Despite a 60% rally in stocks since the March low, analysts at JP Morgan continue their unwavering support of the recovery trade. Among the trades they are becoming increasingly fond of is the reflation trade – short cash while long fixed income and equities. It is interesting to note that cash has now become a very painful position after nearly 12 months of outperformance. Cash is now underperforming every asset in the investment world and while it may be providing investors with some level of comfort it is not providing you with any real returns. In JP Morgan’s opinion this has a great deal to do with the outperformance in many asset classes.
The recovery trade is still there, but the asset reflation trade is starting to grab more attention. Under the asset reflation trade, one is short cash and long both equities and fixed income (especially credit).
• Fixed Income: Move to overall short duration, through
short end of Europe.
• Equities: Stay overweight Cyclical sectors.
• Credit: Overweight US HG as valuations remain
attractive, demand is strong, and corporate fundamentals
• Fx: The strongest currencies this year (AUD, NOK,
BRL) have a lot further to run as policy gaps widen.
• Alternatives: Hedge fund inflows remained mildly
positive in August, but likely to accelerate in Q4.
All assets are rallying. That is great news, but if we are in a recovery trade, are bonds not supposed to be going down? They are rallying instead, despite massive supply. Isn’t a rally in government debt supposed to be a sign of a flight to quality in the face of rising economic risks? Yes, and yes should be our answers, if the recovery trade were the only force driving markets. As we have been arguing here, a more powerful force that is grabbing attention away from the pure recovery trade is the asset reflation trade, or the pain of earning no return on cash in a world where all assets are beating cash and uncertainty is receding. Raising cash holdings is the right strategy during times of high uncertainty, in our view. We have updated our data sources and find that cash holdings remain 0.7 percentage points above their 20-year average share of 30%. Hence, the global investor remains overweight cash.
We continue to see strong flows out of money market funds. The lion share of these outflows are headed to fixed income. YTD, some $4.5 trillion of bonds have been issued, net of redemptions. By any standard, this should have hurt bond prices. But we find that the average price of these bonds has risen 3% YTD, and the yield is down half a percent to 3.25%. Demand for bonds this year must thus have exceeded $4.5 trillion. Our chart shows that bond holdings are now at their highest share in 20 years.
At what point will investors have their fill of bonds and start moving more into equities? The answer is that we do not know. If strategic benchmarks have not changed, then the move from cash to bonds is just an interim stage in portfolio re-risking, towards the eventual move into equities when the recession is truly behind us. But there are signs that some end investors have soured on the equity asset class. Retail and HNW investors are showing little appetite to get back into equities. And a number of US and European defined benefit pension funds have lowered their equity benchmarks in favor of bonds and alternatives. It may be too early to declare the equity culture dead, but it is clearly under threat. We remain long equities versus cash, but are on the lookout for stronger signs of an erosion of equity benchmarks.
The asset reflation trade implies one should be short cash and long all other assets, including the overall fixed income asset class. As a strategy team, we have problems applying this to government bonds, though. Our world portfolio above shows that global investors are most long in government bonds and less so in spread product (largely credit). We continue to see strong demand for corporate bonds, including from pension funds whose liabilities are discounted by corporate yields. Corporates and banks have net issued $1.5 trillion YTD. They have used much of this to strengthen their balance sheets, reducing shorter-dated debt and raise cash holdings, which has been a very negative carry trade. We thus expect issuance to fall dramatically, while demand stays strong. We thus stay long credit.
Source: JP Morgan
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.