The long wave of the new FED’s mandate

• With the replacement of the inflation target (not 2% per annum but an average of 2% over the period), expectations of a rise in prices have grown

• First consequences: sale of long-term bonds, rise in yields, sales of equity with higher residual cashflow in their valuations (such as many Nasdaq companies)

• With the steepening of the curve, the use of bonds as a hedge instrument could return, putting an end to the long phase in which the two markets grew in parallel

• The progress of the vaccination plan also weighs on the investment choices. The sectors most penalized by the pandemic are once again interesting. The high valuations lay the foundations for sector consolidations

The new course of the Federal Reserve on inflation targeting begins to produce the expected effects. At the end of last August, the Fed announced the replacement of the benchmark: not 2% per annum but an average over the period of 2% (average inflation targeting).

Jerome Powell, Chairman, confirmed the Fed's accommodative stance until the goal of full employment is reached, suggesting that it can also go “temporarily” beyond 2% inflation for a certain period of time.

The line of the central bank, combined with the decisive signs of recovery of the American economy (and those, a little more contained, of Europe) has generated in the market the expectations of higher inflation, not hyper but certainly increasing, also fuelled by the large distance that today separates the US economy from full employment, which suggests that expansionary monetary policy will continue for a long time. There are two main causes for the distance from full employment: the growing automation and the acceleration in the decline of low-innovation businesses (zombie companies); inevitably it will take longer to relocate those who have been temporarily expelled from the market to other sectors. There is no shortage of different opinions though. Economic strategist David Zervos, for example, in predicting an economic explosion similar to that of the 1920s once the pandemic is tamed, pointed out that those were essentially deflationary, not inflationary years.

With the start of the new year, operators have nevertheless made the expectations of higher inflation their own, starting to translate them into behaviour. First consequence: the sale of long-term bonds. The price of gold also dropped which, in a still low but growing inflation scenario and almost zero interest rates, is in fact comparable to a bond with a negative carry and long duration.

The surge in the yield curve also led to the (slow) exit from the segments of the stock market with greater duration. Operators have begun to gradually get rid of shares with less predictable future cash flows (many of these are listed on Nasdaq).

Everything happened, for the moment, without trauma. The new trend has made it possible to absorb an anomalous situation: a market in which a fully priced asset such as American equity was matched by overpriced bonds due to the Fed's policy. An anomaly that has led many investors, including such as Simplify 02, to temporarily prefer the VIX as a hedge instrument and not long bonds, both in the United States and in Europe.

Eventually, the steepening of the curve could allow traditional managers (the 60/40 managers, so defined for the habit of allocating portfolios between 60% in bonds and 40% in shares) to return to using bonds as a natural hedge tool, a practice almost useles in the long phase in which the two markets grew in parallel. With the growth of the bond yield, this category of managers could allocate more capital to the stock, giving a further boost to equities.

In terms of investment choices, the consequences of inflationary expectations must be crossed with the effects of the vaccination plan.

In the United States, the United Kingdom and the countries of the European Union, the progress of vaccinations is giving wings to the prices of the sectors so far most penalized by the pandemic, creating the expectation of a return to normal (so-called "reopening trade"). In the early stage (mid-November), when Pfizer announced its vaccine, the market preference had understandably shifted to low cost short-haul airlines and the domestic hotel sector. As the vaccination plan advances, an area of growth could be that of long-haul airlines, airport management companies and sectors related to air transport such as, for example, aircraft components and maintenance or more "value" industrial sectors.

One last consideration to take into account when selecting the assets. The level reached by share prices lays the foundations for sector consolidation. This could happen more easily in sectors that, also following the scenario designed by Covid, will experience an epochal transformation, such as the insurance sector or the automotive sector. Simplify Partners 02's favourite titles today are Pirelli, Avio, Aviva, Centrica, Salvatore Ferragamo, Danone, Aston Martin, Porsche.

Feel free to contact the management team for information on the components of our portfolios and the motivation for our investment choices, for example why we prefer Porsche to Ferrari.

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