts in the nose and spreads to the eyes and then the brain. Public health experts are blaming the indiscriminate use of steroids to treat COVID-19 as the likely cause. Steroids are used to reduce inflammation in COVID-19 patients, but due to pre-existing medical conditions it is resulting in side-effects which are causing harm that outweighs the benefits.
Steroids, in common parlance, are man-made versions of hormones that are found naturally in the human body and help reduce inflammation or provide a boost to growth. Steroids do not cure, but they are good at helping to ease symptoms. Unfortunately, they have side effects and prolonged usage can increase the risk of exacerbating pre-existing conditions or present new complications. It is not just the medical fraternity which is dealing with this “Jekyll and Hyde” problem of steroids. Increasingly, the S word is frequently popping up in the financial lexicon, a reflection of the unintended effects of policy maker actions as they try to control the economic impact of coronavirus lockdowns, creating newer challenges for the world.
Markets Battling Steroids
In our monthly write-ups over the last year, we have been documenting unintended consequences of policy actions. In February 2021, we wrote about the risk of inflation from loose monetary policies, while in May 2021 we highlighted the rising trend of retail participation in equity markets around the world. What is increasingly becoming the norm in markets are exponential price curves as COVID-19 policies are boosting anything and everything up.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			The chart above shows a collection of graphs from various segments of the market: old economy commodity price (steel); share price of market darling Tesla; Bitcoin, a revolutionary concept which is still trying to find a role in real life; and the share price of AMC Entertainment, a nearly bankrupt theatre chain whose business disappeared due to COVID-19, but which became a meme stock discovered by retail investors. What is common among all these price graphs is the indirect impact of policy boost in helping them reach their present levels. But that could potentially change in the near future.
The demand for commodities is being boosted by policy support, while supply is suffering due to coronavirus disruptions, amplifying prices. Asset markets continue to be supported by liquidity measures which are unable to flow into the real economy as continuing lockdown measures crimp demand for capital. Job support via income measures is boosting savings at the same moment as restrictions are curtailing discretionary spending, giving retail investors the excess capital to speculate in financial markets. The unintended boost from ‘policy steroids’ is distorting variables across the spectrum of economic activity in most markets.
The Way Forward
Economies of Europe and the U.S. are likely to look towards relaxation of lockdowns and normalizing activity levels as vaccination rates hit 60-70%, a number which gives epidemiologists comfort about potential herd immunity. We are likely to see that in the latter part of the northern hemisphere summer and it is reasonable to expect a roll back of some of the stimulus measures, income support policies and loose monetary stance of central banks. Clearly, the need to manage the future fallout of exceptional COVID-19 measures is now occupying policy makers’ minds. The recent agreement by G7 on a minimum global corporate tax rate of 15% telegraphs the fact that payback time is coming soon. Leverage taken on to provide steroids to the economy during the pandemic needs to be paid back from future activity levels.
Markets are increasingly fixated on the risk of a repeat of 2013’s taper tantrum when the U.S. Fed reversed accommodative policies the last time around. The good news for Asia is that unlike the past, countries in the region are in a better fiscal shape this time around, something which we wrote about in our November 2020 monthly piece, the Resurgence of Asia. Unfortunately, due to lagging vaccination programs we are likely to see a growth differential emerge between the developed and emerging economies and it is unlikely to close before 2022, unless the coronavirus miraculously disappears.
It is a matter of time before the liquidity punch bowl is taken away from markets. These are times when investors need to exercise caution and give as much importance to capital preservation as they give to the expectation of capital appreciation. Steroids always have side effects and that is why doctors advise use in moderation. Market participants mesmerized by the upward sloping boost from liquidity need to realize that payback time could be approaching and moderating enthusiasm could help long term wealth accumulation.

		
	

			 
		
	 

		  
	
		
			
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			Disclaimer 
This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Information has been obtained from sources believed to be reliable. However, neither its accuracy and completeness, nor the opinions based thereon are guaranteed. Opinions and estimates constitute our judgement as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This information is directed at accredited investors and institutional investors only.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

The post A World On Steroids appeared first on River Valley Asset Management.

  
	
		
			
				
	
		
			A few months ago, the GameStop/ Robinhood episode brought into focus something that many large investors (the institutional kind mostly) had resisted accepting as a force driving the markets. Much has been said about that particular event and bears no further comment from us, but what it did emphasize strongly was that the role of retail investors from Tokyo to New York had suddenly and perceptibly changed the pattern of trading on stock exchanges around the world and impacted stock returns in specific sectors and areas of the market like never before. It also brought home that it would be puerile to dismiss this as transitory and something only to do with the pandemic that would go away once we got rid of it.
It was not just the sheer increase in trading volumes that has palpably moved many markets. The use and proliferation of information and opinions via social media have added a hitherto unknown dimension to trading activity today and likely for times to come.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			Source: BIS

		
	

			 
		
	 

	
		
			
				
	
		
			Small traders/ investors are often attracted by the speculative nature of single stocks rather than by the diversification benefits of indices. Consistent with such preferences gaining in importance, turnover for ETFs tracking the S&amp;P 500 has flattened over the past four years, while that for the S&amp;P 500&#8217;s individual constituents has been rising in the same period. Data points to 2017 as the possible germination of retail investors&#8217; rising influence.
Retail investors are also more likely to trade assets on the basis of non-fundamental information. During the late 1990s tech boom, for instance, they often responded to important news about certain companies by rushing to buy the equity of similarly named but different firms or firms from the same sector or sub-sector. Comparable patterns emerged in early 2021, for instance when the value of a company briefly rose two to five-fold as investors interpreted a social media message as endorsing its stock. However, there are other reasons more germane to each market for the rise of retail investor participation. Below we discuss a few markets where country-specific and market-specific reasons present a cocktail of forces that are much longer term in nature and which could impact trading on stock exchanges as we have known it.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			Thailand: Retail, The Bulwark Against Foreign Selling
Aside from the factors that hold true globally, such as momentum bias, Thai investors face a paucity of alternative vehicles for their abnormally large excess savings. We identify broadly three reasons for this:

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

	
		
			
				
	
		
			
Asset repatriation: Thai residents repatriated $9.4bn of assets, equivalent to c.2% GDP, previously held abroad, by mid-2020 alone, most likely driven by the increased home bias seen during crises. This pool of savings needed to be re-invested and has played a role in the subsequent months’ support to the market.
Gold prices: Thais, like several other Asians, have a cultural bias for gold as an investment vehicle. However last year Thailand saw over $3.5bn in gold sales, the largest outflow seen to date. Whilst a portion of this can be explained by the need to tide over short-term income disruptions, it is believed that the large majority was due to investors capitalizing on elevated gold prices. Such excess capital also needed to be re-invested and much of it likely found its way into equities either directly or through mutual funds or some other investment vehicle.
Deposit rates: The 12-month bank deposit rates have fallen by over 80bps since the beginning of the year to below 50bps, largely due to liquidity support measures from the Bank of Thailand. At such record low deposit rates, it is only natural to expect some capital moving into equities seeking higher returns. It is well understood by investors that Thai companies have a culture and discipline to pay out generous dividends when warranted and supported by earnings. This assures Thais of receiving stable dividends especially from large SOEs, banks and oil companies generally.


		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

	
		
			
				
	
		
			In 2020, foreigners were net sellers, with net sales of Bt264.4bn. Local retail investors, local institutional investors, and local brokers’ proprietary portfolios were all net buyers, with net buy positions of Bt216.7bn, Bt33.5bn and Bt14.2bn respectively. Foreign + non-voting depository receipt (NVDR) holdings in the Thai market dropped steadily to c.25.8% currently compared to its peak of 36% in 2012. The local investors and proprietary traders account for c.60% of trading volumes today versus 49% at the start of 2019 and possibly much lower earlier. Few other markets can boast as strong a domestic support for the market as the Thai market offers.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			Malaysia: The Gloves Are Off, For Now
In 2020, retail investor net inflows into the market were RM14.2bn and this continued into 2021. But there is a peculiarity to this surge, unlike elsewhere in Asia. Retail investors in Malaysia mainly bought glove manufacturers and some consumer discretionary and financials as the pandemic broke out. As a result, KLCI trading volumes increased to RM5-7bn/week in 2020 from c.RM3bn/week a year ago, entirely due to focussed trading in the top 3 or 4 glove manufacturers like Top Glove and Hartalega where volumes increased 10-15x. Oddly, the trading volumes for KLCI excluding the glove manufacturers have declined. (See accompanying chart)
Bursa Malaysia’s average daily traded volume (ADTV) in 2020 was mainly driven by the increase in retail investors&#8217; participation (37% in 2020 vs 24% in 2019). The proportion of online trades increased to 80% in 2020 from 62% on average between 2013 -2019.

		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			Since the start of 2021 though, as the nature of the spread of the pandemic has changed, the pendulum has swung 180 degrees and the effusive love for glove manufacturers has been replaced by that for the technology sector.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			From the accompanying chart it is apparent that the quantum of domestic buying has been insufficient to balance the selling by foreigners, who have been net sellers in Malaysian equities through 2020 and 2021.

		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
			 
		
	 

	
		
			
				
	
		
			It was also the case that the yield spread between equities and the 10-year MGS has escalated to close to two standard deviations above its long-term mean level, giving retail investors another strong reason to be gravitating towards equities.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			Indonesia: Foreigners Rule The Roost
Down in Indonesia, according to IDX, in 2020 the ADTV grew 3x to c.USD1.5bn/day driven by the doubling of retail participation to 70% while foreign participation halved to 18%. Average daily retail value transactions rose c.6-fold in this period. The widening of the retail base is apparent in Indonesia just as much from the recent data. There is also data which shows more young retail investors coming into the market and a growing number of online brokerage accounts.
Yet Indonesia it must be said, has among the lowest retail ownerships of its stock market at just above 8%. This figure has actually declined in 2020 from a peak of c.10% in 2018. Data from the IDX shows that retail investors tend not to focus on small-cap stocks and that 56% of all trades by value are in large cap stocks versus 60% in 2018-20 on average, which intuitively seems surprising given small investors often trade in smaller local companies they tend to be familiar with. This does not seem to be the case in Indonesia.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

	
		
			
				
	
		
			Low level of stock ownership and narrow participation of retail investors in a handful of large stocks has created a market with low depth in liquidity and in domestic retail support. While the aggregate domestic ownership (retail and institutional) has been increasing slowly, it remains low. As a result, the market is prone to sharper moves in either direction when foreigners turn buyers or sellers, compared to other markets where domestic institutions and retail investors’ participation runs deeper and broader and offers the much-needed support. Market pricing inefficiencies abound and therefore persist for protracted periods of time.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			Singapore: The Comeback Kid
Singapore has been one of the best performing stock markets so far this year. While the SGX has seen its share of increase in retail trading volumes, the bigger reason for the STI’s strong performance so far has been Singapore’s demonstrably strong handling of the pandemic, which has endeared it to the local punter and foreign investor alike. As the economy has gradually opened, domestic and international investors’ confidence has returned. Singapore also has a well-developed domestic fund management industry and a sovereign wealth fund that act as buffers in stabilising the market when the chips are down. The SGX reports that retail trading volumes have nearly doubled since pre-COVID days, something that is welcome given the long period of funk in the Singapore market.
Singapore is also resident to a sizeable private wealth sector, where large pools of cash reside and are managed. Much of this is long-term yield-seeking money that finds its way into the nearly 50 listed REITs and Business Trusts. Retail investors too, like their Thai brethren, suffer from abysmally low yields on their bank deposits and have no recourse but to invest in REITs/BTs and similar high yielding stocks that abound in the Singapore market. Incremental high savings too have driven such money into the market since 2020.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

	
		
			
				
	
		
			Vietnam: No More The Minnow
Retail investors have piled into Vietnamese stocks at an unprecedented pace, fuelling Asia’s biggest rally. The flood of local cash has seen trading volumes more than quadruple since the end of 2019. The benchmark index now includes 11 stocks exceeding $5 billion in market value, up from just two in 2015. Foreigners sold a net $876 million of Vietnamese stocks last year, similar to what has been already sold so far this year. Yet, the country’s benchmark VN Index has soared 12% since January this year, suggesting that retail investor participation and support for the market has risen dramatically today than it was even a couple of years back.
Plunging interest rates spurred ordinary Vietnamese to open nearly 400,000 new trading accounts in 2020, a record high. In the first three months of this year alone, they opened almost 258,000 more, helping send daily turnover on the Ho Chi Minh City stock exchange to an all-time high.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			India: Retail Rules!
The most startling findings come from India. The participation of players in India’s stock market has changed dramatically in the last five years.
India’s markets are now dominated by individual investors, who form 45% of traded turnover of equities. Individual investors’ market share has moved up from 33% in 2016 to 45% in 2021. Note that this is pure equity cash trading and does not include derivatives trading, which itself is another huge market.
Foreign investors are only 11% of total trading volume now, down by half since 2016. Domestic Mutual Funds are now only 7% of the market, down from around 10%. Proprietary traders, which are typically the trading arms of local brokerage firms, today account for 25%. If one adds this 25% to the 45% contributed by individual investors, which is also fundamentally UHNIs and who trade across the market-cap curve, then we find that 70% of the market volume is individual and HNI investors of all ilk that drive the market volume and impart liquidity to it.
In addition to this, the National Stock Exchange (NSE) in India is the world’s largest index options market in terms of number of contracts. In the futures market, it is no different where retail has a 30% share and prop traders 40% of the traded volume.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

	
		
			
				
	
		
			However, when one looks at the ownership of floating market capitalization (non-promoter) equities, the picture is quite different. Foreigners own c.43% whereas retail investors own just 18% and Domestic Institutions another c.15%.
What has all this meant for investors in India? The liquidity, coverage by stockbrokers and hence price discovery of the smallest of market cap stocks has increased by leaps and bounds. As a result, money managers thrive investing across the market cap curve with consummate ease versus most other markets in the region that hardly afford such a diversity of investible stocks.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			China: The Taps Are Open
A secular trend of growing Chinese household participation in the stock markets has been underway for several years now. However, given the acceleration and growing accumulation of wealth there, such trends could also see acceleration, where households seek to aggressively buy more equities in future.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

	
		
			
				
	
		
			Chinese households may continue to raise their equity exposure as a result of three drivers:

Beijing continues to cap investments into the physical property markets amidst tight regulations;
Chinese households may buy more insurance products incrementally and insurers may invest more in equities in a low interest rate environment; and
The quality of the equity stock is improving in China with more private sector companies getting listed and becoming sector leaders and domestic champions taking on multinationals in their own backyard. Lately, growing nationalism is adding to their success. Investors are quick to identify with such companies and brands and invest in them. The massive market capitalisation of China’s technology space and more recently the growing EV space are testimony of the power of local investors’ clout.


		
	

			 
		
	 

		  
	
		
			
				
	
		
			Another fact worth noting is that residential properties account for 44% of Chinese households&#8217; total assets at end 2020E, c.12% lower than 56% in 2000, but still a high number. While households have been trying to diversify their asset allocation, they are yet wedded substantially to property owing to the limitations imposed directly or indirectly in three probable ways:

State ownership of natural resources limiting the investment scope of Chinese households;
Cross-border capital control preventing Chinese households investing in overseas assets, including some of the best private sector listed companies in China; and
Moderating growth of real economy making ROE of non-property assets relatively less attractive.


		
	

			 
		
	 

		  
	
		
			
				
	
		
			China’s A-share market ownership resembles other Asian markets like India’s where retail investors and HNIs own 45% of the free-float market cap, while foreigners own just 9%. The opening of the SouthConnect route for Mainland Chinese to buy shares in Hong Kong has only enhanced this trend further. In future, as China allows for greater North-South flow of capital, retail investors hitherto denied the opportunity to invest directly into Hong Kong listed stocks, could add a totally new dimension to trading and capital flows and have a huge impact on valuations of the same stock listed on the A-shares market and in Hong Kong.

		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			Consequences Of High Retail Participation
It is difficult to categorically say if further “institutionalisation of markets” would possibly act as a foil to the growing influence of retail investors. Given the advent of online trading platforms, roboadvisors, ETFs and what have you, it is possible that the retailisation of markets could be a megatrend in itself that is here to stay. The trend could morph along the way as the market participation deepens and broadens further, in terms of the number of both intermediaries and investors which could grow substantially from where they are today in many markets.
Beyond the obvious consequences of ‘retailisation’ that one can think of such as higher and improved liquidity and volatility in trading, the real long-term beneficiaries of this are likely to be the corporates and investors themselves.
With liquidity comes better and more efficient price discovery of assets by markets. Large portions of the equity markets which hitherto lay illiquid and moribund as they do today in smaller markets like Indonesia, Philippines, Malaysia and Singapore, are likely to be ‘discovered’ by the growing breed of new intrepid retail investors. This ought to lead to better valuations that would spur the companies to come back to the markets to raise growth capital and even more M&amp;A activity using their stock as currency. For investors, it would mean a wider array of stocks finding acceptance and being traded more regularly and heavily. Crucially, market inefficiencies of rank undervaluation would be shortened vastly and spur greater participation in these parts of the markets.
Today’s retail participation is often scoffed at and often referenced to in disparaging terms in the media. Yet, recent events and trading patterns have revealed that in fact, retail investors are as well-informed and diligent in their research and have sufficient money power collectively to influence stock prices, not just in the short term but even over longer periods of time. This has in fact unleashed several unintended benefits for capital markets. As such, money managers would do well to recognize the growing importance of this new yet powerful force today which is here to stay and could get stronger over time.
As we sit putting pen to this monthly, the words of America’s great songwriter and folksinger Bob Dylan, in his voice tinged with inebriation and soulfulness, ring in our ears. Arguably one of his greatest creations &#8211; The Times They Are A-Changin’ – could not be more apt at this time…
Come writers and critics
Who prophesize with your pen
And keep your eyes wide
The chance won’t come again
And don&#8217;t speak too soon
For the wheel&#8217;s still in spin
And there&#8217;s no tellin&#8217; who
That it&#8217;s namin&#8217;
For the loser now
Will be later to win
For the times they are a-changin&#8217;

		
	

			 
		
	 

		  
	
		
			
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			Disclaimer 
This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Information has been obtained from sources believed to be reliable. However, neither its accuracy and completeness, nor the opinions based thereon are guaranteed. Opinions and estimates constitute our judgement as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This information is directed at accredited investors and institutional investors only.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

The post The Times They Are A-Changin&#8217; appeared first on River Valley Asset Management.

  
	
		
			
				
	
		
			The Crisis So Far: A Bad 15 Months, But Human Ingenuity Continues To Positively Surprise
As the coronavirus crisis goes into its sixth quarter, much has changed from the early panic the world went through in the first quarter of 2020. While the world has lost a lot in terms of life, livelihood and its innocence vis-à-vis the dangers posed by such organisms, it has learned a lot too. It has learned that the real monsters in our world are not the Godzillas, the aliens or even war and weapons of mass destruction as portrayed by Hollywood movies. The most potent monsters are the ones we cannot see &#8211; the small microbes, the viruses, the germs. We have officially seen nearly three million (and counting) of our fellow humans die of this disease since the beginning of last year.
We have also tested our scientific prowess to the fullest and come out looking quite strong. When it involves enabling millions to use technology to work remotely, to shop and entertain remotely, to get medicated remotely, and so on, we have discovered how far we have improved these capabilities. Most importantly, we have discovered how fast we could use our technological capabilities to create test equipment, treatments and, above all, vaccines. Remember those early days when the experts would remind us that no reliable vaccine has been created in the past in less than 4-5 years? Well, here we are 15 months into the pandemic, and we have already vaccinated nearly 6% of humanity and are building up pace to vaccinate nearly 4% of humanity a month and accelerating. Which means that over 40% of humanity could be vaccinated by the year end, in an amazingly short period of only 12 months since the vaccines came out. This is an achievement that would have been unbelievable even two years ago.
Re-infection And Vaccination: Stronger Governance Structures And Deeper Purses Win The Race
Now the race is on between the rate of spread of infection and the pace of vaccination. While shutdowns and social isolation have helped in slowing the pace of infection, they have taken a large economic and emotional toll. Hence the eagerness to re-open. This has often led to re-openings in many countries happening earlier than epidemiologists would advise. This explains the large recent resurgence in infection rates in some countries. This is especially true in countries which do not have either the economic muscle or the governance structure to maintain the shutdowns. Here, the developing economies (especially the democracies amongst them, which tend to have slower-moving governance structures) look the most vulnerable.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			Infections: The Next Wave Is Happening Stronger And Faster Than The Earlier Ones
COVID-19 cases across the world are having strong second waves. Though these waves have not exactly coincided across geographies, they have been comparable to if not stronger than the first wave which peaked in the middle of last year. The current global daily tally of new cases is only 10% below the peak of early January this year and will potentially reach there soon. The big difference this time is that the numbers are being pushed up now by Asia (primarily South Asia and some countries in South East Asia) and South America. The previous peak was primarily created by spikes in North America and Europe. This has an important implication: the earlier peaks were created by cases in parts of the world which now have a much stronger access to vaccines and are generally the wealthier parts of the world and hence better able to create economic safety nets in case of temporary economic shutdowns. The current peaks are being created by cases in developing countries and hence the impact might be more difficult to deal with.

		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			But, as always, there is a silver lining: the mortality rates are much lower. The cases are being discovered much earlier in the disease lifecycle, the medical fraternity is a lot more prepared in terms of how to treat patients and the population of these countries is much younger. Hence, the impact should not be anywhere near as bad as it was in the early phases. Despite this, the pressure to re-shut some of these economies is rising rapidly and some of the governments do not have the financial or the political capital to push as hard as they did during the first shutdowns. Hence the human toll could again be bad.

		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
			 
		
	 

	
		
			
				
	
		
			Vaccination: The Pace Is Picking Up Rapidly, But It Is Very Unevenly Spread
The Developed Countries Are Racing Ahead
This is the second race, and it is accelerating. About 6% of the world has got at least one vaccine shot so far and this is growing at about 0.9% per week. But the pace and level of vaccination has been varying quite a lot across countries and continents. Nearly 25% of North America is already vaccinated and over 16% of Europe. On the other hand, less than 1% of Africa has got at least one dose of the vaccine and Asia is at about 5%. There is a clear difference here between the haves and the have-nots.
Not only have the richer parts of the world vaccinated more of their populations so far, but their vaccinations are also progressing at a faster pace. For example, already about a third of all Americans have got at least one dose and this number is growing at about 4% a week. This means that in about ten weeks, nearly 75% of Americans would have got at least one dose of the vaccine; this is broadly the threshold for herd immunity. The U.K. is even further ahead with nearly 50% of the population having received at least one vaccine shot, though the pace of vaccination there is slowing down. Even countries in continental Europe are now slowly getting their act together after faltering in their vaccine roll out in the first few months. Germany has already got 15% of its population vaccinated and is vaccinating at about 3% per week. Hence for Germany, herd immunity will happen in about twenty weeks’ time.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			The Emerging Markets Are A Mixed Bag At Best
Within the emerging markets, a few countries seem to be slightly ahead of the pack. Brazil is reaching vaccination levels of 10% and growing at about 2% a week. India, the current epicentre of the spike in new cases, is at about 7% and also growing at about 2% a week. These markets might also head towards the herd immunity percentage by the end of the year. This would be through a combination of vaccinations and an increased number of recovered patients. Though these numbers give some hope for even these developing markets, the strain on their healthcare facilities and the consequent economic impact might be much higher than in the developed markets.
The group left furthest behind are the ones with low and slow vaccination rates. The worst amongst these is Africa which unfortunately is last in queue on this front. Only about 0.7% of Africans have got vaccinated and this is growing at only about 0.1% a week. Here, the disparity vis-à-vis the developed world is stark and heart breaking.

		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			The next amongst these with low and slow rates of vaccinations are some of the richer Asian economies with low infection rates like Australia, Japan, Korea and Taiwan (potentially also China, but here the data is erratic). For example, only about 0.9% of the Japanese have been vaccinated and this is growing at less than 0.2% a week; similarly, the Korean numbers are 2.26% and growing at only 0.4% per week. Even though some of these countries are currently seeing a spike in numbers off a very low base, they seem to be content to lag behind in the vaccine queue. Their current human toll is not that high and they have enough economic might to remain quasi closed for longer. Most importantly these could see rapid growth in vaccination in the coming months.
The third in the group of those with low and slow rates of vaccinations are primarily the Asean countries ex-Singapore. Singapore is doing a good job with nearly 20% vaccinated and growing at about 3.5% a week. But the rest of the countries are lagging a lot. Indonesia is at only 3.7% vaccinated and increasing at only 0.6% a week. Thailand and Philippines are less than 1% vaccinated and growing at less than 0.2% a week. These are the worrying economies as some of them, like the Philippines, are currently seeing genuine second spikes in infections. The vaccination numbers here could improve quickly, but if they do not, their opening up would really take off only in 2022.
The Impact On Economies And Markets
The outcome of these two races – the pace of infection and the pace of vaccination &#8211; will finally impact the race that really matters: the pace of economic normalisation. Here, there is a clear hierarchy. The U.S. (also, potentially, the U.K.) is clearly ahead. Europe, which has been needlessly maligned for its vaccine strategy, is only behind by a month or two. But the impact on markets (especially in the U.S.) might be more muted as a lot of this opening up is already getting priced in. In fact, the more useful take away from this could be the fact that the Fed normalisation (tightening) cycle might start earlier than expected.
China has already opened up, not because of a high level of vaccination but due to better control of the virus by track and trace methods. Emerging markets is where the outcome is mixed. Markets like India, which have run up a lot on the opening up trade, could face head winds as the resurgence meets vaccination rates which are good but not good enough. Even though India might come out of this faster than other similar economies, the impact on markets might be equally negative given the current optimism.
The interesting markets are the Asean group, which are lagging in vaccination rates but have kept infections in check (except the Philippines where there is a resurgence). Here, the base case has to be that the vaccination rates will pick up but with a lag and hence true opening up could lag countries like India by about 3-6 months. Here, markets have not run up as much and hence there might be more opportunities.

		
	

			 
		
	 

		  
	
		
			
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			Disclaimer 
This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Information has been obtained from sources believed to be reliable. However, neither its accuracy and completeness, nor the opinions based thereon are guaranteed. Opinions and estimates constitute our judgement as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This information is directed at accredited investors and institutional investors only.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

The post The Race To The End Of The Crisis appeared first on River Valley Asset Management.

  
	
		
			
				
	
		
			The talking point at the start of the year was ‘bubbles’ popping up in different parts of the market. In parallel, the cacophony caused by the GameStop episode, RobinHood investors and the shenanigans of a motley bunch of celebrity hedge fund managers-turned-evangelists, raised a din so loud, it obscured and drowned out the signals coming from the gentle yet surely changing tide in the bond markets. Before long, this quiet turn gave way to a sharp acceleration of the super-tankerish 10-year U.S. bond yield and U.S. 10-year breakeven inflation rates, just as the GameStop soap opera ratings were petering out.
On the day after Valentines in February, investors on Wall Street (or wherever) and realised that they had a sudden change of heart. Blame Cupid, stupid? The old flames had begun to flicker away and dim while new ones were being kindled. The narrative changed quickly. The unglamorous 10-year bond yield was now the cynosure of all eyes. What had just happened? It was beginning to dawn that everything had just changed!
Lo and behold, the chart that everyone was transfixed by – the U.S. 10-year bond yield &#8211; had just jumped 8.25% on 16th February! Yes, the 10-year was kicking and rearing from that day like a bucking bronco! Interest rate plots and Fed speak, inflation and policy rate forecasts became stale overnight and went into the trash bin.
The rapid vaccinations across the U.S. raised hopes for a sharp drop in social distancing measures and a reopening of the economy which, it was expected, would lead to strong increase in demand for goods and services in time for summer. Expectations turned on a dime that the reopening of America would generate powerful consumption forces and cause labour demand to grow strongly. Elsewhere too, as vaccination programmes gathered strength gradually, it was felt that global industrial production growth was set to accelerate, fuelled by low inventories and strong business investment.
The outcome of all this would have a bearing on inflation measures globally which, it was felt, would surely rise significantly by summer, partly due to YoY base effects, but also due to ongoing supply issues and financial services inflation (in the U.S.), and a likelihood of services sector price increases as social un-distancing drives up demand faster than supply can follow. This was discussed in our February newsletter: Commodities Signal the Inflexion of Inflation.
The passing of the US$1.9tr package more-or-less in full eventually (some had expected it to be significantly pared down) set the cat among the pigeons, driving the 10-yr further higher. Remember too that this is in addition to the $900bn COVID package signed by Trump in his final weeks in the White House. The surge in household disposable income due to newly sent cheques plus the estimated US$1.6tr of household savings would add up to a mind-boggling ~14-15% of U.S. GDP, most of which would be in the hands of people and possibly spent by September this year.
That sets the stage for the markets in the coming months. The trio of pent-up demand, record-low inventories and explosive income growth (via government transfers) is likely to close the U.S. output gap much quicker than anticipated, putting the Fed in the awkward position of having to lift its GDP, inflation and perhaps Fed rate forecasts.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			What has not changed yet is the steadfast adherence of the Fed to maintain loose monetary conditions. Fed Chairman Powell spoke not once but thrice over the course of the month, choosing his words with utmost care yet firmly delivering the message that he was far from moved by the change in expectations. His goals of the economy reaching an average inflation rate and an absolute reduction in unemployment are some distance away yet, although ‘substantial progress’ had been made thus far. He viewed the upcoming inflation increase as being low-base driven and transitory.
However, the bond market is not fully convinced that is the case. The market now believes that ‘substantial progress’ is approaching even faster than expected by the Fed and that guidance on purchases this year is likely signalling reduced purchases by mid-2022. In an extreme case of stimulus-fuelled growth, plans to reduce purchases could be put into effect this autumn as per certain quarters of the market. There is also the not insignificant technical factor of massive multi-year fund-flows shifting away from bonds that could carry yields further and higher in time and magnitude in the weeks and months into summer.

		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			Such a reckoning has slammed the brakes on the equity market rally. The Nasdaq Composite Index has taken it on the chin and the S&amp;P and Russel 2000 have not been spared either. The sceptre of rising interest rates is clearly anathema for many of the high growth technology and biotech stocks which have been riding this raging bull market on little or no earnings and specious valuation ratios to justify their valuations for many years. Even the poster boys &#8211; the FAANG stocks – could not withstand the selling that followed.
As per CS strategists, for equities, the problem historically is when the 10-year yield rises more than 130bp (which would mean rising to 1.9%). It impacts markets in four ways:

The rise in the 10-year impacts equities via bond/ equity valuations
GDP (1% on the TIPS yield could take 1.5% to 2% off GDP)
Earnings (a quarter of margin improvement is from lower rates)
Funds flow (gap between corporate bond yield and earning yield closes, so buybacks slowdown).


		
	

			 
		
	 

		  
	
		
			
				
	
		
			Source: Credit Suisse

		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			In short, the cocktail of rising inflation expectations and bond yields is a recipe for high P/E ratios to contract and lead prices sharply lower for such stocks. This is what is underway now. Based on this, while the Nasdaq100’s absolute decline is easy to explain, the S&amp;P500 too has followed suit. The S&amp;P500’s technology component (if one includes Amazon as a tech company) is now 42%, which makes this once broad-based benchmark a lot narrower than imagined. We note that equities are long duration assets and that rising yields and inflation beyond a tipping point will lead to P/E ratios contracting and stock prices giving up much of the gains of the bull market. This, combined with the S&amp;P500 now being so tech-laden, has made it a veritable ‘duration monster’!

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			The speed with which the yield curve has steepened means not only that this is a decisive shift in the narrative but that the real growth in the economy is indeed about to inflect higher sharply in the months ahead. Inflation will spike owing to last year’s low base. And this is where it gets interesting.
It will be crucial to see how the next two or three months leading up to ‘re-openings’ in the U.S., the U.K., Europe and the rest of the world play out, and how far bond yields will rise. Right now, the consensus has swiftly moved to the 2% mark for U.S. 10-year yields and zero for Bunds. It will be equally important to track the core PCE inflation to see where it ends up (expectations are for 2.5-3%) and how long it stays elevated.
For equity markets, a massive portfolio shift has been underway anyway since late into 2020. Technology stocks and ‘Work from home’ (WFH) beneficiary stocks have been under pressure and could remain so for some time to come. On the other hand, the dregs of the past &#8211; the financials and energy stocks &#8211; have made a strong comeback. Commodities continue to be the rage as the growth reflation theme gains further currency. The weak dollar and the change in growth expectations have helped Emerging Markets and Asia to come back strongly as well.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

	
		
			
				
	
		
			Real rate moves are likely to lead to further de-rating of high growth stocks in future. However, forward earnings expectations are likely to rise 20% or more over the course of the year. Thus, earnings could more than offset the rate headwinds through the course of the year. Over time, the inflection in spending and earnings could be a more important driver of stocks than just the rise in rates.
What we also need to watch out for are bond fund outflows. Rates kept rising in 2013 and 2018 until there was a surge in bond fund outflows. That phase is still to come and thus bond fund flows could put further pressure on rates as redemptions accelerate. Credit flows are key, given relatively less liquidity and the risk of greater spillovers to equities.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			QQQ and 10-yr: A Love-Hate Relationship
Having said all the above, corelations such as the ones we are talking about today work differently at different times in practice. Take a look at recent history and the chart below. It shows the Nasdaq 100 ETF (QQQ) in red and the 10-yr yield in black. The green zones show when they rose together (positively correlated) and the blue zones show when they moved opposite each other (negatively correlated). The 10-year yield doubled in each of the three green zones and QQQ still moved to new highs.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			Source: Stockcharts.com

		
	

			 
		
	 

		  
	
		
			
				
	
		
			The indicator window shows the Correlation Coefficient, which is an attempt to quantify the relationship between the 10-yr yield and QQQ. It is positive when they move in the same direction and negative when they move in opposite directions. This indicator is all over the place and it is hard to tell if there is a clear correlation either way. Sure, QQQ and the 10-year yield are negatively correlated over the last four weeks, but that does not mean they are always negatively correlated.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			In sum, we note the following key points:

The mind-boggling combined stimulus of ~14-15% of GDP over less than a year into the U.S. economy is likely to create all sorts of primary and secondary effects. These are proving to be a massive challenge to estimate for economists and the market just yet. GDP estimates and earnings estimates, while being driven up chunkily, could yet fall short when the actual numbers arrive much later. By then the stock market needs to work out how to price this in, keeping in mind the significant shifts happening with inflation expectations and real yields.
S&amp;P500 forward earnings are set to rise by 20%+ based on various forecasts. Compare that to 2013 when GDP growth was ~2.5% and forward earnings grew just 6.5%. The rally in 2013 was driven predominantly by the multiple going up 23%. This time, it is hard to make a case that the absolute level of the S&amp;P500 would rise based on merely earnings multiple expansion.


		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			Source: Jefferies

		
	

			 
		
	 

	
		
			
				
	
		
			
For that to happen, we must now begin to see growth becoming more diverse and broad-based as the cyclical sectors of the economy catch the reflationary force-field in the economy and begin growing or growing faster than they have in the past. This time around, Emerging Markets should be less vulnerable to a rise in the TIPS yields because their basic balance of payments surpluses are close to a 15-year high.


		
	

			 
		
	 

		  
	
		
			
				
	
		
			
U.S. corporations have plenty of ammunition on their balance sheets. As confidence returns, this cash can be used to kick-start a fresh wave of share buybacks, raise dividends and fire up M&amp;A activity once again (see chart alongside).
Finally, the correlation between technology stocks and bond yields is at best tenuous as we have seen over the last decade, which has been the golden period for technology stocks in history. While the current negative correlation might play for a while, it is not guaranteed that they would continue to underperform regardless of their own growth fundamentals. A more nuanced and stock-specific strategy is what might serve well from here on.


		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			We will likely look back at 2021 as the watershed year when global growth finally took hold and began to flower after many fallow years. The markets will perhaps realise over time that the rise in yields and inflation owing to GDP growth was in fact a good thing after all and that the three could co-exist, just as they did through 2003-2008 before things overheated. The stock market will adjust itself to this change in economic climate, as it always does, with a few hiccups and convulsions along the way. Sector rotations are already underway and may continue strongly through the year as the entrenched tech bulls yield finally. Emerging markets and Asia are having their best days in a long time to the extent that some of their rallies look extended in the short run and could be due for a correction.
There is plenty for markets to think about and to price this spring and summer. Meanwhile, the verse from the 2013 Taylor Swift and Ed Sheeran ditty plays in our heads as we pen this…
And all I feel
In my stomach is butterflies
The beautiful kind, makin’ up for lost time
Takin’ flight, makin’ me feel right
.
.
.
All I know since yesterday
Is everything has changed

		
	

			 
		
	 

		  
	
		
			
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			Disclaimer 
This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Information has been obtained from sources believed to be reliable. However, neither its accuracy and completeness, nor the opinions based thereon are guaranteed. Opinions and estimates constitute our judgement as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This information is directed at accredited investors and institutional investors only.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

The post Everything Has Changed appeared first on River Valley Asset Management.

  
	
		
			
				
	
		
			The last issue on anybody’s mind after having lived through a decade of deflation and now facing an unprecedented economic shock induced by the coronavirus, would be the return of inflation. But then we have been living through extraordinary times. Markets have yet to come to grips with new paradigms and phenomena brought about by unorthodox central bank policies: rather than sticking to their traditional “lender of last resort” role, central banks now act to stabilize financial markets at the first whiff of economic trouble. The liquidity sloshing around is creating interesting cocktail circuit buzz, like the recent episode of retail investors using Reddit message board Wallstreetbets to take on deep-pocketed hedge fund shorts on Gamestop using Robinhood accounts; the saga has been copiously documented in the press as a tale of David versus Goliath, “revenge of the small investor”, etc. Instead of getting caught up in bubble speculations, we look this month at opportunities and challenges brought about by the liquidity-induced boom we are currently seeing in commodity prices and the risk of it being a harbinger of structural inflation.
Last month&#8217;s newsletter outlined the path to a $100 trillion global economy. Our guest author postulated there that the global deflator (inflation proxy in GDP data) could stay elevated in the 2-4% range for the next few years, driven by stimulative fiscal and monetary policy by most of the large world economies. This month we elaborate more on the drivers of this inflationary phenomenon and how to position investments to benefit from them.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			Inflationary Risks
Inflation is a measure of the rate of increase in prices of goods and services in an economy. It can occur due to cost-push factors like increase in cost of production or demand-pull factors like the willingness of consumers to pay more. Many times, a combination of circumstances can lead to an imbalance in demand-supply, leading to dislocation and to market participants adjusting prices to reflect underlying trends. The coronavirus shock was initially seen as a deflationary force impacting demand across sectors, but the rapid fiscal and monetary intervention in every major economy in the world has supported income and asset prices, resulting in a quick recovery of demand. On the other hand, in the near-term, the supply side of economic activity continues to remain disrupted, either due to prolonged lockdown in many regions of the world or due to trade disruption caused by pandemic measures. From a longer-term perspective, we are seeing champions of protectionism gaining the upper hand in most economies: policy makers, having learnt lessons from critical equipment shortages during the heights of the crisis in 2020, are trying to build local capabilities not only to satisfy basic demand and but also to protect local jobs impacted by the coronavirus dislocation. Globalization, which was a deflationary force for the last couple of decades, seems to be in retreat.
The liquidity boost from ultra-loose monetary policies across most of the major economies is driving speculation in not only asset prices but has also spilled over to commodities at a time when supply disruptions are tightening the demand-supply equilibrium. Over 2021, we are likely to see this drive price increases for consumer goods, as strong demand gives enough justification for producers to pass through cost increases.
Monetary Boost
Milton Friedman, the Nobel Prize winning economist, made the oft-quoted proposition: “Inflation is always and everywhere a monetary phenomenon”. After a couple of decades of stable inflation, the simultaneous monetary stimulus unleashed by the central banks of large economies (the U.S., Europe and Japan), to tackle the fallout of the coronavirus pandemic is going to retest the hypothesis. In conventional times, the two mechanisms through which monetary policy potentially affects inflation are through narrowing the output gap and through raising inflation expectations. Compared to underlying economic activity, money supply in most economies in the world today is in an overshoot, thereby boosting demand. On the other hand, normal supply has been disrupted by uncoordinated lockdowns in various countries. This has resulted in a distortion in the short run equilibrium. To the extent that it is transient, the flow through impact on prices and inflation will be short term. The charts below show the trend in money supply and inflation in the U.S.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			The chart on the left above tracks the long term (5 year) trend in money supply relative to economic activity and inflation. The ballooning of M2 in the U.S., the largest economy in the world, over the last nine months is unprecedented not only in the short term but also when one looks at long term trends. The chart on the right above shows inflationary pressures building up in the U.S. as manufacturing prices react to quickly normalizing demand as well as increases from rising input costs induced by supply disruptions. The rapid pace of money supply growth over the last year can be gathered from the chart on the left below while the chart on the right below shows how inflationary expectations, which fell in the wake of the pandemic, are quickly moving back up, reflecting the loose monetary conditions.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			The boost from low rates and loose monetary policy is leading to speculative rallies in not just asset markets but seems to be spilling over to commodities, which can start a self-reinforcing inflationary spiral as rising input costs boost prices in a period where demand has recovered, helped by fiscal income support measures, way above the equilibrium rate justified by level of wages and economic activity.
Commodity Rally
Commodity prices have been on a tear since the middle of last year. What started with an early recovery in activity in China, as its economy normalized from COVID-19-induced lockdowns, continued as demand picked up momentum in most parts of the world, helped by government fiscal support measures. With supply struggling to catch up with demand due to restrictions in movement in many parts of the world, the tightening demand-supply dynamics have attracted speculative capital into the commodity space. Price increases have been seen across board whether in soft agricultural commodities or hard economically-sensitive products like metals and oil (see chart below). In many cases, prices currently are running way above previous cyclical highs, even though global GDP is still significantly below levels of activity seen just before the onset of the pandemic.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			The global liquidity boost to asset prices makes one cautious about extrapolating current trends, especially as near-term prices continue to be supported by supply bottlenecks which could abate as economies open up once a large part of the vulnerable population is vaccinated. On the other hand, there are reasons to worry about long term supply, as commodity sectors have seen a structural decline in capital spending since the middle of the last decade. The chart above shows the falling investment spending trends across two large segments of commodity industries: energy and mining.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			Companies operating in these industries have been under pressure from ESG-aware investors to become better corporate citizens by focusing on the outcome of their activities and improving governance, in addition to improving shareholder returns in a declining commodity price environment. Consequently, even before COVID-19, there were arguments being made that we could see a supply shortfall due to insufficient investments to satisfy the long-term trend of rising demand. A strong recovery in global GDP in 2021/2022, on the back of government support programs, could see the current tight supply-demand situation continue for a longer-than-expected period.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			Before we consider ‘higher for longer’ commodity scenarios, we should touch a bit on the inflationary implications of a commodity rally. The chart alongside shows the historic correlation between GSCI commodity index and US CPI inflation. Going by past experience, it is likely that we will be seeing a passthrough of the recent rally in commodity prices into inflation. The magnitude of rise is likely to depend on the longevity of the current rally. If prices sustain at current levels without coming off, past data would suggest a rise in inflationary expectations to the 2-4% range. A commodity super cycle, which is not a current market expectation, could take inflation a lot higher and, to that extent, we think it is worth exploring the case for a prolonged commodity price rally.

		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			Super Cycle Thesis
One of the side-effects of the pandemic has been rising awareness of environmental and social issues, which is reflected in the greater acceptance of ESG frameworks not just among investors but also among individuals. The election of Biden as the U.S. president has brought “climate change” back to the centre stage of U.S. policy making, after four years of assault by the Trump presidency. The re-entry of the U.S. into the Paris Agreement gives greater heft to the global pledge for a carbon neutral world by 2050, which till recently seemed a purely European project. The real-world implication of the climate neutrality pledge is a rising demand for investment across a whole host of environment-friendly technologies, whether they be new sources of energy, or cleaner forms of transportation, efficient buildings, higher recycling, etc.

		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			The world not only needs to change current patterns of consumption but also needs to invest to ensure society can continue with its current level of progress using alternate technologies. Goldman Sachs’ Carbonomics study estimates that the world will need to invest $16tr on capex over the coming decade to achieve its environmental pledge. The chart alongside shows that this level of incremental capex intensity is akin to periods of previous “commodity super-cycles”, the most recent one being driven by BRIC’s boom in the 2000’s. The key driver of this is higher intensity: investing in green infrastructure is 1.5 to 3x more capital- and job-intensive than investment in a unit of traditional energy source.
A lot will depend on economic policies adopted globally in a post-COVID-19 world. As activity normalizes, if governments start withdrawing stimulus measures, we could see a quick cooling off of the current tight supply-demand conditions. On the other hand, many observers make the argument that it is going to be difficult for politicians to step back from stimulus in an era where redistribution is increasingly becoming the mainstream political narrative due to widening income and wealth disparity.
A stimulative demand situation in a tight supply environment, with rising demand for investments into newer technologies to meet the climate pledge, can set the world up for the next commodity super cycle. Only time will tell the outcome of various competing factors which interact to deliver the final commodity prices which will impact all our lives. Irrespective of how the world ends up, we continue to see plenty of opportunities to invest in Asia.

		
	

			 
		
	 

		  
	
		
			
				
	
		
			Impact on Asia
In our November 2020 monthly The Resurgence of Asia, we looked at not only the benefits of handling the coronavirus pandemic better but also commented on the flow through benefits of the emerging global liquidity surge. The chart alongside shows how strong money supply growth telegraphs a rapid real GDP growth over 2021-22 in Asia ex-Japan.
Not only is Asia in a better position to benefit from post-COVID-19 global growth recovery, but the commodity boom which we highlighted earlier in this piece also has significant economic benefits for parts of South-east Asia like Indonesia and Thailand where a significant portion of the rural population depends on soft commodities to earn a livelihood. Historically, we have seen consumption booms in these countries during periods of elevated commodity prices.

		
	

			 
		
	 

	
		
			
				
			 
		
	 

		  
	
		
			
				
	
		
			As market participants we cannot be immune to the bull market frenzy going on in certain parts of the marketplace. It naturally raises questions of “what if the bubble bursts”. To the extent one is not involved in those parts, it is not relevant, though as we have stated many times in past write ups, it will create volatility which as professional investors we need to navigate. But every episode of volatility also leaves behind in its wake a plethora of opportunities. An astute investor is one who is aware, willing, and able to grab them.

		
	

			 
		
	 

		  
	
		
			
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			Disclaimer 
This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Information has been obtained from sources believed to be reliable. However, neither its accuracy and completeness, nor the opinions based thereon are guaranteed. Opinions and estimates constitute our judgement as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This information is directed at accredited investors and institutional investors only.

		
	

			 
		
	 

		  
	
		
			
				
			 
		
	 

The post Commodities Signal the Inflexion of Inflation appeared first on River Valley Asset Management.

Commodities Signal the Inflexion of Inflation