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There are certain debates that are somewhat ever-present in the world of finance. Two that will immediately spring to the mind of most investors would be active vs passive, and value vs growth. These debates, or iterations thereof, have evolved not least in part due to the very public ‘fintwit’ (financial Twitter) arena in which they are now conducted. Twitter undoubtedly brings out the absolute worst in ‘debate’ as only an echo chamber that encourages all of the fallibilities of human psychology can, but it has also likely continued to bring the debate to the forefront for a greater number of investors’ minds.

In late 2018 passive investing in US domestic equity overtook active, and has continued to grow that lead since, with its market share now standing at 54%:

Source: Bloomberg, Fortem Capital

The main driver of this has been investors’ preference for funds that track the S&P 500, and the evidence would suggest that they would be right:

S&P Indices versus Active (SPIVA) scorecards are reports published by S&P Dow Jones that compare the performance of active funds against their benchmarks; they make fairly sobering reading for active equity investment. Unsurprisingly it is the US where active managers struggle most; it is widely accepted that the US large cap equity market is the most efficient in the world, and so would be the most sensible place for passive to dominate first, as it has. The numbers back this up.

Market conditions in 2020 were what most active managers were suggesting were needed for the ‘dumb’ money to look just that. However, in spite of the numerous opportunities for outperformance that the pandemic should theoretically have provided, 57% of domestic US equity funds underperformed the S&P Composite 1500 index in the year, the 11th consecutive year of active underperformance. Larger sample sizes make for even worse reading; in good times as well as bad, active management has consistently underperformed in the US:

Source: SPIVA 2021, Active Funds vs Benchmarks, US Equity (01/01/2001 – 31/12/2020)

To many readers, the above will be nothing new, and indeed the rise in passive investing in US equity is testament to this.

In addition, the major US benchmark index has also enjoyed significant outperformance versus its global peers, driven largely by the heavy weighting to disruptive technology stocks that have become global behemoths (to a staggering extent noted at the end of this piece).  For investors looking at fundamentals, for years the technology heavy S&P 500 has provided the growth that has been lacking in the global economy as a whole; while growth is hard to come by, investors are happy to pay a heavy premium for it. And in the absence of significant productivity growth, it may well be the case that the world’s major domestic benchmark equity index continues to outperform.

For investors in need of income, this has for some time posed a problem, especially given the meagre yields now available from even the riskiest part of the bond market.

The US equity market has relatively low dividend yields versus its UK and European peers:

Multiple expansion has been the primary driver of returns; investors have paid up for growth where it has existed:

As a result, income mandates have either tended to be structurally underweight US equity due to the low level of income available on the benchmark index, or invest in active funds that target higher dividend paying companies in the US market. And therefore they have tended to underperform substantially.

Higher dividend companies are sometimes assumed to be lower risk due to the history of a high dividend imputing financial discipline. However, in the era of free money, US corporates have used leverage to fund share buybacks and dividends; the higher dividend payers are in the parts of the market with poorer quality balance sheets.

As dividends are often not covered by free cashflow, dividend cuts are highly likely in the event of a downturn / recession. During the Global Financial Crisis, few high dividend paying stocks in the US maintained their dividend, and the S&P High Dividend index underperformed the main benchmark index significantly.

Call selling has been used as a solution in order to maintain exposure to the S&P with an enhanced yield. However, with the Fed’s unprecedented intervention into the market suppressing volatility and therefore option prices, the risk of those calls expiring in the money is on average not compensated by the premium raised; traditional naked call selling bleeds heavily in a bull market, and covered call selling locks in underperformance in a bull market.

However, there is a way one can deliver significant income, gross of withholding tax, while tracking the major US benchmark index, allowing income investors and mandates to have a weighting more akin to other clients and mandates of similar risk profile, whilst not eschewing naturally derived and taxed income in order to do so. It requires significant derivative expertise which allows a certain level of financial alchemy.

In May 2021 Fortem Capital launched a Fund looking to do just that, and it is.

Over a longer period, whilst usual caveats associated with backtests apply, derivatives do give defined payoffs dependent on moves in the underlying:

Income investors have become used to compromising where the benchmark US equity index is concerned. In order to maintain a weight commensurate with non-income investors of the same risk profile, they have typically had to either compromise on overall income, or take more risk elsewhere in order to make up the difference, something that has become increasingly risky and difficult as yields and credit spreads have fallen to record lows.

The fact  that Apple, Alphabet, Amazon and Facebook are together worth more than the entire Japanese stock market (>$7trn), Apple and Facebook are together worth more than the FTSE, and Amazon is bigger than the DAX on its own, means that any investor that needs to compromise their exposure to these names is taking a risk in of itself, and has likely suffered as a result to date. Whilst it is impossible to tell whether the phenomenal growth that these names and the S&P have enjoyed continues into perpetuity in relative terms, in a low growth environment any companies that do provide meaningful growth are likely to continue to command a premium for it, and with 54% of the market investing passively and growing, the risk of income investors being left further behind is real.

The Fortem Capital US Equity Income Fund allows income investors, or even those in search of a yield pick up without adding duration and credit risk in the fixed income space, to not have to compromise; the Fund aims to track the S&P 500 TR net, whilst providing a dividend yield of 4%.

The Fund launched in May 2021 and is doing exactly that.

To learn more about accessing individual strategies or Fortem Capital funds:

T 020 8050 2900 E sales@fortemcapital.com

Disclaimer

Inflation has captivated investors in 2021 as, for the first time in more than a generation, what was previously a conspiracy theory purported by crackpot economists has re-emerged. In June 2020, the likelihood of this inflationary burst occurring was discussed in Definitely Maybe Heading for an Inflation Supernova. Whether the current, stubbornly non-transitory, spike is indeed the beginning of a secular supernova remains to be seen, but the probability of such a scenario has undoubtedly increased over the past 12 months.

Inflationary concerns have brought yield curves of government bonds into focus. It is arguably clear that most market participants have never had genuine inflation to contend with, given the erratic moves being seen in the market currently. Of particular interest to investors is the US Treasury Yield Curve which, because of the underlying market’s sheer size, tends to drag others with it.

The US Treasury Yield Curve

The Federal Government funds its obligations by virtue of Treasury-issued debt. This debt is spread across maturities; short term bills (3m – 1y), medium term notes (2y – 10y), and long-term bonds (20y – 30y). The curve plots the current yield at the various maturities and the shape of the curve gives an indication of expectations about future monetary policy as well as economic growth.

Liquidity Preference Theory states that the curve is typically upward sloping due to investors demanding a premium for the relative illiquidity of longer-term maturities. Typically, an inverted curve has been seen by investors as a horseman of an impending recession; the 2s10s spread turning negative (2-year yield higher than 10-year yield) has had a particularly good predictive record.

Erratic Curve Shifts

Recent weeks have seen severe flattening across yield curves. Unusually, it has been some of the smaller government bond markets leading the US, as hawkish moves and tones from the likes of the UK, Australia and Canada have dragged short term rates higher, in spite of the Federal Reserve’s insistence that inflation is transitory and that an aggressive hiking cycle will not be needed. Of equal note is the softening at longer maturities as investors price in lower growth in the coming years. There were some well documented casualties amongst hedge funds employing the popular ‘steepener’ trade, and their forced liquidations exacerbated the flattening.

Source: Fortem Capital, Bloomberg

The Treasury market is taking the Fed’s transitory inflation narrative at face value. Pre-GFC, investors required a healthy premium in the 5-year yield against CPI. Since then, it has more or less tracked CPI, the exception being when the market correctly predicted that the deflation brought about by the oil price crash in 2014/15 would prove transitory; yields did not move in spite of CPI’s dip. This year the market is similarly predicting that inflation will prove transitory, the difference being that while in 2015 investors were rewarded in real terms (yields were above inflation), this time the real yields have turned highly negative:

Source: Fortem Capital, Bloomberg

The burning question is whether the yield curve is correctly priced.

One might argue from here that if inflation does soften in the coming months and proves transitory, the front of the curve has priced in too much in terms of hikes; curves steepen led by the front end coming back down. Or, if it is more secular, then the front of the curve is correct, and the back end catches up; curves steepen driven by the back end rising.

What Next For Inflation

One of the major transitory arguments of ‘base effects’; the fact that year-on-year numbers were, at the beginning of the year, referencing a severe deflationary shock, has been revised as high prints have continued to come. Another argument, particularly with regards to commodities, was the replenishment of reserves that were depleted in the aftermath of the crisis. However, commodity price rises have proved similarly stubborn, and reserves are not yet fully replenished. Some of this is down to supply chain issues, but the structural vulnerability of supply chains that has been shown is in itself inflationary.

Other things to note, as have been noted here previously, are the world’s changing demographics, namely an ageing population. In addition, increasingly progressive mandates of governments around the world, particularly with regards to green policy and reducing inequality. In the case of the US, spending plans are akin to wartime, including infrastructure, the green transition, and direct injections of cash into the real economy through stimulus cheques.

The debate around whether inflation is transitory will continue to rage, possibly for long enough that one might question whether a reasonable definition of how long transitory is has passed. One simply cannot come down on one side or the other with complete confidence. However, the probability ascribed to stickier secular inflation must have changed given the seismic policy response and fundamental shift of the past 18 months.

SUPPLY & Demand

Aside from the inflation argument, investors are potentially looking through an important supply side factor in the US Treasury market; increasing net supply, and where that supply is occurring in maturity terms. Average net issuance of short-term bills since June 2020 has been -$76bn whereas in terms of longer dated notes and bonds the number is +$210bn. It was always likely that issuance would move to longer dated maturities, it is relatively more stable debt. Longer dated issuance also serves as a neat hedge against policymakers’ own assumptions about the transitory nature of the inflation – it is for readers to make their own minds up whether anything should be read into the fact that issuance of TIPS has come down significantly, whilst the Fed’s own TIPS holdings have trebled; perhaps they are not as confident on inflation’s transitory nature as they say…

Whether they are right or wrong, the wall of treasuries that are needed to fund the Biden administration’s spending plans, coupled with the potential for $80bn per month of purchases through QE to be tapered off, may mean that longer term yields must rise materially for purely structural reasons.

These structural factors, coupled with the potential for a generally less favourable mix of growth and inflation, and whatever macroeconomic headwinds and shocks are bubbling below the surface, are likely to mean that the goldilocks regime for the traditional 60/40 portfolio is less likely to be repeated. The price risk for yields looks to be firmly to the upside, and therefore for bonds to the downside (yields and bond prices move inversely).

The global economy finds itself in the midst of the greatest monetary and fiscal experiment in its modern history; this time genuinely is different. Whether it plays out in a way that is detrimental to traditional asset allocations remains to be seen, but the risk of it doing so must be something investors consider as policy looks to be entering a new cycle.

Disclaimer

The horrors of World War II heralded a global order centred around three central tenets:

•  Equal sovereignty of states

•  Internal competence for domestic jurisdiction

•  Territorial preservation of existing
boundaries

It is very recent history in which invasions and empire building were par for the course. Much of the world’s progress and prosperity over the past 70 years has been built on globalisation made possible by the underlying assumption that threats to territorial integrity were largely consigned to the past.

Civil wars, unfortunately, were considered to fall under the realm of self-determination and so have persisted all too frequently, often to the devastation of those caught in them.

The above assumptions have allowed global citizens to benefit from a ‘peace dividend’ as countries’ spending on defence as a proportion of GDP has fallen dramatically and allowed for higher spend on education, healthcare and other public services.

Wladimir Putin’s invasion of Ukraine has cast doubt over these assumptions, cast doubt over the very framework on which the international community is built, and thus has incurred an international reaction not seen since the Second World War.

The invasion of Ukraine, and just as importantly the reaction to it, has seismicramifications for the global order as it is currently understood.

Those ramifications will become better understood in the years to come, but one area of focus is the role of the US dollar as the global reserve currency. It is not news that the monetary hegemony that the US has enjoyed for decades has been gradually declining; the USD share of global FX reserves has already fallen from above 70% to below 60% in the past 20 years, but events this year may have put the final nail in the dollar’s coffin on the global stage, however gradual that death is.

Source: IMF, Fortem Capital

To understand this, one has to first take a trip through economic history to see how the USD first achieved its status.

Bretton Woods

At the end of WWII, there was a requirement for a new global monetary system. Two proposals were put forward, one by John Maynard Keynes, and the other a more USD centric idea.

Keynes argued that there would be a basket of commodities, Bancor, that would be a neutral reserve asset designed to settle trade between nations. Any creditor nation, which sold more than it bought, would run a Bancor surplus, which it would sell to buy its own currency; currency strengthens. A nation in deficit would need to sell their own currency to buy Bancor to settle trades; currency weakens. This in effect would have been self regulation of currencies relative to the deficits that their nations ran.

Harry Dexter White, Chief International Economist of the US Treasury, put forward a proposal with the dollar at the centre, pegged to gold, and other currencies pegged to the dollar.

An iteration of the second proposal was adopted and the Bretton Woods System was born, with the dollar pegged to gold, and became operational in 1958.

The Death of Bretton Woods and the Birth of the Petrodollar

The US encountered a problem in the late 50s and 60s as Europe and Japan woke from their slumber, ran surpluses, and drained America of the gold reserves it had built.

In 1971, with US inflation nearing 6% and growth falling (sound familiar?), Nixon shocked the world by abruptly breaking the link between the dollar and gold; the current era of fiat currency was entered into. Perhaps what was to transpire some years later was best surmised by John ‘Typhoon’ Connelly, the US Treasury Secretary at the time, who explained to his counterparts at the Rome G10 Summit of 1971 that ‘the dollar is our currency, but it’s your problem.’

The system entered a fairly chaotic time, but the 1973 oil crisis presented the US with an opportunity; Henry Kissinger proposed that Saudi, and therefore OPEC, would only take dollars for their oil in exchange for military security guarantees. This meant that all of the world’s net energy importers would need dollars to buy their oil, an almost insatiable demand, and would allow the US to run ever increasing deficits without the devaluation of its currency. The US dollar/ petrodollar became the world’s global reserve currency; the US was very much having its cake and eating it.

The Global Economic Custodians 1974 – 2005

With great power comes great responsibility.

Now that the price of oil was effectively pegged to the dollar, the dollar needed to be managed for the world rather than just America, which was now effectively in charge of global inflation.

This was never more apparent than in 1979 at an IMF meeting in Yugoslavia. Oil had spiked to $140 in today’s money; nations paying for their oil in dollars (everybody) were hurting. Paul Volcker, the Fed Chair, was told in no uncertain terms by the US’ creditors (everybody) that they expected the US to act. Volcker took interest rates to 15%, to the detriment of the US economy which entered recession, but effectively saving the dollar oil-price-dependent global economy.

The US behaved as the custodians of the global reserve currency might be expected to.

Oil went through a period of relative stability until 2005 when the global economic boom, epitomised by the rise of the oil hungry Chinese manufacturing behemoth, meant that oil rose, and kept going, in dollar terms.

The First Nail in the Coffin

A combination of oil hungry developing economies, tensions in the Middle East and muted production caused oil prices to spike heavily from 2005-2008, peaking at $140. Again, energy importers were hurting at a time when economic growth was also slowing.

The US once more had a choice, Ben Bernanke this time rather than Paul Volcker. His problem was that the spike in oil prices coincided with a deepening sub-prime mortgage crisis in the US. Would he raise rates and act as the global economic custodian, or cut them to save the domestic US economy?

Readers will be aware of what transpired. Volcker managed the dollar as the global reserve currency, Bernanke as America’s domestic currency.

China in particular, as the worlds major importer of oil, was particularly badly affected by the high prices. For any autocracy, the main risk to the regime is civil unrest, and there is nothing like a serious bout of inflation to increase the likelihood of it (sound familiar?).

China made noises about preferring a system that sounded much like Keynes’.

From there, there have been numerous statements from different sources about the potential need for change to the petrodollar system, but a very slow move away.

The Final Act

The fact that the US, in the eyes of those needing to hold huge amounts of treasuries in order to pay for their oil, could not be relied upon to act in the interests of the global economy over the US economy had precipitated explorations along other avenues, particularly in the case of China and Russia. One only has to look at their holdings in US Treasuries to see that change was afoot. With regards to Russia, the writing has been on the wall with regards to the invasion for some time in hindsight:

Putin has clearly made a number of miscalculations with the decision to invade Ukraine.

Firstly, in his nostalgia for the former Soviet Union, he was told and believed that the Russian tanks would be greeted with flowers being flung from pavements lined with Russian flags being waved by the people of a ‘country’ that longed to be returned to the bosom of Mother Russia.

Secondly, perhaps as a result of the culture wars that are tearing the western world apart, he did not think that any coordinated policy response was likely from a fractured West. The annexation of Crimea in 2014 undoubtedly played a role in this assumption. He would have at least banked on Europe’s reliance on Russian energy to mean sweeping sanctions were unlikely.

However, the response has been swift and severe, with none more major (and possibly surprising) than the freezing of Russia’s FX reserves. It cannot be overstated how seismic a move this was, effectively it is the US and Europe defaulting on their obligations to Russia.

It is certainly not for this publication to argue as to whether it was the right thing to do, but the freezing of Russia’s foreign reserves is likely to permanently alter the way in which the international community thinks of reserve assets. This time it was the invasion of a sovereign  nation which gave cause for the West to tell Russia that their dollars, euros & pounds were worthless. For other nations that rely on foreign reserves there will now be a question as to whether failing to meet emissions standards, having a questionable human rights record etc might lead to similar sanctions in the future; it is a risk some will be unwilling to stomach.

China introduced yuan-priced oil contracts in 2018 to facilitate a move away from the petrodollar, but to little avail. However, the Wall Street Journal suggested in March that Saudi Arabia were considering allowing China, who buy 25% of the oil that Saudi exports, to pay for it in yuan as well as including yuan-denominated futures contracts (petroyuan) in Aramco’s pricing model. It is no coincidence that China’s courtship of Saudi has accelerated at the same time as relations between the Kingdom and the Biden regime have become more strained.

Conclusion

For decades investors, and indeed humans generally speaking, have been blessed to live in a world that has been largely peaceful, at least by historic standards, and incredibly prosperous. Low rates have been accompanied by low inflation, and globalisation has brought an economic connectivity that would have previously been scarcely believable. The financialisation of assets has been a seemingly irreversible juggernaut.

Until now.

Events this year have turned the financial and geopolitical world on its head. The ramifications of this are likely to be felt for years to come. An inflationary war has heaped fuel onto an inflationary fire that was already burning brightly.

In the more immediate future, there is an administration in the US that plans record fiscal spending at the same time as its own central bank attempts to begin to shrink its own grossly inflated balance sheet. The US needs external buyers of treasuries in order to fund that spending, it may be on the way to losing foreign buyers that it currently relies on.

The idea that an empire can end tends to be inconceivable to those living through its crescendo. Investors would do well to remember that there were many empires that came before the current American one; they all eventually fell.

Disclaimer