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Market Commentary

2nd quarter 2021

Reading time 10 minutes

  • Central banks were able to convince the markets that the current record inflation is only a temporary phenomenon: economic growth and inflation will cool off in the coming years
  • Interest rate at the long end recede, yield curve flattens
  • Equity markets reaches new historical high while risk indicator continue to decline
  • No change in central banks expansionary monetary policy over the coming 18 months
  • Governments get more concrete with their unprecedented spending plan

Central banks have won the battle over inflation expectations

In the last quarter, we experienced a rare combination of strong economic growth, rising inflation, and buoyant stock market. All this with no sign of a change in ultra-expansionary monetary policy and expansionary government spending policies. The latter have now moved from announcement (a core competence of politicians) to implementation planning - both in the EU and the USA. It is counterintuitive that financial markets remain unimpressed and do not hyperventilate when in the US year over year inflation is at 5% (one of the highest levels in 40 years) and the level of economic stimulus is at an unprecedented high level. The magic lies (once again) with the central banks. Their communication and information policy has been very successful in dissipating (legitimate) fears of inflation getting out of control. These fears had characterized the market dynamics in the first quarter.

Inflation and economic growth will normalize in the coming years

By now, the consensus is that the current acceleration in inflation is temporary in nature - a flash in the pan ignited after the painful contraction of 2020. Yes, there are resource bottlenecks in many areas, and that in turn is driving up prices. However, central banks are looking at things in a broader context and expect price inflation to normalize in the coming years. Economic growth will cool and interest rates will not rise significantly, with the first FED rate hike expected in late 2022/early 2023. The worrying spread of the Covid delta mutation is paradoxically good news from the perspective of inflation expectations, as it is able to dampen "excessive" economic growth somewhat.

Inflation expectations therefore declined in June. In parallel, nominal interest rates in most currencies with yield curve above zero (USD, AUD, CAD, GBP, NOK) have fallen the most for long maturities, while they have fallen less or even risen slightly for short and medium maturities. During the quarter, yield curves flattened, generating a positive performance. A different story for the CHF and EUR curves, which are both below zero. Both curves have moved upwards towards normalization and accordingly had a negative impact on the performance of CHF and EUR bonds.

Financial markets reach new historical high with declining risk indicators

The consensus reflects an ideal development of the economy, driving financial markets to new all-time highs. Risk indicators have continued to fall, not only the VIX but also historical volatility, credit and high yield spreads. While growth stocks (stocks with high sales and earnings growth) had lost ground in Q1 due to rising inflation and interest rate expectations, they experienced a renaissance in Q2 and led the broad market. Quality stocks (companies with high profitability and low debt) were also in high demand in Q2. The latter in particular shaped the Swiss equity market and gave it a strong performance.

After our risk-based equity strategies were able to keep up well with the market in Q1, they underperformed their respective benchmarks in Q2. Strongly positive markets, mainly driven by growth stocks, combined with declining risks provided an unfavorable environment for our investment approach.

Why should you invest in a risk-based strategy?

Risk is not about consensus, which is the expected outcome for the distribution of possible events. The current market consensus reflects, in historical context, very optimistic assumptions. Risk has to do with the distribution around the consensus. We cannot and do not predict the course of events. Nevertheless, we and many other investors recognize structural imbalances: high valuation, debt, central bank balance sheet, trade deficit, US/China power transition, and some more. All of this should be incentive enough to pay more attention to the left-hand side of the distribution - that is, the area where things can go wrong. If and when such events will occur is written in the stars. At the same time, we and our customers need to be aware that this ideal consensus can last for a long time and that the optimistic assumptions may turn out to be correct in the end. Patience and discipline remain the recipe for reaping the long-term benefits of a risk-based strategy.

OLZ CIO Carmine Orlacchio

Carmine Orlacchio

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