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Wall of worry for reflation rebuilt

By 13 July 2021August 7th, 2022Commentary3 min read
  • The wall of worry for reflation and value appears rebuilt.
  • Whilst absolute returns for indices have been contained recently, relative returns have not.
  • The magnitude of relative sector dispersion in Europe over the last 6 weeks has been identical to the 6 weeks prior to the March 2020 pandemic low.
  • This has reset expectations and valuations in our favoured companies to attractive levels, likely setting the scene for a stronger second half for value equities in Europe.

Whilst bond yields have declined, inflation expectations have moved less. In Europe inflation expectations have barely budged. Below we show the Five Year, Five Year Euro Inflation Swap. This is an indicator commonly used by central banks to assess the market’s future inflation expectations. There is no deflationary growth scare to be seen in Europe as of now.

This means that European real yields are now deeply negative, close to -2%, and in line with the record lows seen in recent years.

This decline in real yields has given extra oxygen to highly valued securities. But for expensive securities to keep outperforming, yields – both nominal and real – need to keep declining. For yields to go lower, bond market investors need to accept larger real losses than 2% per year. Whilst this is not impossible with quantitative easing dominating volumes, bond market investors will be required to envisage a truly pessimistic scenario for nominal GDP to justify these valuations. Our judgement remains there is an asymmetry in the long term risk profile here, with stable or higher yields more likely than lower yields. This outlook ought to support our positioning.

There is also a self-limiting element to the yield decline. Lower yields have enabled an easing of financial conditions, and perhaps a delay in Fed tightening. This ought to reduce the probability of an economic slowdown, extend the runway of the current expansion and underwrite cyclical earnings growth.

There are also investor concerns about peak stimulus. But the scale of growth in private sector deposits over the last 18 months is so large, that the positive stimulus effect will be extended over a long period as these excess savings re-enter the economy. Below we show European Private Sector Deposits in Euro trillions since 2000. Typically, private sector deposits grow in the Eurozone by €200-€400bn per year – but over the last year deposits jumped €1.1tn. This 12% year-over-year growth takes EU Private Sector Deposits close to €12tn, or over $14tn.

In the US the picture is even more extreme. US bank deposits typically rise by $500bn per year. But over the last year deposits rose by six times the normal rate, by a staggering $3tn, taking total system deposits to $17tn.

The scale of these excess savings both in Europe and in the US will help underwrite this recovery. Inventories across supply chains remain low, lead times remain long. The outlook for cyclical earnings growth remains solid. The recent dip in bond yields will act to stimulate the recovery further. The dispersion in returns in recent weeks likely provides an attractive entry point for European value equities and an attractive exit point for expensive securities. We remain optimistic about the absolute and relative returns for the LF Lightman European Fund in 2021.

Lightman – July 2021