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STATE OF AFFAIRS
The pandemic has become a catalyst lifting the prominence of the Italian-American economist Mariana Mazzucato to new heights. The economic and societal recipes described across her acclaimed theories reflected in the best-selling “Entrepreneurial State: Debunking Public vs. Private Sector Myths”, “The Value of everything” and her latest “Mission Economy” essentially upgrade the role of government in general and the impact of public investment and innovation specifically. Mazzucato delivers a harsh critical reading on the concepts of value creation and value extraction. She ponders that the financialization that occurred over the past 50 years has shifted the financial sector from a supporting role in the allocation of capital towards a value-creating sector. On the contrary she points out that the financial sector is rent-seeking at its base, generating income without producing inclusive and just value through new goods and services. Moreover, she states that the narrative of the unproductiveness of government has been caricaturized notwithstanding that most innovative progress was rooted in public funding. Essentially Cold War military funding enabled the birth of the internet and the technological revolution that ensued. She promotes the idea that the state has the capacity to engage in transformational measures and planning whilst at the same time defining a correct definition of value. The word value has been captured through the lens of price discovery and competitive forces and taken hostage by the financial sector redefining value in terms of (maximizing) shareholder value, value chains, adding value. Value only determined by the price dynamic as result of scarcity and preferences. In “Mission Economy”, dedicated to all who fight for the common good, redefining public policy with an objective to redirect growth becomes a key ambition. In order to explore how to ‘do government’ differently, the Institute for Innovation and Public Purpose has become a platform attracting ideas and visions across global issues related to climate, health and digitalization. Governments should claim more leadership by setting common, inspiring and daring goals. Successful public-private partnerships can be established and designed in order to benefit the public interest. Mazzucato stands for rethinking capitalism and government. Now enters Hayek.
As a firm believer in the value of nuance I briefly want to touch upon the work of Friedrich Hayek, an Austrian-British economist and philosopher, defender of classical liberalism. In order to bring balance to the above proposition for more government leadership I draw the attention to the messages that Hayek delivered in his seminal work published in 1944: “The Road to Serfdom”. His critique was built on the argument that in a government-led system where challenges are addressed through a central plan replacing competitive market forces and the pricing mechanism, institutions must be established that would take care of formulating such plans. These institutions would have to exercise broad discretionary powers in economic policy. Lacking guidance from competitive profit-and-loss signals, he argued that people who rise to power in such a (socialist) regime might be prone to run the system to their own personal advantage. Hayek went as far as stating that totalitarianism is not a historical accident that emerges because of a poor choice of leaders under a socialist regime. Totalitarianism is the logical outcome of the institutional order of socialist planning. Essentially state-dominated transformations stifle the emergence of counterfactual outcomes and thinking. Visibility or knowledge of opportunity costs would disappear alongside competition. He was a firm believer in the rule of law, private property and contract and a fierce defender of free democracies. According to Hayek, complex systems are best served by leaving competitive market forces in place allowing for better learning (knowledge) and required (social) adjustments.
The purpose of the above confrontation is not about taking a stance. Merely I want to draw attention to the risk that unintended consequences might arise the moment a blind belief in the merit of broad-based government interventionism becomes the standard approach. We sense that in a post-pandemic era, new industrial policies, green deals and targeted protectionism might increase the systemic risk. On top of currently high uncertain conditions, additional sources of uncertainty are injected. Mazzucato does not hesitate to point fingers at, what in her view, are culprits. She blames the investment fund industry as feeding the financialization. The efforts and energy that the industry puts into redirecting savings towards governments and corporates backing UN Sustainability Development Goals is disregarded.
One of the main questions that remains unresolved is the process that underlies the implementation of strategic plans into successful ventures with highly inclusive societal value. Tinkering, trial and error or sheer luck define capitalism. We should remember that a lot of the public spending that supposedly was at the basis of gigantic entrepreneurial success and reward was not planned. How to regulate the monopolistic behaviour of technology, pharmaceutical or industrial giants is a question for another debate. Both debates should not be mixed up.
The FED meeting mid-week did not bring any surprise. As flagged, Chair Powell did stress that monetary policy would remain accommodative, allowing labour markets to recover not in quantity but also in quality. Inflation as a by-product of pro-cyclical FED policy is welcomed and not feared. Indeed, backed by the Flexible Average Inflation Targeting as official policy objective, we observe that the market has fully adopted that outcome. We are ready to have fully priced conditions that would call core year-on-year PCE inflation between 2.00% and 2.50% over the next three years at worst, beyond at best. The current 12-month average for core PCE inflation sits at 1.4%. Over January 2020 we pencilled in 1.7%. So inflation can hit 2.9% over 2021 in order for a three-year average to hit the 2.00% Fed objective. That also means that tapering of large-scale asset purchases is not on the agenda for 2021. Implicit yield curve control is working well. Ten-year and 30-year Treasury rates dropped by 1 and 2 basis points (bp) to 1.06% and 1.83%. Anxiety in equity markets temporarily pushed 10-year rates below 1.00%. This was short-lived as the battle between retail and professional market participants will be short as well.
Volatility in European Government Bond (EGB) markets spiked over the past week. Rates whipsawed as correlation with US rates pulled them lower only to end the week on a bad inflation surprise pushing 10-year German rates back towards the -50 bp support levels by now. By close of business, the benchmark German rate finished at -52 bp, unchanged over the week. German and Spanish CPI prints surprised, flipping into positive territory well above consensus. We can expect higher CPI volatility over the next quarters as temporary VAT cuts are rolled back and base effects propel inflation above 1.00%. Inflation-linked government bonds in the Eurozone continue to outperform. Value remains present. Performance-wise, EGBs printed a -0.74% performance result over January 2021.
Sounding like a broken record but European Investment Grade corporate bonds stand firm and resilient. Over the first month of 2021, they retreated 0.33%. European High Yield corporates eked out a small +0.15% result. Corporates with access to European public capital markets have little to worry about. Large EU companies enjoy a double wall of defence: the ECB corporate bond purchase program next to EU governments providing guarantees in size and length of time. However, the sensitivity of expected returns to changes in core government rates is elevated across both sectors. As always, when confronted with conditions of tight credit risk premia, managing credit portfolios becomes a complex equation. Decisions on issuer selection, on weightings across ratings and capital quality and overall rate and spread duration sensitivities become truly dominant.
Emerging markets posted small negative returns during the first month of 2021. Local currency spreads widened by 5 bp to 363 bp and hard currency spreads by 15 bp to 405 bp. Whilst Investment Grade paper has hardly moved or even managed to perform a bit, lower-rated paper, mostly single B, struggled.
Emerging market currencies (EMFX), when expressed in EUR, saw a small (+0.5%) positive return. Nigeria (+5.7%), Ukraine (+2.4%) and Ghana (+1.9%) were the clear winners, whereas Chile (-3.2%), Colombia (-2.5%) and Brazil (-2.2%) were the clear underperformers.
Best rate return was for Costa Rica, as it reached a staff-level agreement with the IMF. We believe current valuations are overly upbeat and as a result we do not share this optimism. Congressional approval is challenging in a country that is very complacent on debt levels. The country has a history of rejecting tax hikes. Amidst a slow recovery and ahead of the 2022 elections, fiscal austerity initiatives will not be high on the agenda.
Worst rate return was for Brazil as the government discusses proposals for more emergency aid. The looming risk of a breach of the ‘constitutional’ spending cap and market games played by the debt agency during last Thursday’s auction scared investors. Shortly before the auction, they changed the offered DV01, squeezing the market and inducing a rally. We believe this ‘unpredictable’ behaviour is extremely dangerous for an issuer that has a very challenging issue calendar for the year ahead.
For those who reflected on tapering and its potential impact on emerging markets valuations, the FED meeting was re-assuring. Our stance remains unchanged. Low rates, powerful monetary and fiscal stimulus will direct investors to emerging markets. Local currency debt will benefit from historical cheap EMFX valuations the moment synchronized growth will become visible. Also, we expect emerging market central banks with extremely negative real policy rates to start normalizing (Brazil, Czech Republic and Mozambique).
Financial markets are adjusting to the reality of a prolonged collaboration between fiscal and monetary policy makers. Above the short- and medium-term impact on valuations across market sectors, we observe a clear push towards higher government intervention. Without expressing a moral judgement on the quality and intensity of such transformative moments across economies and communities, we are aware of the pitfalls of extreme outcomes.
Pure and bare capitalism is not warranted, as it is leading to ballooning inequality and exhausting the planet’s resources. The moment the pendulum swings in favor of higher government intervention, presented as a better solution to address apparent deficits in capital allocation, vigilance is required.
The best we can hope for is that the quality of the democratic political process, the checks and balances so to speak, contains any deviant behaviour by leaders in power or ambitious leaders awaiting their moment to take power.